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Audit, due diligence review, and agreed-upon procedures engagement – are they all the same?

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AUGUST ALCASABAS

I recently ran into a friend who sought advice as to what professional service I would recommend for his organization’s requirements. I am sure many CFOs, key executives, business development officers and financial advisors can relate to this: Do I go for an audit, a due diligence review or an agreed-upon procedures (AUP) engagement?

My friend is a CFO and his company was looking at acquiring a 100% equity in a privately-owned business operating outside of Manila. He specified that they wanted an assurance that all revenue, expenses, assets and liabilities of the target entity were properly recorded during a three-year review period and were supported by legitimate documents.

To check whether a financial audit is appropriate, I had to go back to his stated purpose.

Firstly, the organization needed assurance. I instantly thought of having the financial records of the target entity audited. The target is currently audited by an individual accounting practitioner and from my friend’s initial contact with the target, questions regarding the reliability of the financial records immediately arose. To manage his expectations, I emphasized that while the audit provides assurance, it does so on a reasonable basis.


Secondly, the organization’s need to be assured of “all” of the target’s revenue, expenses, assets and liabilities makes an audit insufficient. As pointed out, an audit only provides reasonable assurance. The testing procedures carried out in an audit are done on a sampling basis and are determined based on a materiality threshold that the auditor and the client agree on. At the end of an audit engagement, the acquiring organization’s stated purpose would not be addressed.

Further, while an audit is expected to provide reasonable assurance on the financial statements of the target, it is not designed to address specific M&A issues. Remember that the requirement is in view of the planned business acquisition. The results of an audit would not be enough to help the organization decide on the suitability of the transaction.

I then took the opportunity to explain to my friend the difference between a due diligence review and an AUP engagement.

Due diligence is a process by which information is gathered about the target, its business and its environment while considering the structure of the transaction. This is to ensure that parties to an M&A transaction make an informed investment decision. Financial due diligence (FDD) is just one of the many types of due diligence engagements. The FDD has a broader scope and a different objective compared to an audit.

The FDD is not just about checking the facts and reformulating them. It is about analysis and evaluation, interpretation and communication of the information to the prospective buyers/sellers. The FDD typically focuses on quality of earnings, quality of assets/liabilities, cash flows and working capital, forecasts, business structure and operations, and quality of financial information.

The minimum end products of an FDD are normalized EBITDA (or any appropriate valuation metrics) and adjusted net assets that the client can then use in its valuation of the target and later on during negotiation. These take into account key issues or red flags identified in the FDD review process.

The FDD provides inputs essential to management’s decision concerning the transaction. However, it does not provide any form of assurance. This is because the FDD relies heavily on management enquiry and analytical procedures. Vouching, tracing and physical inspection, even on a sampling basis, are not typically carried out in an FDD. Hence, an FDD would not address the specific requirements of my friend’s company.

The FDD from an M&A perspective is different from that of an audit or a review of financial information covered by Philippine Standard on Review Engagements (PSRE) 2400 – Engagements to review financial statements, and PSRE 2410 – Review of interim financial information performed by the independent auditor of the entity.

The remaining option for my friend is an AUP engagement. As the name suggests, this may be the best fit for the company’s requirement. As long as the company is transparent about the specific results it wants to see, an AUP engagement is expected to deliver the best outcome. However, an AUP engagement does not provide any level of assurance. Nonetheless, the company can request that specific audit procedures, such as vouching, be carried out on certain or all items in the target’s financial statements. It is up to the company to discern whether assurance is more important than the outcome of specific procedures that an AUP engagement is capable of achieving.

The AUP engagement from an M&A perspective is different from that of an audit or a review of financial information covered by Philippine Standard on Related Services 4400 – Engagements to agreed-upon procedures.

Considering my friend’s specific requirements, I told him that an AUP engagement would be the most appropriate
service for them. After a lengthy discussion with his colleagues, they finally decided to go ahead with such.

Before advice is provided, it is essential for an advisor to fully understand a client’s specific needs and intentions.

A review engagement from a compliance point of view is different from a review engagement required to support an M&A transaction. To be of value to our clients, we have to proactively communicate with them before an engagement letter is even finalized.

The author is a senior manager with the Financial Advisory group of Navarro Amper & Co., the local member firm of Deloitte Southeast Asia Ltd. – a member firm of Deloitte Touche Tohmatsu Limited – comprising Deloitte practices operating in Brunei, Cambodia, Guam, Indonesia, Lao PDR, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.

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