Financial due diligence (FDD) is the examination of a target company's financial information before a transaction closes. The buyer wants to know whether the earnings are real, whether the business needs more working capital than the price assumes, and what obligations behave like debt. A CPA firm doing FDD produces a report that supports price, structure and the purchase agreement.
This guide gives a request list organized by area, the core analyses, a worked example with the arithmetic, a report outline and a note on standards. The quality of earnings piece is covered in more detail in the quality of earnings guide; this page is the working checklist around it.
Scope and standards
FDD scope is set with the client. A typical buy-side scope covers:
- quality of earnings and adjusted EBITDA;
- net working capital and the proposed peg;
- net debt and debt-like items;
- cash proof and quality of cash;
- revenue, customers, margins and cost structure;
- payroll and benefits;
- capital expenditures and fixed assets;
- accounting policies and the basis of preparation.
Tax diligence and legal diligence are usually separate workstreams, and the report should say what is excluded.
A firm commonly performs FDD as a consulting engagement under the AICPA Statement on Standards for Consulting Services (CS section 100). If the client wants an attest engagement, it can be structured as agreed-upon procedures under AT-C 215; see agreed-upon procedures. The engagement letter should fix the scope, the limits on reliance, who may use the report and the data cut-off date. If the firm audits the target or the buyer, consider independence before accepting. See independence and nonattest services for small firms.
Request list
Send the list early and track items by owner and date.
Financial statements and accounting
- Audited, reviewed or compiled financial statements for the last three years and the year to date.
- Monthly trial balances and general ledger detail for the same periods.
- Management accounts and any board reporting packs.
- Accounting policies and any changes in the period.
- Chart of accounts and mapping to the statements.
- Reconciliation of the financial statements to tax returns.
- Prior auditor or accountant management letters.
Revenue and customers
- Revenue by customer, product and month.
- Top 20 customers with contracts and terms.
- Backlog, deferred revenue and contract liability rollforwards.
- Credit memos, returns and rebates.
- Customer concentration and any customers lost or at risk.
Costs, payroll and margins
- Cost of goods sold detail and standard cost reports.
- Payroll registers and headcount by month, including owner compensation.
- Commissions, bonuses and benefit plans.
- Related-party transactions and arrangements, including leases.
- Nonrecurring items identified by management.
Working capital and cash
- Monthly balance sheets with receivable and payable agings.
- Inventory listings, costing method and reserves.
- Bank statements and bank reconciliations for all accounts.
- Customer deposits, accrued liabilities and prepaid expense schedules.
- Cutoff procedures and year-end close process.
Debt and other obligations
- Debt agreements, covenants and compliance certificates.
- Lease agreements and commitments.
- Contingent liabilities, litigation and warranty claims.
- Unpaid taxes, deferred compensation, accrued bonuses and vacation.
- Guarantees and off-balance-sheet arrangements.
Capital expenditures and fixed assets
- Fixed asset register and capex by month.
- Capitalization policy and recent additions.
- Maintenance spending versus the asset base.
Core analyses
Adjusted EBITDA bridge
Illustrative example. Reported net income is 600,000. Interest is 80,000, income taxes 150,000, and depreciation and amortization 170,000.
Reported EBITDA = 600,000 + 80,000 + 150,000 + 170,000 = 1,000,000.
| Adjustment | Amount | Reason |
|---|---|---|
| Owner compensation above market | +120,000 | Owner paid 300,000; market replacement cost 180,000 |
| Litigation settlement | +60,000 | Nonrecurring |
| Related-party rent below market | -48,000 | Lease at below-market rent will reset on closing |
| Unrecorded bonus accrual | -30,000 | Earned but not accrued |
| Adjusted EBITDA | 1,102,000 | 1,000,000 + 120,000 + 60,000 - 48,000 - 30,000 |
Every adjustment needs support: documents, a market comparison or a calculation. Adjustments that cannot be supported are listed separately as management's proposals. See adjusted EBITDA.
Net working capital and the peg
Net working capital for deal purposes is usually current assets excluding cash, less current liabilities excluding debt and debt-like items. The peg is the level the business needs, normally set from a trailing average. The purchase price is adjusted at closing for the difference between the closing working capital and the peg.
Illustrative monthly working capital for the trailing six months, in thousands: 410, 425, 440, 455, 430, 420. The sum is 410 + 425 + 440 + 455 + 430 + 420 = 2,580, so the average is 2,580 / 6 = 430. The peg is 430,000.
If closing working capital is 405,000, the shortfall is 430,000 - 405,000 = 25,000, and the price drops by 25,000 under the typical mechanism. If seasonality is material, a trailing 12-month average or a seasonal peg is more appropriate, and the choice is negotiated.
Net debt and debt-like items
Net debt is debt plus items that behave like debt, less cash. Candidates for debt-like treatment include accrued bonuses, deferred compensation, unpaid income taxes, customer deposits received for work not yet performed, deferred rent, capital lease obligations, and unpaid transaction costs. Whether an item is debt-like is a negotiated term; the report presents the facts and the amounts.
Proof of cash
A proof of cash reconciles receipts and disbursements per bank to the books by month. Gaps in the proof point to unrecorded transactions or revenue that did not reach the bank. See proof of cash.
Report outline
- Executive summary: headline findings, adjusted EBITDA, working capital peg, debt-like items, key risks.
- Scope, sources and limitations: what was reviewed, the data cut-off, who may rely on the report.
- Basis of preparation: accounting policies and quality of the financial information, including whether the statements are audited.
- Quality of earnings: reported to adjusted EBITDA bridge by period, with adjustments described and supported.
- Revenue and margin analysis: customers, products, pricing and trends.
- Operating costs and payroll.
- Net working capital: monthly history, definition, peg and seasonality.
- Net debt and debt-like items.
- Cash flow and capital expenditures.
- Other matters: related parties, contingencies, subsequent events, systems.
- Appendices: supporting schedules, reconciliations and the information request list.
Common mistakes
- Accepting management's adjustments without support.
- Setting a working capital peg from a single month or ignoring seasonality.
- Treating cash on the balance sheet as freely available without testing restrictions and cutoff.
- Missing debt-like items in accruals, deposits and deferred compensation.
- Failing to reconcile the management accounts to the audited or tax figures.
- A report that does not say what was not covered.
FAQ
What is financial due diligence?
A review of a target's financial information before a transaction, covering earnings quality, working capital, debt-like items and cash.
How is FDD different from an audit?
An audit gives an opinion on the financial statements under GAAS. FDD analyzes earnings and balances for a deal, usually under consulting standards, with no opinion.
What is a working capital peg?
A target level of working capital that the business needs to operate. Closing working capital above or below it adjusts the price.
What is a debt-like item?
An obligation that a buyer treats as debt in the price calculation, such as accrued bonuses, deferred compensation or unpaid taxes.
Is a quality of earnings report the same as financial due diligence?
Quality of earnings is the core of financial due diligence. The full scope also covers net working capital, net debt, cash, capital expenditures and accounting policies.
Sources
- AICPA, Statement on Standards for Consulting Services No. 1 (CS section 100), Consulting Services: Definitions and Standards
- AICPA, AT-C section 215, Agreed-Upon Procedures Engagements
- AICPA, Code of Professional Conduct, independence and nonattest services (ET 1.200 and 1.295)
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error