Due diligence is the best way to assess the value of a business, the associated risks and whether the transaction is viable when a company is considering an M&A transaction.

There are several types of due diligence, the most commonly known being financial and legal due diligence. Legal due diligence reviews licenses, contracts, warranties and more. Other due diligence angles include human resource (HR), Intellectual Property, and Operational.

In this post, we’ll dive deeper into financial due diligence, including tax due diligence.

What is Financial Due Diligence

Financial due diligence is an investigative assessment of a company’s financial health and position. It is conducted by outsiders, similar to a throughout corporate audit, to understand the historical and current financial performance. Then, future forecasts can be prepared and any potential risks or issues identified.

The seller’s financial performance is examined through historical statements, general ledgers, current operating results, business plans, budgets and forecasted financial information.

Usually, the scope includes working capital and capital expenditure requirements, an analysis of the historical quality of earnings, quality of net assets and net debt.

The objective is to identify any unreported liabilities, understand the target company’s current financial position and determine if earnings are sustainable.

Furthermore, the review findings provide information that is essential to finding a fair purchase price that is agreeable to both parties.

Tax Due Diligence

The need for tax due diligence is sometimes overlooked by buyers, but it helps to properly manage potential tax risks.

It is a review of all different taxes that a company is required to pay, based on its tax obligations and the jurisdiction(s) where it is located and operates the business. A few elements of tax due diligence are to:

• Ensure the taxes have been calculated properly without under-reporting
• Validate the tax return documents (usually for the last five to seven years)
• Check the company’s level of compliance with tax laws
• Identify any tax-related case pending with the tax authorities
• Identity the potential challenges by the tax authorities on certain tax claims lodged
• Identify the tax risks in the local jurisdiction and also foreign jurisdictions due to presence, activities or transactions taking place there

Furthermore, an M&A transaction can provide unique tax planning opportunities. In jurisdictions worldwide, tax systems are growing increasingly complex. More taxes get imposed on businesses, leading to more aggressive tax-reducing strategies by taxpayers and stricter enforcement by tax authorities.

Benefits of Financial due Diligence

The benefits of a financial due diligence can far exceed the costs. There may be underlying risks, underreported financial liabilities, financial reporting issues or others.

If a buyer is unaware nor protected from these risks, they can have a significant negative impact on the expected return or profit.

When any potential risks are identified during the financial due diligence, the buyer can consider bargaining for a lower purchase price or even terminate the M&A transaction.

Who should do Financial Due Diligence

Usually, financial due diligence in an M&A transaction is thought of from the buy-side perspective. As explained before, the aim of financial due diligence on the buyers’ side is to make sure the business is financially healthy and has potential.

However, it’s not only the buy-side that should be doing their due diligence. In M&A transactions, it is advisable for the seller to carry out its due diligence as well. A number of deals fail due to issues arising during due diligence.

If the seller conducts due diligence on their company before a buyer gets involved, they can proactively resolve any issues and identify any gaps – increasing the chances of a successful M&A transaction.

How HKWJ can help

Our professionals at HKWJ Tax Law & Partners Limited are here to assist your financial due diligence. We have successfully helped multiple overseas companies with M&A transactions in Hong Kong and Asia.

We provide the following due diligence services:

• A comprehensive review and assessment of the seller’s financial and tax positions
• Checking whether the financial and tax requirements/obligations have been complied with by the sellers
• Identifying the potential financial and tax risks/significant issues of the sellers and quantify the effects, if possible.
• Advising the financial and tax issues that clients need to pay attention to arising from the potential M&A transactions (such as the utilisation of the tax loss of the company acquired)

Separately from the due diligence assignment, we can suggest ways to mitigate any risks arising during the financial review.