How to Buy a Business: Due Diligence vs. Audit Reports
Due Diligence vs. Audit: Key Differences & Why Due Diligence is Critical for Business Acquisitions
Which is Better for Buyers?
While audit reports validate the accuracy of a company's financial statements, due diligence reports offer a more comprehensive view of the entire business. They go beyond the numbers, identifying potential risks, uncovering hidden liabilities, and providing a deeper understanding of operational performance. With key elements such as Quality of Earnings (QoE) and Adjusted EBITDA, due diligence reports give buyers and sellers the insights they need to make informed decisions about a potential acquisition or sale. At Torino Accounting Group, we specialize in conducting thorough due diligence for buyers and sellers, ensuring you have the full picture to make confident, well-informed decisions in your transaction.
What is a Due Diligence Report?
A due diligence report is a comprehensive analysis conducted during the early stages of a business acquisition. It covers multiple aspects of a company, offering a detailed look beyond just the financials. Here’s what it typically includes:
Financial health: A deep dive into revenues, profits, debt, and liabilities.
Quality of Earnings (QoE): Evaluates the sustainability and reliability of earnings (more details below).
Legal standing: Reviews pending lawsuits, regulatory compliance, and other legal exposures.
Operations: Examines the business model, supply chain, and management.
Market risks: Considers competition, market position, and industry trends.
Taxes: Assesses liabilities, exposures, and tax strategies.
EBITDA and Adjusted EBITDA: Focuses on understanding a company’s real profitability
The purpose of due diligence is to give the buyer a clear, complete picture of the company they’re acquiring. It helps uncover potential risks, liabilities, or hidden costs that may not be evident from financial statements alone. In short, it’s about forward-looking insights, helping buyers make informed decisions.
What is an Audit Report?
An audit is an independent, formal review of a company’s financial statements. The goal is to verify that the financials are presented fairly and in accordance with GAAP or IFRS standards. An audit focuses solely on financial data and the accuracy of the company’s financial statements.
Higher cost: Audits are often more expensive because they must be performed by independent certified auditors.
Why it’s done: Audits are usually required for regulatory compliance, particularly for public companies or businesses seeking financing. The primary goal is to validate the integrity of financial statements.
You can link to an authoritative source like the American Institute of Certified Public Accountants (AICPA) or another relevant resource for further reading about audit standards and financial reporting.
Key Differences Between Due Diligence and Audit Reports
Purpose
Due Diligence: Evaluates the overall business for potential acquisition, covering a wide array of financial and non-financial aspects.
Audit: Focuses solely on verifying financial accuracy for compliance and regulatory purposes.
Scope
Due Diligence: Broad, covering financials, operations, legal, tax, and market risks.
Audit: Narrow, focusing only on financial statements and internal controls.
Approach
Due Diligence: Looks for risks and opportunities to help buyers make decisions on acquisition terms and valuation.
Audit: Focuses on whether financial statements are accurate but doesn’t focus broader business risks.
Why Due Diligence is Better for Buyers
For buyers, a due diligence report provides far more value than an audit for several reasons:
Beyond financials: While audits confirm financial accuracy, due diligence uncovers risks and opportunities related to legal issues, contracts, customer relationships, and operational challenges. These aspects are crucial for a buyer’s full understanding of the business.
Risk identification: Due diligence often reveals hidden risks that may not appear in financial statements, such as contingent liabilities, weak market positioning, or regulatory concerns.
Decision-making support: Due diligence offers buyers the insights they need to decide whether to proceed with an acquisition and negotiate the purchase price. Audits don’t provide this level of actionable information.
Tailored to the buyer’s needs: Due diligence can be customized to focus on specific areas important to the buyer, such as intellectual property or tax exposures. In contrast, an audit follows a standardized approach.
While audits serve an important purpose, due diligence offers a more comprehensive understanding of a business and its potential risks, making it a better tool for buyers.
Quality of Earnings (QoE) in Due Diligence
One of the most important components of a due diligence report is the Quality of Earnings (QoE) analysis. This examines the sustainability, reliability, and accuracy of a company’s earnings and helps differentiate between recurring revenue and one-time items that may inflate earnings.
A QoE analysis is critical because it helps buyers understand:
Sustainability of profits: Are earnings likely to continue, or are they inflated by one-time events?
Cash flow: High-quality earnings often correlate with strong, sustainable cash flow.
Adjusted earnings: By stripping out non-recurring items, buyers get a clearer view of actual profitability.
During the due diligence process, a QoE report evaluates:
Non-recurring revenues and expenses: To isolate sustainable earnings.
Revenue recognition policies: Ensures alignment with proper accounting standards.
Cost structure: Identifies whether expenses are temporary or reflective of ongoing business practices.
Earnings stability: Looks for trends to determine whether earnings are stable, growing, or declining.
In short, a QoE analysis ensures that buyers aren’t misled by one-time events or aggressive accounting practices, giving them a true picture of a company’s financial health.
EBITDA: What Is It?
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a commonly used metric in business valuations and due diligence. It measures a company’s profitability from its core operations, but EBITDA can sometimes be manipulated to present a more favorable financial picture. That’s why due diligence thoroughly tests EBITDA.
How EBITDA is Tested in Due Diligence:
Adjustments for non-recurring items: Stripping out one-time gains or losses to reflect only recurring revenue and expenses.
Normalization of earnings: Adjusting for unusual expenses or revenue, such as owner compensation or one-time bonuses.
Revenue recognition policies: Ensuring that revenue is recognized according to accounting standards and not prematurely, which would inflate EBITDA.
Expense management review: Ensuring operating expenses are properly accounted for and haven’t been artificially reduced.
Industry benchmark comparison: Comparing EBITDA to industry peers to identify any significant deviations.
Adjusted EBITDA: Is it Important?
During the due diligence process, Adjusted EBITDA provides a more accurate picture of a company’s operational performance by accounting for one-time, non-recurring items like litigation settlements or restructuring costs. Adjusted EBITDA removes these financial “distractions” and highlights the company’s true earning potential. Additionally, Adjusted EBITDA can be tailored to the business being purchased to remove items specific to the industry.
For buyers, overstated EBITDA could result in overpaying for the business. On the other hand, an accurate EBITDA offers a clearer, more reliable view of a company’s value and long-term profitability.
Conclusion
While audit reports validate financial accuracy, due diligence reports offer a comprehensive view of the business, identifying risks, uncovering hidden liabilities, and providing a thorough assessment of operational performance. With components like Quality of Earnings and Adjusted EBITDA, due diligence reports are far more useful for buyers looking to make informed acquisition decisions.
If you’re considering acquiring a business, make sure to conduct due diligence with expert guidance to ensure you're making the right investment. Contact Torino Accounting Group for specialized due diligence and audit services.