CH 16 DUE DILIGENCE, INVESTIGATION & FORENSIC AUDIT

MCQ--DD.3

FTA Renewables S.p.A, is based in Europe and has operations in renewable energy. The

company’s operations are spread out in many countries. The company is also looking for

various acquisitions.

VAS Private Limited is a company based in Pune having operations into solar energy. The

company’s management projected that its operations should increase significantly and it

should become one of the largest companies in the sector in the next five years on the basis

of the management plan. However, due to some unforeseen circumstances, the promoters of

the company are looking to sell their business.

FTA Renewables S.p.A (acquirer) is interested in acquisition of VAS Private Ltd (target) and

has started the discussions with the target company for the same.

The due diligence of the target company is in process and the reviewer has come up with

following observations so far:

(i) The target company has certain balances with its related companies which are under

reconciliation for long time.

(ii) The target company had certain demands in respect of taxation matters on which

the court has given a stay.

(iii) The target company has some assets which are carried in its books at more than

their current market value due to capitalization of foreign exchange loss as the same

was permitted in Indian GAAP.

(iv) The target company had two properties which were under litigation.

(v) The target company had given guarantees which were not appearing the financial

statements.

Reviewer needs your advise that which of the above mentioned observations should be

reported by him to the acquirer?

CNO-DD.060

• a) i, ii, iv and v.

• b) ii, iii, iv and v.

• c) i, ii, iii, iv and v.

• c) i, ii, iii, iv and v.

MCQ--DD.4

IMIR Inc is a major technology, engineering, manufacturing and financial services

conglomerate, with global operations having its registered office in US. The Company’s manufacturing footprint extends across eight countries in addition to US. It has several

international offices and a supply chain that extends around the globe.

HIN Private Limited is a medium-sized Fast Moving Electrical Goods (FMEG) company and

is also involved in power distribution equipment manufacturing. This company is based in

India and enjoys a good market share in a wide spectrum of products like Industrial &

Domestic Circuit Protection Devices, Cables & Wires, Fans, Commercial and Industrial

Applications.

IMIR Inc (Acquirer) is currently in talks to acquire HIN Pvt Ltd (Target). The initial price has

been agreed for the acquisition of business based on net worth and profitability of the target

company with an assumption that all contingent liabilities of the target impacting its future

business have been considered. The acquirer appointed a firm to carry out the financial due

diligence review of the target company and advised that the firm should strictly work as per

the scope.

The firm during the course of its review found some showcause notices (which have not

matured into demands) being issued against the target company. The firm also found that

there could be a potential high value labour claim which may arise out of the negotiation

which was ongoing between the target company and the labour union and the labour wage

agreement was already expired.

The firm discussed all these matters with the management of the target company. The target

company confirmed that these matters are under discussion and was confident that these

matters would not result into any liability and hence it did not consider the same in the initial

price. The firm after its discussion with the target reported these matters to the acquirer.

In the given situation, please suggest which one of the following should be correct?

CNO-DD.060

• a) In the given case, the initial price between the target and the acquirer is already set

  which includes the impact of contingent liabilities. Hence the above mentioned matters

  relating to showcause notice and labour claim should be ignored by the firm.

• b) In the given case, the initial price between the target and the acquirer is already set

  which includes the impact of contingent liabilities. However, since these matters have

  not been considered by the target company in the initial price, it would be appropriate

  to consider the impact of matter related to labour claim as that may result in liability in

  future but the matter related to showcause notice should be ignored by the firm.

• c) In the given case, the firm has gone beyond its scope of financial due diligence review.

  Financial due diligence review covers review of trading results, assets and liabilities

  and accounting policies and practices of the target company. The management of the

  target company should talk to acquirer so that the acquirer can ask the firm to limit its

  work as per the scope agreed.

• d) In the given case, even though the initial price between the target and the acquirer is

  already set but still the firm needs to look at any hidden liabilities which may arise in

  the two cases – show cause notices and labour claim. Accordingly, the firm has done

  the right thing by reporting these matters to the acquirer.

MCQ--DD.6

Karma Ltd got incorporated in 1980’s as a private limited company and started its business into two

segments – retail and construction. The two business activities were completely different but those

were managed very well and the company grew significantly over a period of time. In year 2001, the

company got converted into a public company and in 2008, the company also got listed on Bombay

Stock Exchange.

The turnover of the company was increasing, however, the margins were not increasing as per the

expectations of the management and the management analysed this aspect and realized that the

margins were not so high in case of retail segment.

The company decided to focus more on construction business and include infrastructure in its line

of business. This was also because of the fact that the government policies were favourable towards

this sector. For this the company decided to sell its retail segment in 2015.

The new investor for the retail segment carried out a due-diligence of the business involving various

aspects and the company sold this segment in January 2016.

Since the business of the company was infrastructure and it involved transactions with government

officials also, the management suspected certain suspicious transactions for which it decided to

carry out a forensic audit in the financial year 2016-17. Certain transactions were identified as per

this audit on which the management worked and set up certain new processes and stringent controls

so that the business can function in an efficient manner.

In the financial year ended 31 March 2019, an investigation was set up against the company which

impacted the company significantly in terms of its reputation and business. The company lost some

significant contracts during the process of investigation itself.

In the light of the above mentioned facts, you are required to comment on the following:

1. At the time of due diligence, the reviewer assessed the business feasibility also which

included the assessment whether business would be more beneficial at its current location or

not. The management of Karma Ltd did not understand this perspective. The management

argued that the reviewer should not have this assessment as part of his scope as the company

has been doing this business for many years at that location.

CNO-DD.060

• a) The contention of the management was correct.

• b) Reviewer was correct as due diligence covers assessment of business feasibility as

  well.

• c) Reviewer was correct as due diligence covers assessment of business feasibility as

  well, however, considering the company was doing this business for decades it should

  not have been carried out by the reviewer.

• d) Management was correct, however, the same thing should have been discussed with

  the investor as part of the sale contract.

MCQ--DD.7

The company has various litigations going on including those related to matter of taxation.

The company had taken consultations in respect of those litigations from some renowned

legal/ tax consultants. The reviewer for due diligence reviewed these consultation documents

and also asked for the documents related to these matters. Further he also suggested that

the positions taken by the company in some matters was not correct.

CNO-DD.060

• a) The reviewer needs to have independent assessment of legal/ tax cases and any

  outcome needs to be discussed with the management.

• b) The company can provide consultation documents but should not have provide any

  other document to the reviewer as those are confidential.

• c) The reviewer can review the consultation document but should ask for further details,

  if required.

• d) The company cannot provide documents of any other consultant to the reviewer.

  However, the documents related to cases can be shared with the reviewer.

MCQ--DD.8

The due diligence reviewer was given audited financial statement of the company for his

financial review. However, the reviewer asked for certain documents pertaining to the year

which was already audited by the statutory auditors of the company and the management of

the company declined this request.

CNO-DD.060

• a) The management is correct.

• b) Reviewer can ask for documents even for the period for which audit is completed.

• c) Reviewer can ask for documents for the period for which audit is completed but he

  cannot give any assessment on that. That can be given for his documentation purpose

  only as per the requirements of the auditing standards.

• d) Reviewer cannot ask for documents for the period for which audit is completed.

  However, if the same document is required for further period for which audit is not

  completed, then the management should give him that document.

MCQ--DD.11

AB Ltd. which is based in Mumbai, is in the business of manufacturing

leather products since 1995 and wants to acquire FC Leathers Private

Limited, which is based in Pune and engaged in the business of selling

leather products manufactured by different companies. Before

acquisition AB Ltd. wants to get a due diligence review to be done of FC

Leathers. AB Ltd. appointed S & S Associates for conducting overall due

diligence of FC Leathers. During the review the accountant asked FC

Leathers to provide financial projections of the company for next five

years, but FC leathers refused to provide the same and claimed that

financial projections is not a part of due diligence review.

Whether the objection raised by the management of FC Leathers is

correct? Give reason.

CNO-DD.020

• a) The objection raised by FC Leathers is correct, as due diligence

  doesn't include review of financial projections.

• b) The objection raised by FC Leathers is not correct, as due

  diligence refers to an examination of a potential investment to

  confirm all material facts of the prospective business which a

  company wants to acquire and financial projection is a part of

  same.

• c) The objection raised by FC Leathers is correct, as reviewer

  cannot comment on financial projections in his report.

• d) The objection raised by FC Leathers is not correct, as the target

  company cannot refuse in providing any information required by

  the reviewer.

MCQ--DD.16

JIN Ltd. which is based in Mumbai, is in the business of manufacturing leather products since 1995 and

wants to acquire OM Leathers Private Limited, which is based in Pune and engaged in the business of

selling leather products manufactured by different companies. Before acquisition JIN Ltd. wants to get

a due diligence review to be done of OM Leathers. JIN Ltd. appointed S & S Associates for conducting

overall due diligence of OM Leathers. During review, the accountant asked OM Leathers to provide

financial projections of the company for next five years, but OM leathers refused to provide the same

and claimed that financial projections are not part of due diligence review.

Whether the objection raised by the management of OM Leathers is correct? Give reason.

CNO-DD.020

• a) The objection raised by OM Leathers is correct, as due diligence doesn’t include review of financial

  projections.

• b) The objection raised by OM Leathers is not correct, as due diligence refers to an examination of a

  potential investment to confirm all material facts of the prospective business which a company

  wants to acquire and financial projection is a part of same.

• c) The objection raised by OM Leathers is correct, as reviewer cannot comment on financial

  projections in his report.

• d) The objection raised by OM Leathers is not correct, as the target company cannot refuse in

  providing any information required by the reviewer.

MCQ--DD.1

ARA & Associates is a partnership firm and has been in existence for the

last 15 years. The firm is engaged in consultancy business related to

various areas and has built a good name for itself over the period.

Some of the clients of the firm are very old who have been continuing

since its existence. The business of the firm has gone through various

phases some of them were very bad. But currently the business is going

very well and the firm is looking to expand its operations into different

geographies. For this, the firm's management decided that some of its

senior partners will move to new offices and new partners would be

inducted. A team of new partners is in discussion with some of the senior partners,

regarding their joining the firm. The new partners would be interested to know whether the terms

offered to them are reasonable having regard to the nature of the

business, profit records, capital distribution, personal capacity of the existing partners, socio-economic setting etc. and whether they would be able to derive continuing benefits in the form of return on capital to be contributed and remuneration of services to be offered. In addition, they also want to ascertain whether the capital to be contributed by them would be safe and applied usefully or not.

For this purpose, an investigation of the business of the firm was set up

on behalf of these new partners.

At the time of scrutiny of the record of profitability of the firm's business,

the investigating accountant picked up records of last 4-5 years wherein

he observed that the profits for 2 years were highly erratic and

fluctuating. The investigating accountant, therefore, investigated the

profits of last 7-8 years to iron out the fluctuation. He also examined

the provisions of the partnership deed particularly the composition of

partners, their capital contribution, drawing rights, retirement benefits

and goodwill. He also asked for details of jobs/ contracts in hand and

the range of current clientele of the firm, for his examination. Some of

these procedures of the investigating accountant were not found

appropriate by the senior partners of the firm and they advised the

investigating accountant not to go beyond his scope.

Please advise which of the above-mentioned procedures of investigating

accountant is/are not appropriate and what improvements/ changes are

required in his approach.

• a) The investigating accountant should not have asked for the

  records of the profits of last 7-8 years, as that would be too much

  of the information for his review. Also, the details of jobs/

  contracts in hand and the range of current clientele of the firm

  are confidential and hence does not get covered in his scope.

• b) After finding 2 years which were unusual because the profits

  during those 2 years were highly erratic and fluctuating, the

  investigating accountant should have reported the matter to the

  new partners instead of asking for more details related to the

  profits of last 7-8 years. Also, he is not required to examine the

  provisions of the partnership deed as these details would have already been discussed with the new partners and they would

  have checked that.

• c) The procedures of the investigating accountant look completely

  reasonable considering his scope of work. Further, no changes

  are required in his work approach.

• d) At the outset, it can be said that investigation in the given case

  was not required. However, even if the new partners decided to

  carry out the investigation it should have been limited to mainly

  inquiry procedures by the investigating accountant. The

  investigating accountant could have also reviewed the manner of

  computation of goodwill which doesn't seem to have been

  performed on the basis of the above-mentioned facts.

MCQ--DD.2

At the time of investigation, the investigation officer asked for the information of financials for

the last 5-7 years.

The management explained that there was no need for this investigation. Further the

company has gone through the processes of due diligence and forensic audit in the past. Also

the financial statements related to the period prior to investigation are audited and hence

cannot be shared.

CNO-INTG.040

• a) Since the company went through audit process related to period prior to investigation,

  investigation should not have been set up.

• b) Since the company went through processes of due diligence in the past, investigation

  cannot be set up.

• c) Since the company went through processes of forensic audit in the past, investigation

  cannot be set up.

• d) The contention of the management is not correct.

MCQ--DD.10

ZARI & Associates is a partnership firm and has been in existence for the last 15 years. The firm is engaged in consultancy business related to various areas and has built a good name for itself over the period.

Some of the clients of the firm are very old who have been continuing since its existence. The business of the firm has gone through various phases some of them were very bad. But currently the business is going very well and the firm is looking to expand its operations into different geographies. For this, the firm’s management decided that some of its senior partners will move to new offices and new partners would be inducted.

A team of new partners is in discussion with the senior old partners regarding their joining the firm.

The new partners would be interested to know whether the terms offered to them are reasonable having regard to the nature of the business, profit records, capital distribution, personal capacity of the existing partners, socio-economic setting etc. and whether they would be able to derive continuing benefits in the shape of return of capital to be contributed and remuneration of services to be offered. In addition, they also want to ascertain whether the capital to be contributed by them would be safe and applied usefully or not.

For this purpose, an investigation of the business of the firm was set up on behalf of these new partners.

At the time of scrutiny of the record of profitability of the firm’s business, the investigating accountant picked up records of last 4-5 years wherein he observed 2 years which were unusual because the profits during those 2 years were highly erratic and fluctuating. The investigating accountant, therefore, went into the profits of last 7-8 years to iron out the fluctuation. He also examined the provisions of the partnership deed particularly the composition of partners, their capital contribution, drawing rights, retirement benefits and goodwill. He also asked for details of jobs/ contracts in hand and the range of current clientele of the firm for his examination. Some of these procedures of the investigating accountant were not found appropriate by the senior partners of the firm and they advised the investigating accountant not to go beyond his scope. In the given situation, which of the following is correct:

CNO-INTG.040

• a) The investigating accountant should not have asked for the records of the profits of last 7-8 years as that would be too much of the information for his review. Also the details of jobs/ contracts in hand and the range of current clientele of the firm are confidential and hence does not get covered in his scope.

• b) After finding 2 years which were unusual because the profits during those 2 years were highly erratic and fluctuating, the investigating accountant should have reported the matter to the new partners instead of asking for more details related to the profits of last 7-8 years. Also he is not required to examine the provisions of the partnership deed as these details would have already been discussed with the new partners and they would have checked that.

• c) The procedures of the investigating accountant looks completely reasonable considering his scope of work. Further, no changes are required in his work approach.

• d) At the outset, it can be said that investigation in the given case was not required. However, even if the new partners decided to carry out the investigation it should have been limited to mainly inquiry procedures by the investigating accountant. The investigating accountant could have also reviewed the manner of computation of goodwill which doesn’t seem to have been performed on the basis of the above mentioned facts.