FINANCIAL DUE DILIGENCE SERVICES is a discipline lacking definition, scope, clarity and agreement in Australia within the accounting profession. The poor cousin among financial disciplines, it has no mandatory requirements, yet the impact of properly conducting (or not conducting) financial due diligence can have a stunning impact on investment returns.

Since the 1980s, when corporate mergers and acquisitions were made swiftly and ruthlessly, we have witnessed a revolution in the approach and requirements of managing the issue of risk in financial markets and the public sector. The disciplines of corporate governance, risk management and strategic planning have become gospels for administering large private and public enterprises. Many of the requirements for financial management and applicable ethics have either become the subject of mandatory professional rules. Or it has been codified in legislation following the economic damage caused by the sharemarket crash of 1987 and subsequent failures of state and federal governments in Australia to manage entities they then controlled such as the State Bank of Victoria, Tricontinental & Rothwells.

Over the past 20 years there have been many changes. A new and expanded Corporations Act has replaced the (English-based) Companies Act. Two new sets of Australian auditing standards have been introduced (once in 1997 and again in 2006). The Code of Professional Conduct has been transferred from the accounting bodies to an independent Australian Professional and Ethical Standards Board. ASX-listed companies must issue corporate governance statements, and whole-of-government reporting has been introduced. And so the list goes on. We have standards and laws governing everything it seems, except for one very important discipline: that of financial due diligence.

It is a remarkable situation and interesting to note that among the miscellaneous professional standards, there are no requirements on financial due diligence services.

References for conducting due diligence services are difficult to find because it is not a mandatory requirement in The Corporations Act 2001, not required by Australian Accounting Standards, not a requirement of the Income Tax Assessment Act 1997 (not even defined), and not required by law in Australia.

Due diligence as a term became popular in business circles following many of the unsuccessful business acquisitions of the 1980s. Essentially it referred to the investigation of the assertions made by directors and management in relation to target companies the subject of takeover or merger activities. The public sector has another term for it: "probity".

Clearly, its objective is to provide a coherent and focused investigation to assist in evaluating a financial proposition (merger, acquisition, grant or project evaluation). The process also identifies negotiation issues and confirms the assertions adopted in the documents or reports being relied upon. Ultimately, the aim of the investigation is to enhance the understanding of the economic entity, providing information on key issues that need to be addressed both before and after completion and settlement of any transaction or other relevant decision.

The scope of any due diligence assignment is limited by timing and (financial) resources. Due diligence has many aspects to it beyond the financial focus.

Typically, though, the three main focus aspects are financial, taxation and legal. In many cases the subject matter crosses over disciplines. For instance, the availability of tax losses under the 'continuity of ownership test' or 'same business test' (SBT) will affect the financial returns available. And depending on the taxation advice, especially in relation to the SBT, may limit the ability of a new owner to make changes to the business being considered for acquisition.

With legal and taxation matters having such a strong impact on the financial matters, it is important that these issues and the relationships between disciplines are identified to properly address their impact and the ability of the acquirer to address them. Considering that specialist knowledge may be required across a range of professional disciplines, it poses the question: Who should perform a due diligence review? The scale and scope of the assignment will dictate the team of people (internal and external) required. On a larger-scale acquisition the due diligence review will invariably be performed by a multidisciplinary team, typically led by the sponsor of the target business. The team, which should be formed at an early stage and communicate and meet regularly, should cover the key aspects of the business/market, operations, commercial and human resources.

Typically, the due diligence would assign key responsibilities to people based upon the following significant subject matter:

* Project manager: To manage and coordinate the transaction of the business

* Business: To analyse business strategy, sales, markets and competition

* Operations: To analyse production, supply chain, plant and equipment, OH&S and environmental concerns.

* Commercial: To consider various commercial matters such as legal, tax, IT and human resources.

Even if the transaction to acquire another business is not particularly large, all the matters referred to above need to be investigated and considered to search for the facts and evaluate their impact on the decision to proceed with the transaction(s).

There are many varied reasons for conducting due diligence, but essentially these relate to ensuring that the proposed acquisition does not leave the acquirer with: less value of assets than was agreed to; more value of liabilities than was agreed to; contingent liabilities that were not envisaged (including warranty claims); less capacity in resources than was claimed; a mismatch (cultural, strategic or behavioural) whereby different values, goals and beliefs could reduce the expected benefits of an acquisition.

For smaller-scale financial due diligence assignments, practitioners should consider whether independent experts in other technical disciplines are required to identify all the financial risks of proceeding with a transaction.

Also, just as practitioners make an assessment about the skills and experience of partners and staff to deliver financial services to clients, practitioners are required to assess whether or not they themselves have the requisite skills to conduct financial due diligence services. In larger corporate entities or the public sector, practitioners should consider whether to outsource the delivery of these services.

There are many examples of financial disaster arising from inadequate financial due diligence being conducted. Recent examples have included the acquisition of FAI Insurance by HIH Insurance or the investment in One.Tel investment by PBL and News Corp. Both cases appear to be a triumph of making huge financial commitments based upon "who you know, not what you know".

A thorough analysis of the FAI financial records may have uncovered the financial insurance arrangements, which had the effect of turning FAI's net result from a projected loss of $19.9m into an $8.6m profit.

Given that businesses such as FAI have manipulated financial performance reports to turn losses into profits, consider whether you as a practitioner can believe the financial information of the business your client intends acquiring unless due diligence is conducted.

Today, financial due diligence is expected of larger business acquisitions. Yet given the influence of the SME market on the Australian economy, financial due diligence is a hugely neglected discipline and one that CPA Australia is in an ideal position to address.

What happens in practice?

In practice, auditors (both external and internal) have been engaged to conduct financial due diligence services. But the reality is that many other parties, from management accountants, corporate advisory teams, insolvency practitioners, and others have been engaged to perform these activities.

Auditors are ideally suited to conducting financial due diligence because they have a framework to work with in Australian auditing standards, and have core skills in assessing risks and conducting investigation procedures. Ultimately, auditors are experienced at forming an opinion on a diverse range of information. Auditors will firstly agree with the client commissioning the services scope and timing for the financial due diligence assignment. They will usually apply at least two ASAs as the framework for conducting their work: Engagement to Perform Agreed-Upon Procedures, and Review of Financial Reports.

The review report is a lesser form of assurance than the audit and is usually applied for the purpose of timing: a full audit may attract attention to confidential acquisition moves. Primarily, an auditor is charged with determining whether there is any significant issue that may affect the decision to proceed with a transaction.

To maintain confidentiality, the auditor (and all members of the due diligence committee if one has been formed) will normally adopt code names in all correspondence. When working at the "target" the auditors will maintain a low profile, such that they are conducting a quality review assignment for financing purposes. Even though key management personnel are normally signed up to medium- or long-term contracts upon acquisition, two of the greatest assets of many organisations are the skills and culture of its people. In many cases it is not possible to bring them into the "loop" because both parties are keen to avoid any disruption of staff or the possibility of alerting them to the proposed transaction.

While the writer admits self-interest in being a registered company auditor, it is crucial to understand that financial due diligence should not be the domain of auditors alone. Provided that an appropriate level of skill, experience and framework is engaged to conduct the work, there are many examples where financial due diligence should be conducted by senior financial management, by business services (public) practitioners, by public sector accountants or corporate advisory specialists. The key point is that financial due diligence is actually conducted, and that the people doing so have the requisite skills.

The mystery of financial due diligence is that normally it raises a simple question like, "Should we acquire this economic entity?" Yet answering this can be like answering the oftheard enquiry of "How long is a piece of string?" The obvious answer is that it depends - upon the level of risk acceptable to those asking the question.

"Risk comes from not knowing what you're doing," said US investment guru Warren Buffett. Ultimately, it is risk that drives the level of scope and type of reporting necessary for financial due diligence.

Risk is effectively a premium to be paid for investing your assets. When the likelihood of success is largely unknown, the risk is higher. When the likelihood of success is largely known or expected, the risk is less and the premium is less. It is an inverse relationship between risk and premium/ return on investment.

Assessing clients' risk and tolerance to investments should be conducted as an exercise tailored for each client and each proposed transaction. There needs to be a solid understanding of the client's financial capacity to invest in the proposed acquisition, both now and for the longer-term.

Some clients may be experienced investors that have detailed knowledge of the industry in which they are investing, and the workings of the business they wish to acquire. The greater the knowledge of the client and their resources, the lesser the level of financial due diligence required.

CPAs are ideally suited to the role of leading due diligence projects as practitioners with SME clients, as senior advisers within the public sector, and in pivotal roles within large enterprises. CPAs have the appropriate mix of qualifications and experience to bring advisers from other disciplines together, lead projects and advise the relevant decision makers.

The financial reporting and governance centre of excellence has recently established a working group that contains a wide diversity of experience in financial due diligence matters to develop guidance materials. This is in order to provide our members with sufficient knowledge and criteria to suitably conduct these engagements and ensure that at least a minimum level of quality control and service is delivered. This project seeks to promote CPAs as the choice for those seeking providers of these services.

Our working group is seeking to give members in public practice, in the public sector and in large corporate entities, resources and a solid framework for conducting these assignments. It is most likely to have a very practical impact on practitioners because they will have additional services to promote and provide for their clients. Overall, the outcomes from this project are directed to enhancing the strength of the CPA brand and providing our members with greater opportunity in their careers. Over the next year CPA Australia will continue to provide a range of general and technical initiatives and practical resources to address financial due diligence services. Our working group and the inhouse technical team will build on resources already available. Fact sheets on the best practice for financial due diligence services are also in the pipeline.