Due Diligence or Audit: What Actually Separates Them

An audit is commissioned by a company, works to standards set outside the engagement, and produces an opinion on whether the statements give a true and fair view. Diligence is commissioned by a buyer, works to a scope the buyer sets, and produces findings rather than an opinion. Neither substitutes for the other, and where the scope is set is what separates them.

What is an audit, and what is a diligence exercise?

The confusion between these two is not a finance confusion, so start outside finance altogether. The confusion is about who asked the question.

Somebody is selling a flat. The seller hands over a structural report prepared last year for the building's residents by a qualified surveyor, and it is genuinely reassuring: the frame is sound, the report is signed, the surveyor is competent. The buyer reads it twice. Then the buyer pays a second surveyor of their own to walk through the flat with them, and tells that person exactly what the worries are. Does the overhead tank leak. Does the lift maintenance arrangement carry on after the sale. Is there anything running with the neighbours that a new resident inherits.

Nothing in the first report was wrong. The report simply was not written for the buyer. A survey of the building is not a survey of the flat, and nobody had told the surveyor to ask a single one of those three questions. The whole distinction sits in that last clause, and the finance version only adds vocabulary.

The audit, defined on its own terms

An auditAn independent examination of a company's financial statements by a professional the company appoints, ending in a written report to the people the report is addressed to. is an examination of a company's financial statements by an appointed professional who is independent of the people who prepared them. The company appoints the auditor. The auditor examines the statements. The auditor then reports, in writing, whether those statements give a true and fair viewThe phrase an audit report uses to say that the statements present the position and the results honestly and without material distortion. Its exact meaning is set by the standards, not by the parties. of the position and the results.

Three things about that examination are fixed before anybody in a transaction turns up. The ground the examination has to cover is fixed. The wording available to the report is fixed. Whether the company had to have an audit at all is fixed. None of the three is negotiated between the auditor and the company, and none of them moves because a transaction is going on. The auditing standardsThe published rules a professional auditor works to, covering how the examination is planned, what evidence is gathered and how the conclusion is expressed. are published by the Institute of Chartered Accountants of India at icai.org, and the requirement to be audited at all sits in company law, at mca.gov.in. Their text changes, and a reader who needs the current version should read it at those two places.

The examination ends in an opinionA professional conclusion expressed in a set form of words, addressed to named readers, on a question the professional was engaged to answer.: a conclusion, in a defined form of words, addressed to defined readers, on one question.

The diligence exercise, defined on its own terms

Due diligenceThe examination a buyer runs on a business it has agreed to buy, covering whatever the buyer has instructed its advisers to look at, before the buyer becomes committed. is what a buyer does after it has agreed the shape of a purchase and before it becomes committed to it. Harivansh Packaging Limited has agreed the shape of a purchase of Sundarban Polymers Private Limited: a whole company, at an enterprise value of Rs 1,320 crore struck at 10.0 times the target's earnings before interest, tax, depreciation and amortisation (EBITDA) of Rs 132 crore. Enterprise value is not the amount that reaches the sellers. Take off the Rs 180 crore of net debt sitting inside Sundarban Polymers and the equity value is Rs 1,140 crore, and that is what Harivansh Packaging actually pays.

Confirmatory diligence is the milestone at which the buyer stops taking that shape on trust. Devyani Kulkarni, the chief financial officer of Harivansh Packaging Limited, and Ashwin Rege, who leads the transaction team, write down what they need to know. The two of them engage the buyer's advisers and instruct them on what to look at, what to leave alone, how deep to go and by when. The advisers work through the information the sellers make available and come back with what they found, what they could not establish, and what in their view should change in the price or in the paper.

An audit is an examination against a standard set outside the engagement, and a diligence exercise is an examination against a list of questions written inside it. Everything else about the two engagements falls out of that one sentence.

Confirmatory diligence is a moment in a fixed sequence and not only a word. On this transaction the fixed order of events is: approach and confidentiality, indicative offer and term sheet, confirmatory diligence, documentation, signing, the conditions period, completion. Twenty two weeks ran from term sheet to completion, and nine of them were the conditions period. Signing therefore sits at week thirteen. Confirmatory diligence lives inside those first thirteen weeks, running alongside the drafting rather than before it. The paper is being written while the questions are still being answered, and the answers are what the paper ends up saying.

Who commissions each one, and who is it written for?

A company appoints its auditor, and the auditor reports to the company's members. Notice how odd that arrangement sounds when it is said plainly: the people being examined are the people paying for the examination, and the report goes to a third group. The arrangement is neither an accident nor a weakness. An audit exists for exactly that reason. The people who put money into a company are not in the building. Shareholders cannot inspect the ledgers, and even if they could, most of them would not know what they were looking at. So an examination is required, performed by somebody qualified and independent, reporting to them rather than to the management whose work is being examined.

The consequence for a buyer is precise and easy to miss. The readers of an audit report are a class of people defined entirely outside the buyer's transaction, and the buyer is not one of them. The audit of Sundarban Polymers Private Limited was addressed to the people who hold Sundarban Polymers, in their capacity as its members, and it would have been written in exactly the same words if Harivansh Packaging Limited had never existed. The buyer is reading somebody else's post.

Diligence inverts every part of that. Harivansh Packaging engages the advisers, Harivansh Packaging pays them, and Harivansh Packaging is the only reader. There is no third group, no defined class, nobody in the future who is entitled to pick the report up. The person paying is the person asking and the person reading, all at once. The document can therefore be exactly as blunt as the buyer wants it to be. An audit report is written to be read by strangers years later. A diligence report is written to be read by one team this month, and it reads like it.

The everyday version is the flat and the two surveyors. The building's structural report went to the residents. The second surveyor's note went to the buyer. Both were honest, both were competent, and only one of them was answering the buyer's question.

What standard does each work to, and who sets it?

The source of the standard is the decisive difference, and it is worth slowing down for.

An auditor cannot decide to examine less. The scopeThe boundary of what an examination covers. Everything inside it is looked at, and everything outside it is not, said or unsaid. of the work is settled by the auditing standards, which the Institute of Chartered Accountants of India publishes at icai.org, and by company law, at mca.gov.in. The company paying the fee did not write those and cannot amend them. If the standards require a piece of work and the company would rather it were skipped, it is not skipped, and if it were, the report would not be the report it claims to be. The examination has a floor underneath it that neither party to the engagement put there.

Diligence has nothing of the kind. There is no published rule anywhere setting out what a buyer's confirmatory diligence must cover. There is no minimum, no required procedure, no form of words at the end. The scope is a commercial instruction: Devyani Kulkarni and Ashwin Rege write down what they want looked at and how much they are willing to spend on looking, and that document, not any standard, is the boundary of the work.

An audit works to a standard set outside the engagement and diligence works to a scope set inside it, and every other difference between them follows from that one.

Follow it through and see how much falls out. Because the standard is external, an audit can be relied on by readers who were not in the room when it was arranged. Such readers know what it must have covered without asking. Because the scope is internal, a diligence report can only be understood by somebody who also knows what the instruction said. Two diligence exercises on the same business can cover completely different ground and both be done properly. Because the standard is external, an audit's conclusion can be expressed in a fixed form of words that means the same thing everywhere. Because the scope is internal, a diligence report's conclusions are a list, not a verdict.

The household version, again in one line: the building's structural report had to cover the frame whether or not the residents wanted to pay for that; the buyer's own surveyor covered precisely what was asked for and not one thing more.

What does each one produce at the end?

An audit produces an opinion. The word opinion is doing heavy work, and it is meant literally. An opinion is a conclusion on a question, expressed in a form of words that has been settled in advance, addressed to named readers, and signed. The forms it may take, and what each form signifies, are published at icai.org.

Diligence produces findingsThe individual things a diligence exercise establishes, each written up on its own, with what was seen, what it appears to mean and what could not be settled.. Not a verdict, not a grade, not a conclusion on the transaction. A list: this is what was found, this is what could not be established, this is what it might mean for the price, this is what the buyer should take protection for in the agreement. Twenty items on that list can point one way and the twenty first can be the one that matters. The judgement about which is the buyer's, and the report will not make it.

An opinion is something a defined group of readers may lean on, and a set of findings is an input to a decision somebody else is making. Nobody signs a diligence report in the way an opinion is signed.

The same distinction answers a question people ask in the wrong order. People ask whether a diligence report is as reliable as an audit report, as though the two were competing for the same job. The two are not competing. RelianceThe right of a particular reader to act on a professional's work and to hold that professional to it. Reliance attaches to named readers, not to anyone who happens to see the document. is a relationship between a document and a named reader, not a quality the document has on its own. An opinion carries reliance for the people it was addressed to and for nobody else. A diligence report carries reliance for the one party that commissioned it, and even that party is not being told what to do.

What does each cover, and who decides what is left out?

An audit covers what the standards require it to cover. Nobody in the transaction chooses that, and nobody in the transaction can widen it either. A buyer cannot pay an auditor to look harder at the parts of last year the buyer happens to care about. Paying for that would be a different engagement altogether.

Diligence covers what the buyer paid for. Read that again with the emphasis in the right place. Not what the buyer wanted, and not what the buyer would have looked at with infinite time: what the buyer instructed, inside a budget, against a signing date thirteen weeks out. A buyer can decline to look at something. Buyers do it constantly and for perfectly respectable reasons. The information is expensive to gather. The subject is small enough that being wrong about it would not change the price. The seller will not open that part of the business until the transaction is much further along. The signing date is fixed and something had to give.

A gap in diligence is a decision somebody made, and it is recorded in the scope rather than in any finding. If the buyer's advisers were told not to examine the target's information technology arrangements, no finding will ever say so. Findings describe what was looked at. Silence is not a clean bill of health, it is an absence, and the only document in which the absence appears is the instruction that created it.

Which is why the scope document is the first thing an experienced reader of a diligence report turns to and the last thing an inexperienced one thinks about. Read cold, the report shows what was found. Read after the scope, it shows what was found and also what nobody went looking for. Only the second reading establishes what is actually known.

What happens to each report afterwards?

The audit opinion is published with the accounts. The opinion is a public document, and it stays public for as long as anybody keeps a copy of the accounts. Anybody can read it, including a competitor, including a customer, including somebody thinking of buying the company three years from now.

The diligence report goes to the buyer and stops there. The report is not published, not filed, not shown to the seller in most transactions, and not shown to the market. Years later, when somebody studies this purchase, the diligence report is the one document they will never see.

And yet the report's effects are the most visible thing about the transaction. A diligence finding usually leaves its trace not in a document anybody sees but in a clause, an adjustment or a price. Reading a completed transaction backwards from its terms therefore reveals a great deal about what diligence found.

The traces are concrete enough to name. A transaction with an unusual mechanism for adjusting the price at completion signals that somebody was not comfortable with a number. A transaction whose completion depends on a particular counterparty's consent signals that somebody checked whether that contract survived a change of holder and did not like the answer. A price struck below what the sellers were asking signals that something was found, even though no reader will ever be told what.

None of this is a code to be cracked, and a reader can certainly over read it. But the direction of travel is sound: the paper is where the findings went.

Which questions did diligence actually ask on this transaction?

Abstractions about scope are cheap. The four questions asked on this transaction are the concrete version.

Sundarban Polymers Private Limited reports revenue of Rs 880 crore and EBITDA of Rs 132 crore, a margin of 15.0 per cent. An audit of that company examines whether its statements give a true and fair view. The requirement to have one, the standards it works to and the forms its conclusion may take all sit outside this transaction, at icai.org and at mca.gov.in, and would have been exactly the same in a year with no transaction in it.

Confirmatory diligence asked four questions. Every one of them turned into a term of the deal, so the answers can be read off the agreement.

The first question was whether Rs 132 crore is the right base. The enterprise value of Rs 1,320 crore is struck at 10.0 times that figure, so a rupee of EBITDA that does not repeat costs the buyer ten rupees of price. Diligence asks whether the Rs 132 crore contains anything that happened once: a settlement received, a cost that was suppressed for a year, a customer order pulled forward. The work has a name, normalisationWorking out what a year's earnings would have been without the items that will not happen again, so that a figure used for pricing represents the ordinary run of the business., and it is diligence work end to end. An audit is not asking whether last year repeats. An audit asks whether last year is reported honestly, and that is a different question with a different answer.

The second question was whether the working capital position is normal. A business carries stock, is owed money by its customers and owes money to its suppliers, and the net of those moves around. If the sellers let the position run down between agreeing the price and completing, the buyer receives a thinner business than it priced and has to put the money back in itself. The answer to this question is written into the agreement as a normalised working capital figure of Rs 96 crore, against which the actual position at completion is measured. Actual working capital came in at Rs 108 crore, Rs 12 crore above the agreed figure, so the price adjusts up by Rs 12 crore.

The third question was what net debt will actually be on the day the transaction completes. The bridge from enterprise value to what the sellers receive runs through net debt, so this is not a detail: Rs 1,320 crore less Rs 180 crore of net debt is the Rs 1,140 crore equity value. If the real figure on the day is different, the equity value is different. Diligence tested the Rs 180 crore assumed for Sundarban Polymers. At completion the actual figure was Rs 195 crore, Rs 15 crore higher, so the price adjusts down by Rs 15 crore.

The fourth question was whether the contracts with two counterparties transfer with the business. Some contracts carry on regardless of who holds the company and some do not. Diligence read them and found two that needed the counterparty to agree. The answer went into the agreement not as a price adjustment but as two conditions to completion, sitting alongside a regulatory approval and the absence of a material adverse change: three things that had to be true before the nine week conditions period could end.

Not one of those four is an audit question, and every one of them moved either the price or the conditions.

How big was the price effect, and does its smallness matter?

Now put a number on what diligence found, restricting the count to the two items that moved the price. Working capital came in Rs 12 crore above the Rs 96 crore agreed, so the price goes up by Rs 12 crore. Net debt came in Rs 15 crore above the Rs 180 crore assumed, so the price goes down by Rs 15 crore. Plus Rs 12 crore and minus Rs 15 crore net to minus Rs 3 crore, and the equity value paid moves from Rs 1,140 crore to Rs 1,137 crore.

Rs 3 crore against Rs 1,140 crore is 0.26 per cent. A reader meeting that number for the first time tends to have one of two reactions, and both of them are wrong in an interesting way.

The first reaction is that a quarter of one per cent means the diligence was a waste of money. The second is that so small a movement proves the diligence was thorough, with little left to find. Both readings die on the same fact. The two adjustments were individually Rs 12 crore and Rs 15 crore, four times and five times the net, and a buyer that ran only one of the two enquiries would have been wrong by Rs 12 crore or by Rs 15 crore rather than by Rs 3 crore.

The net is small because two independent findings happened to point in opposite directions and happened to be close in size. Nothing made that happen. Neither enquiry knew what the other would find, and the working capital answer would have been plus Rs 12 crore whatever net debt turned out to be. The smallness of the net is exactly why both were computed and it is never a reason to skip either.

There is a household version of this that everybody has lived. A household checks the electricity bill and the rent statement at the end of the month. One is Rs 1,200/- higher than expected and the other is Rs 1,500/- lower, so the month is Rs 300/- better off, and it would be a strange conclusion to draw that checking either of them was pointless. Had only the electricity bill been checked, the household would have believed itself Rs 1,200/- worse off. The net was small; the checks were not.

The accounts carry a clean opinion. What has the buyer been told?

The honest answer is narrower than instinct suggests.

A clean opinion tells the buyer that a competent, independent professional examined the statements of Sundarban Polymers Private Limited against a standard the professional did not write, and concluded that they give a true and fair view. Knowing that much is worth something real. A clean opinion rules out a whole category of unpleasant surprise. Anybody bothers with the exercise for that reason, and a buyer looking at a target with no audited accounts at all would feel the absence immediately.

Now list what it does not tell the buyer, restricting the list to things this transaction actually turned on. A clean opinion does not say whether the Rs 132 crore of EBITDA is a figure that repeats. The report does not say whether Rs 96 crore is a normal working capital position for a business of this shape. The report does not say what net debt will be on a completion date that had not arrived, and a future date is not a fact about the period examined. The report does not say whether two particular contracts survive a change of holder, and that is not a question about the statements at all.

Nobody was engaged to ask any of those four questions, and an examination cannot fail to answer a question that was never put to it.

So the substitution fails in both directions, and it is worth saying the less obvious direction out loud too. Diligence cannot stand in for an audit either. The buyer's advisers were not appointed under company law, did not work to the auditing standards, are not independent of the buyer in the way an auditor is independent of management, and are not reporting to anybody's members. Their work is more useful to the buyer and it is not an audit, and no amount of thoroughness converts one into the other. The two documents answer different questions for different readers under different rules.

What does a buyer relying on audited accounts actually hold?

Strip it down to the plainest possible statement. A buyer relying on the audited accounts of Sundarban Polymers holds an opinion addressed to somebody else, on a period that has already ended, about statements prepared by the people selling the business.

Each of those three clauses carries its own weight, so take them one at a time.

Addressed to somebody else. The buyer is not among the readers the report was written for, and whatever the buyer may feel while reading it, it is reading a document that was never intended for its use.

On a period that has ended. Every question that matters to a buyer is about the future: does this repeat, what will the position be on the day of completion, will this contract survive. An examination of a completed period is silent about all of them, not through any shortcoming but because that is not what a completed period contains.

About statements prepared by the seller. The statements are the management's, not the auditor's. The auditor examines and reports; it does not prepare. So the buyer is reading an independent conclusion about a document written by the party on the other side of the table.

All of that is genuinely useful and none of it is what a buyer needs, and the gap between those two sentences is exactly the space diligence occupies.

How do a lender, an analyst and a household read the same distinction?

The distinction stops being academic the moment somebody has to act on it, and three different readers act on it differently.

Start with the people lending the Rs 1,000 crore of new borrowing that funds part of this purchase, alongside Rs 140 crore of the buyer's own cash. The lenders are not the addressees of the audit and not the addressees of the buyer's diligence report. Structurally the lenders hold neither document. A lender's demands are therefore a matter of commercial negotiation between the parties rather than a settled convention. The shape of a lender's question is a diligence question rather than an audit question every time: not whether last year was reported honestly, but whether the Rs 132 crore repeats often enough to service the borrowing that has been raised against it. An examined past is a poor answer to a question about a future cash flow.

Now the analyst reading this transaction from outside, months after completion. The analyst will never see the diligence report. The terms are visible: a price, a working capital peg, a net debt adjustment, two consents written in as conditions. An analyst who reads those terms as evidence of what was examined learns more about the transaction than one who reads only the audited accounts of either party. The terms are the visible residue of a private investigation and the accounts are not. That is not a trick and it is not a substitute for knowing the business, but it is a habit worth building.

Then the household version. Most people meet this distinction in real life without a single word of finance vocabulary. A person buying a small shop is shown three years of records prepared by the seller and certified by somebody. The instinct is to treat certification as the end of the enquiry. The discipline is to treat it as the start: the certificate says the records are what they claim to be, and it does not say whether the two biggest customers are related to the seller, whether the rent agreement transfers, or whether last year's numbers included a one time contract that has since ended. Somebody has to be paid to ask those three questions, and if nobody is paid to ask them, the answers arrive after the money has changed hands.