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Financial Review Checklist On a Due Diligence Process



In its simplest form, due diligence represents the stage during which “everything is bared” between the parties. You need to make available all accounting, financial, operational, customer, marketing strategies, vendor, legal, intellectual property, employee, and/or just about any other piece of vital company data to the acquiring party to examine and review. The following checklist are an all inclusive financial review action list carried on due diligence process of a business acquisition.



General Financial Review

  • Obtain these financial data for the last three years: balance sheets; statements of income and retained earnings; statements of cash flows.
  • Review the financial statements and notes, noting the type of audit report and whether there are any unusual or significant footnote disclosures.
  • Describe the accounting principles employed by the company and the methods of applying those principles. Consider whether they are consistent with other companies within the industry. Your description should generally be more detailed than the information contained in the footnotes to financial statements. It should highlight differences in accounting principles employed by the buyer and seller, particularly where accounting determinations may have an effect on the transaction price.
  • Determine whether there have been any changes in the application of accounting principles or methods that could make comparisons of historical financial statements more difficult. Highlight the effects on financial trends during the most recent three years caused by changes in accounting principles or methods.
  • If the company has engaged a public accounting firm, arrange to review its work papers, paying particular attention to memoranda on accounting issues and legal matters and evaluations of internal accounting controls.
  • Review the reports of outside specialists (e.g., actuaries, financial consultants, etc.) used by the company for their potential effect on financial matters.
  • In connection with your review of the company, you should gain an understanding of the significant elements of the company’s system of internal accounting controls. You should identify the key controls by discussion, inquiry and observation.



Cash Review

  • Obtain summary of banking relationships and a schedule of monthly bank balances during the year. Note trends during the year. Describe the company’s policy regarding the investment of idle balances.
  • Review bank account reconciliations and obtain explanations for unusual reconciling items or reconciling items that have not been resolved on a current basis.
  • Describe the company’s banking arrangements. In particular, review any restrictions on cash balances, compensating balance agreements, and line of credit arrangements. Do banking arrangements appear adequate based on the company’s cash requirements?
  • Inquire whether there were any unusual receipts, such as settling insurance claims or other recoveries. Review the company’s cash management system (forecasting, budgeting, etc.) and the attendant controls.
  • Marketable securities. Obtain a schedule of marketable securities, separated into current and noncurrent categories, and list original cost, date purchased, interest rate, maturity date, current basis of recording, and current market value.



Accounts Receivable  Review

  • Obtain a reconciliation of the detailed accounts receivable records to general ledger control accounts and obtain explanations of unusual reconciling items.
  • Describe the company’s credit system. Indicate current credit policies and normal special trade terms (particularly deferred payment terms or agreements to accept returns of goods). Note changes during the past three years in standard credit terms. Compare with customary credit terms in the industry.
  • Obtain an accounts receivable aging as of the most recent date possible and for the same date in the prior year. Also obtain a schedule of significant individual account balances. Discuss with management any large or overdue accounts.
  • Obtain a summary of all accounts in dispute or in process of legal collection.
  • Review the adequacy of the allowance for doubtful accounts, giving consideration to the current accounts receivable aging, the actual write-off experience during the past three years, and receivables collected subsequent to the balance sheet date. Inquire as to the methods used by the company to establish the allowance for doubtful accounts.
  • Obtain a schedule of the number of days sales in accounts receivable for each month-end during the past three years. If the company does not use the last in, first out (LIFO) basis to calculate days sales outstanding (DSO), consider the appropriateness of the methodology used in light of the sales cycle.
  • Inquire as to unusual increases or decreases in the accounts receivable balances during the periods under review.
  • Obtain a summary of accounts factored or hypothecated, the attendant costs, and whether the accounts were sold with or without recourse.
  • Inquire as to company’s policy for obtaining proper sales cutoffs.
  • If the company charges interest on past due accounts, inquire as to compliance with the Truth-In-Lending Act.


Inventory Review

  • Obtain an inventory summary by major product lines (or major product) for the current and prior year. Such a summary should show separately raw materials, work in progress, and finished goods.
  • Obtain a recap of the latest physical inventory by major product line (or major product) that shows a comparison of physical inventory results with book amounts. Obtain a list of book-to-physical adjustments for the past three years and obtain explanations of significant book-to-physical adjustments.
  • Inquire whether inventory consigned is excluded from the latest inventory listing and whether all owned inventory, including the inventory stored off company premises (warehouses, consignees, processors, etc.) is included. Also inquire as to the pledged or hypothecated inventory.
  • Describe the company’s policy for providing for obsolete and slow-moving inventory. Obtain a summary of obsolescence write-offs and provisions for slow-moving inventory for the past three years. Relate this step to discussions with marketing and production personnel.
  • Describe the company’s method of inventory control. Note how production schedules are coordinated with inventory levels and sales requirements.
  • Review the company’s cost system, paying particular attention to: whether standards are based on sufficiently detailed method studies, standards are developed (and actual cost accumulated) in a manner that enables determination of variances, how often standards are updated to approximate actual, how often overhead rates are reviewed, and the types of costs included in overhead, the percentage relationship among labor, material, and overhead, whether the cost system is used as an effective management control tool or whether it is used only for financial reporting purposes, bbtain a schedule of inventory turnover rates and gross profit percentages by product line (or major product) for the past three years. If possible, compare to similar businesses within Thomson and/or industry data.
  • Physically observe the general condition and quality of the inventory.
  • Ascertain whether inventories are stated at the lower of cost or market, and describe the methods used by the company in making these calculations. Particular attention should be paid to products or product lines with low gross profit rates.
  • Obtain a schedule of major differences between the book and tax basis of inventories.
  • If inventories are determined on the LIFO basis, obtain a schedule summarizing the individual layers as of the review date and changes during the past three years. Outline the effect of any liquidations. Discuss with tax department whether acquiree appears to be complying with Internal Revenue Service LIFO regulations relating to method of computing LIFO.



Property, Plant, And Equipment Review

  • Obtain a summary of property, plant, and equipment and accumulated depreciation broken down into category totals (e.g., land, buildings, equipment, etc.) for the past three years. Show beginning balances, additions (or provisions), retirements, and ending balances. Inquire as to significant fluctuations.
  • Obtain a current listing of each major owned facility showing location, original cost, age, and current book value. The listing should also provide the method and rate of depreciation.
  • Inquire as to replacement values of owned facilities. Review recent tax assessments and insurance appraisals, if any (indicate dates and methods of appraisals).
  • Obtain a listing of leased facilities showing locations, annual rentals, expiration dates, renewal options, ownership, and age. Note the accounting treatment of each lease: Review terms of significant leased facilities. Consider the effect of the renewal terms. For leases about to expire, consider what the new rentals will be by reviewing current rents for similar facilities. Consider the effects of new rental terms on future financial results.
  • Obtain a listing of all major owned equipment that provides location, original cost, age, current book value, and replacement value as well as the method and rate of depreciation.
  • Obtain a listing of all major leased equipment that provides location, annual rental, expiration date, renewal options, ownership, and age. For leases about to expire, consider the effects of new rental terms on future financial results. Note the accounting treatment of each significant group of leased equipment. Review company policy regarding capitalization of leases.
  • Review company policy regarding repairs versus capital expenditures for both facilities and equipment.
  • Review the cost of maintenance and repairs of major facilities and equipment for the past three years. Investigate significant fluctuations.
  • Inquire as to whether any plant or equipment has become obsolete and should either be written off or have its useful life shortened.
  • Physically inspect property, plant, and equipment for its general condition and age and note equipment that does not appear to be in use. Note any evidence of obsolescence, such as partial replacement of a group of machines, few purchases of equipment in recent years, technological changes, machines with substantial idle time, proposed purchases, and so on.
  • Review company’s method of physically identifying specific fixed assets and review the latest inventory of fixed assets.
  • Review the company’s depreciation methods and rates.
  • Review company controls over capital asset appropriations and dispositions.
  • Obtain a schedule providing the differences between the book and tax basis of property, plant, and equipment
  • Inquire as to costs expected to be incurred for existing plant and equipment to comply with governmental regulations (e.g., Environmental Protection Regulations and the Occupational Safety and Hazards Act).



Review Of Prepaid Expenses, Deferred Charges, And Other Assets

  • Obtain a schedule of major prepaid expenses, deferred charges, and other assets. Review the method and period of amortization or write-off. Inquire as to the appropriateness of these accounts and propriety of the write-off period.
  • If key-person life insurance is recorded, ascertain that the company is the owner and beneficiary of the policy and that the cash surrender value is properly recorded as an asset. Obtain listing of any borrowings against loan values of the policies.
  • Review the propriety of classification of prepaid expenses, deferred charges, and other assets as current or noncurrent assets.


Long-Term Investments Review

  • Obtain a schedule of long-term investments showing the name, percentage of ownership, original cost, basis at which stated, and current market value.
  • Determine that the method of valuation (equity versus cost) is proper as well as the method of recording income thereon.
  • Obtain a schedule of all advances to affiliates or unconsolidated subsidiaries. Review the underlying financial, tax, and/or operating factors that gave rise to the balances that exist.
  • Determine whether the tax basis of investments is substantially different from the book basis.
  • Obtain a schedule of dividend and interest income related to investments.



Intangible Assets Review

  • Obtain a schedule of intangible assets showing the book basis and amortization policy.
  • Ascertain the reasonableness of continuing value.


Current Liabilities Review [Other Than Income Taxes]

  • Obtain a schedule of major current liabilities by category (trade payables, notes payables, accrued liabilities, etc.). Determine that their status as current is proper.
  • Obtain a reconciliation of detailed accounts payable records to general ledger control account and obtain explanations for unusual reconciling items and reconciling items that are not resolved on a current basis.
  • Inquire as to normal trade terms of accounts payable and special trade terms. Obtain a summary of discounts taken or lost during the past three years. Review the trend in days payables outstanding (DPO) statistics.
  • Ensure that trade payables, notes payable, and accrued liabilities include all material items: (1) Accrued salaries, wages, vacation pay, commissions and bonuses, and related payroll taxes, (2) Amounts withheld from employees, (3) Unemployment and workers’ compensation liabilities, (4) Customer advances or credit balances, (5) Dividends declared/unclaimed dividends, (6) Advances from officers, employees, and others (7) Judgments, damages, and other claims, (8) Retrospective insurance adjustments for open policy years (may also indicate potential payments to the company), (9) Interest payable, (10) Provision for warranties, (11) Accrued taxes [other than on income], (11) Reserves for adjustments on renegotiable government contracts, (12) Pension and profit-sharing plan obligations.
  • Identify any accrued liabilities (at the closing date) that require actual payment in order to be deductible for income tax purposes (e.g., if accrued salaries are not paid within two and a half months after year-end, there is no tax deduction in the year accrued).
  • Inquire as to company’s policy for obtaining proper receiving cutoffs. Obtain a listing of open or unmatched receiving reports at the beginning and end of period and inquire as to treatment.
  • Consider whether a search for unrecorded liabilities is necessary. If so, pay particular attention to accounting conventions whereby the last month’s recurring payables (e.g., rents, property taxes, and utilities) are recorded in the subsequent accounting period.
  • Ascertain that the short-term portion of long-term debt is appropriately included in current liabilities.
  • Obtain schedules of notes payable for each quarter during the past three years, including security description, ending balance, interest rate, maturity date and other pertinent terms. Also, note minimum and maximum borrowings in each year. Read and abstract note agreements.
  • Briefly outline the company’s short-term financing methods. Inquire as to any restrictive terms or other significant terms. Obtain agreements for significant borrowings. Inquire as to conditions that may result in the withdrawal of commitments for unused lines of credit.


Deferred Revenue Review

  • Analyze the deferred revenue balance for the last three years, in light of the billing cycle and renewal trends for subscription products. Investigate any unusual variances.
  • Develop an estimate of the cost to fulfill the obligations represented by deferred revenue.
    Income Taxes Review
  • Review the general corporate information (e.g., state of incorporation, corporate status, and capitalization structure). Identify which jurisdictions and what returns the company should be filing.
  • Determine the company’s tax accounting methods (e.g., cash or accrual, FIFO or LIFO, etc.) and the tax elections in effect (e.g., Sub S corporation, deferred subscription revenue, etc.).
  • Ascertain and schedule the type, amount, and year of expiration of available tax carryovers (e.g., net operating losses, net capital losses, foreign, general business, and corporate minimum tax credits, charitable contributions, etc.).
  • Review federal, state, and local tax returns (income, property, sales and use, employment, excise, etc.) for the last three years. Note whether and where consolidated returns are filed. Determine whether all compliance requirements have been properly and timely met. Indicate which years are still open.
  • Determine the status of federal, state, and local tax audits. Review any revenue agent reports issued in the last three years. Indicate on a separate schedule the nature and amount of any deficiencies identified. Describe the issue and status of any current disputes with the IRS or other tax authorities.
  • Review the company’s operations and underlying documents to determine whether there are any tax exposures that could affect the company as the buyer (e.g., improper expensing of capitalizable expenditures, overvaluation or other §6662 [substantial valuation misstatement provisions covering corporations] exposures; intermingling of business and personal expenses; etc.).
  • Schedule major differences between book and tax income for the years under review, and determine whether any of the differences result from questionable tax accounting practices. Review classification of deferred tax debits and credits and determine whether they are current or noncurrent. Review Schedule M timing and permanent differences, and describe and analyze any significant tax cushion or un-provided-for tax risks.
  • Review the purchase agreement and other documents and summarize the tax effects of the proposed transaction. Additionally, consider: (1) Tax planning opportunities, (2) Whether it is advisable for the company to obtain an advance tax ruling on the proposed transaction, (3) The potential exposure to the target company with respect to joint and several liability for the selling group’s federal taxes, (4) Whether there is exposure for failure to file income tax returns in states where nexus exists, (5) The company’s exposure to sales and use taxes, (6) The possibility of unusual compensation issues, (7) Unusual or innovative tax planning techniques the company has employed in past years, and their continued viability.
  • Obtain a summary of property taxes for the past three years. Inquire as to any significant increases noted, and inquire whether any significant increases in property taxes are expected.



Long-Term Debt Review

  • Obtain a schedule of long-term debt, which includes security description, principal amount, interest rate, advance payment privileges or penalties, late payment penalties, renewal and conversion privileges, sinking fund requirements, and principal repayment terms.
  • Review indentures and describe major restrictive covenants such as on working capital, dividends, reorganizations, and the like. Ascertain whether debt is callable based on a general provision, such as a material adverse change. Inquire of legal counsel whether the company is in compliance with restrictive covenants. If the company has defaulted, determine whether such default has been cured and whether the applicable penalties were satisfied or waived.
  • Inquire of legal counsel whether the impending transaction would, if executed, constitute an event of default. Inquire whether the debt would become callable or otherwise subject to renegotiation.
  • Review the relative significance of short- and long-term debt in the company’s current capital structure. Inquire as to unused lines of credit and planned future borrowing requirements, both short and long term.



Contingent Liabilities Review

Inquire whether there are any contingent liabilities outstanding. Obtain a description of any major contingencies identified. Specifically, investigate:  (1) Threatened litigation pending tax matters, (2) Liabilities arising out of regulatory investigations, allegations based on liable or erroneous or omitted data, obligations relating to warranties and product defects, (3) Collectibility of receivables, (4) Agreements to repurchase receivables sold, (5) Debt guarantees on behalf of unconsolidated and/or unaffiliated entities, (6) Price redeterminations and terminations under government contracts


Commitments Review

Obtain a summary of major outstanding commitments, for example: (1) Commitments for fixed asset purchases, (2) Fixed quantity purchase commitments for paper and other raw materials or services (e.g., printing, mastering, keying, etc.), (3) Advertising campaigns and promotional services, (4) Physical plant or building construction, (5) Forward foreign exchange transactions, (6) Long-term purchase and sales agreements, employment contracts, (7) Pension and profit-sharing and similar plans, (8) Postemployment retirement health and welfare benefits.



Leases, Franchise, And Royalty Agreements Review

  • Obtain a summary of leases (coordinate with work performed on Property, Plant and Equipment [PP&E]) where the company is either lessee or lessor. Summarize significant aspects of the agreements (e.g., terms, minimum rentals, contingent rental arrangements, cancellability, assignability, renewal or purchase options, and escalation clauses). Also, inquire as to sale and leaseback arrangements.
  • Inquire as to the assignability or transferability of lease agreements in the event of transaction. Also, inquire as to escalation or renegotiation clauses, as appropriate.
  • Obtain a summary of franchise and/or royalty agreements, and describe significant terms of such agreements. Relate royalty agreements to major products and list royalty payments/receipts in each of the last three years. If royalty or franchise agreements are significant to the ongoing business, inquire whether agreements are cancellable if the proposed transaction takes place.


Capital Stock Reviw

  • Obtain a summary of all stockholder equity accounts indicating legal title of security, par or stated value, shares authorized, shares outstanding, liquidating preferences, dividends in arrears, participating rights, dividend preferences, sinking fund requirements, conversion privileges, dividend rate, and whether dividends are cumulative.
  • Obtain a listing of major shareholders of each type of equity security.
  • Schedule activity in paid-in capital and retained earnings accounts for the past three years. Review adjustments for items that should have been reflected in the income statement.
  • Schedule transactions in treasury stock; identify the objectives and reasons for treasury stock transactions. Inquire as to what method of valuation is used (cost or constructive retirement).
  • Obtain a schedule of cash and stock dividends and stock splits for the past three years, and review the appropriateness of their accounting treatments. Confirm that all such transactions have been authorized by the board and documented in the board of director meeting minutes.
  • Inquire whether there are any restrictions on retained earnings.
  • Obtain a summary of activity during the past three years relating to stock options, the stock purchase plan, stock warrants, or any other rights to purchase stock. Read the pertinent plans and agreements and consider what the status of these plans, warrants, and rights will be at the transaction date.



Income Statement Accounts Review

  • Obtain explanations for significant fluctuations in the income statements for the last three years. Captions such as cost of goods sold and selling and general and administrative expenses should be supported by detailed analysis.
  • Identify nonrecurring, extraordinary, or unusual items included in profit and loss.
  • Obtain an analysis of product or product line profitability (i.e., sales, cost of sales and direct selling, general and administrative expenses). Analyze gross profit percentages. Compare sales trends of product lines.
  • Schedule sales to the company’s largest customers, affiliated companies, and other related parties for the last three years. For affiliates and other related parties, inquire whether sales were made at arm’s-length prices. For individual customers who represent a significant volume of sales, evaluate their current financial status.
  • Also, for individually significant customers, coordinate with those Thomson individuals reviewing marketing to identify how these customers are treated/handled differently, if at all, and what the current status of the company’s relationship with these customers is.
  • Review major long-term contracts (including government contracts; determine the method of income recognition). Inquire as to methods used by the company to monitor the status of long term contracts and whether work in process will be completed at a normal profit margin.
  • Identify the company’s policy with regard to sales returns and allowances and what the applicable accounting policies are. Schedule sales returns and allowances by product line (or major product) and customer. If significant returns and allowances are noted for a particular product line, identify the underlying reason. Consider the implication on matters such as the timing of the recognition of sales, adequacy of reserves, company’s quality control and research and development efforts, and so on.
  • Obtain an analysis and understanding of key financial and operating statistics for the last three years and projected three-year period. In addition to classic accounting and investment ratios, examine those statistics that are fundamental to business’s economics, for example: (1) Market growth/share renewal rates, (2) Price, (3) Real versus inflationary growth, (4) Shifts in product mix and profitability, (5) Revenue per customer, (6) Revenue per sales representative, (7) Sales and marketing as a percentage of sales, (8) Other functional costs as a percentage of sales lead time required to ramp-up to the next level of sales activity, (9) Fixed versus variable costs (from an economic perspective), (10) Average compensation, (11) Headcount distribution, (12) Operating income per employee.
  • Analyze “other income and expense” accounts. Identify separately recurring and nonrecurring items.
  • Estimate increases or decreases in major income or expense categories post transaction. Consider, for example, the effect of including the acquired company’s employees under the acquiring company’s profit-sharing and pension plans; operating efficiencies due to the combination of similar departments or sale of duplicate facilities; and so on.



Budgeted And Forecasted Data Review

  • Obtain a description of the company’s budgeting system, and discuss sources of budget input data and budgeting system controls. It is important to determine whether budget is a bottom up budget created by operating units or a top-down budget produced by senior management.
  • Review prior years’ budgets and compare budgeted to actual results.
  • Discuss with management the basis of key assumptions, particularly where assumptions differ from recent trends.
  • Identify the company’s business cycle and sensitivity to general economic trends.



Financial Information System Review

  • Identify, flowchart, and describe all systems: (1) Transaction sales support and customer information, (2) Order entry and fulfillment, (3) Product development and delivery, (4) Work flow and other infrastructure, (5) Communications.
  • Evaluate the adequacy of the system of controls (e.g., segregation of duties, input, processing, access and documentation controls, physical security, and system development and modification procedures). Provide headcount by function.
  • Indicate whether such systems are company managed or service bureau based.
  • Identify disaster recovery/contingency plans in place for key systems.
  • Describe any system limitations affecting the current business, including those impacting new product development activities and the company’s ability to offer all media formats.
  • Detail ongoing support requirements and operational costs. Describe current ongoing development efforts and their status. Also describe any development projects planned for the next three years.


The concept of reserve due diligence is extremely important to understand. If you, as the selling company, will be accepting future payment from the acquiring company as part of the consideration received, you’ll want the right to examine the acquiring company’s financial and operational data in order to protect your interests. Legitimate acquirers understand this issue and generally do not have a problem with providing relevant data. If resistance is received, a red flag should go up.

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