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In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.
Classic financial due diligence (FDD) attempts to explain reliable results in a way that satisfactorily resolves existing information asymmetries. However, the degree of reliability of financial figures depends on whether an audit or less complex tests have been performed. We will discuss here the differences between audit, review, agreed-upon procedures (AUP) and compilation.
An audit provides reasonable assurance about whether the financial statements are free from material misstatement. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit will always detect a material misstatement when it exists.
The procedures selected depend on the auditor’s professional judgment, including the auditor's assessment of the risks of material misstatement. In making those risk assessments, the auditor obtains an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances. However, the auditor does not issue an audit opinion on the effectiveness of the entity's internal control. This would require a separate, different type of audit.Furthermore, the audit of financial statements includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by the legal representatives, as well as evaluating the overall presentation of the financial statements. Explicit conclusions are also drawn about the appropriateness of management’s use of the going concern basis of accounting. If there is significant doubt on the entity's ability to continue as a going concern, the auditor is required to draw attention in the auditor's report to the related disclosures in the financial statements or, if such disclosures are inadequate, to modify the opinion.
The audit is conducted either in accordance with the International Standards on Auditing (ISA) or relevant local auditing standards. The report, including the opinion, is issued in the form of an "Independent Auditors' Report".
A review provides a certain level of assurance that the financial statements do not require any major adjustments (conclusion on the financial statements). A review includes primarily making inquiries among personnel and performing plausibility checks of financial data. Typical audit procedures, such as observation or obtaining confirmations, are not performed here.
The procedures are carried out in line with the International Standard on Review Engagements (ISRE) 2400 or a corresponding local standard. The report is issued in the form of an "Independent Practitioners’ Review Report".
Agreed-upon Procedures (AUP) are tests of certain selected areas of the balance sheet and/or income statement. Here, individually agreed-upon procedures, such as target/actual comparisons, recon-ciliations and confirmations are carried out and any deviations identified are presented. No assurance is expressed here. Instead, users of the report draw their own conclusions from any inconsistencies. Professional AUPs are carried out in line with International Standard on Related Services (ISRS) 4400 or a corresponding local standard. The report is issued in the form of a so-called “Independent Practitioners‘ Report” (on Applying Agreed-upon Procedures) or “Report on Factual Findings”.
A so-called compilation is a presentation of information and data by the management in the form of the preparation of financial statements. It essentially includes summarising financial information after any accrual/deferral postings. No tests are carried out in this case. Thus, there are no inconsistencies and no opinion or conclusion is expressed. In contrast to the options presented above, independence of the accountant is not a requirement for a compilation engagement.
Financial statements are prepared in line with International Standard on Related Services (ISRS) 4410 or a corresponding local standard. The report is issued in the form of a so-called “Practitioners’ Compilation Report”.
In summary, there are various types of how financial statements can be dealt with, depending on the level of control:
In the case of unaudited financial statements or financial statements that have been audited by a local auditor but where the level of examination cannot be assessed, it is recommended to modify an FDD so that it primarily focuses on the reliability of the figures.
Roger Haynaly
Partner
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Transaction advisory | Mergers & Acquisitions
