CFAP 6

Due Diligence
Practice Questions
Jamshaid Akhtar (ACA)

Q. 1
Your firm has been approached by Eagle Courier Limited (ECL) to provide due diligence review
on a potential acquisition. ECL is a leading courier service company having a network of offices
throughout the country. ECL has a vast fleet of delivery vans and motorcycles.
ECL intends to use its courier industry experience and expand into food delivery business by
using its current fleet of motorcycles. However, it would require bringing on board a vast
number of restaurants and build its own online food ordering website, of which they do not
have any expertise and experience.
For this purpose, ECL has identified an online food ordering business Foodi.com (FC) for
acquisition. FC is a partnership concern and was set up by three college friends in 2014. FC
received the best ‘start-up business’ award in 2015. Founders of FC had borrowed funds from
two individual investors, which are to be repaid in 10 years.
IT, restaurant relation, customer support and administrative departments are led by the
partners. Being an online service business, the only major assets of FC are a fleet of motorcycles
obtained on an operating lease of 5 years and computers.
Apart from 500 riders, FC employs 30 staff, out of which 10 are related to IT department, 10
belong to customer support, 5 belong to restaurant liaison and the remaining 5 are responsible
for the accounts, HR and administration of the business.
Extracts from audited profit or loss statement for four years are as follows:
2017 2016 2015 2014
-------------------- Rs in million --------------------
Revenue 55,000 50,000 20,000 10,000
Operating expenses (34,650) (30,000) (16,000) (15,000)
Lease rentals (5,750) (4,600) (2,875) (1,150)
Operating profit/(loss) 14,600 15,400 1,125 (6,150)
Finance cost (3,075) (3,155) (1,615) (1,615)
Profit/(loss) for the year 11,525 12,245 (490) (7,765)
Required:
Identify and explain the matters you would focus on in your due diligence review. Also identify
any additional information / document you would require during the review. (15)
(ICAP Summer 2018, Q 2)
Ans. 3
(i) FC being a partnership business is not subject to regulation and oversight of corporate
regulatory authorities and we would need to inquire about the financial reporting
framework used for the preparation of the financial statements and whether it is
acceptable.

Documents/information required:
▪ Audited financial statements of four years
▪ Any regulatory returns filed by FC
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(ii) It is crucial to identify the role of other 2 persons who have financed the business of FC. It
is important to determine whether the partners can sell their business without the
consent of the lenders.

Documents/information required:
▪ Copy of partnership deed
▪ Copy of agreement with the lenders
(iii) Evaluate why the finance cost remained the same and then increased when business
became profitable i.e. assess whether there is any profit sharing agreement with the
lenders.
Documents/information required:
▪ Balance of the outstanding loan
▪ Terms of repayment of loan
▪ Copy of agreement with the lenders
(iv) Evaluate the reasons for significant improvement in revenue/profits in 2016.

Evaluate whether the levels of revenue/profits of 2016 and 2017 are sustainable.
Documents/information required:
▪ Forecast profit and loss account for next three years should be obtained
▪ Reasonableness of assumptions on which they are based should be evaluated
▪ Number of active customers registered with FC
▪ Contracts with restaurants
(v) Though the increase in expenses appears reasonable on an overall basis i.e. based on the
increased activities (revenue). However, to assess whether the change is reasonable we
have to obtain details/breakup of major expenses.
(vi) All the partners are crucial to the success of FC, as the business relies heavily on them. We
would have to see whether ECL would be able to find adequate replacement for the
expertise of the partners. Moreover, continuity of other key staff should also be
ascertained for smooth operation of the business.
Documents/information required:
▪ Names of the key staff
▪ Job description of the staff
▪ Offering letter / employment agreement
(vii) ECL plans to use their own delivery riders for the business. It therefore needs to be
ascertained whether the riders are employed on a fixed salary or commission plus fixed
salary and are they entitled to any redundancy payments. The same also needs to be
ascertained for other staff of FC who would not be retained.
Documents/information required:
▪ Contract with the employees/appointment letters.

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(viii) FC fleet of delivery bikes have been acquired on a five-year lease. It seems that it is a
finance lease as the useful life of the bikes is also five years. ECL plans to use its own fleet
for food delivery, so it needs to be ascertained that whether the lease agreement contains
any clause of early exit and its associated cost.
Documents/information required:
▪ Lease agreement
▪ V Valuation of motor cycles and the lease liability
(ix) The valuation of the website should also be taken into consideration. Since ECL intends to
use the online system developed by FC, the systems should be tested for security and
should be considered in valuation of the website.

Documents/information required:
▪ Security certificates obtained by FC
▪ Detail of amounts paid to developer for constructing the web site
▪ Any other certificates obtained by FC
(x) All off balance sheet items should also be taken into consideration along with the
assessment of it’s probable outcome.
Documents/information required:
▪ Names and addresses of the legal advisors of FC
▪ Names and addresses of all banks of FC
▪ Details of any pending cases against FC
▪ Details of future contracts with suppliers
(xi) The applicability of the income tax and sales tax on the business of FC should also be
considered. It should also be ensured that the tax return have been filed appropriately
and would not result in any future claims by the tax authorities.
Documents/information required:
▪ Tax returns
(xii) It also needs to be ensured that whether the information systems of FC and ECL could be
integrated.
Documents/information required:
▪ System specification of both the companies

Q. 2

You are employed as an audit manager in Bashir and Company, Chartered Accountants. One of
your clients, Davidsons Pharma Limited (DPL), is considering to acquire 60% shareholding in
Sehat Healthcare (Pvt.) Ltd. (SHPL) and has requested your firm to carry out a due diligence.

During the fieldwork of due diligence exercise, your team has brought the following matters to
your attention:

(i) A major customer which accounts for 10% of SHPL’s annual sales has refused to place
further sale orders. On inquiry, it was revealed that competitor has offered significant discount
of 12% to increase its market share.
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(ii) DPL has central distribution model where single distributor has non-exclusive rights
countrywide with commission rate of 5%. All sales made to the distributor on 30 days’ credit.
On the Other hand, SHPL has a regional distribution model where multiple distributors are
involved country wide with commission rates ranging from 2% to 4%. Under this model, all
sales are made on cash.

Required
Discuss how the above matters are to be investigated for due diligence review and also
recommend the additional procedures to be performed in this respect. (12 Marks)

Ans. 2

Termination of Supply agreement:

Loss of a major customer may lead to a reduction in forecast revenue by as much as 10% per
year. It is vital to establish all potential revenue and cost implications due to loss of the
customer to ascertain the impact on the overall acquisition price.

The switching of major customer has wider implications if the competitor is directly targeting
the major customers of DPL. It is possible that other major customers may also switch to the
competitor, which would have further implications on future revenue and cost forecasts.

Additional procedures:
i. Analytically review the revenue earned from the customer to help determine an
appropriate estimate for the potential loss of future revenues and cash inflows.
ii. Identify other major customers and review any supply agreements in place to determine
their expiry.
iii. Obtain any correspondence to identify any renegotiation occurred on the terms of their
agreements.
iv. Analyze the impact of aggressive competitive marketing strategy to offset the impact of
discount offered by competitor.
v. Review minutes of board of directors meeting which may give an insight about the
reasons of losing this customer.
vi. Inquire the management about the possibility of offering discount by analyzing the
profitability analysis.
vii. Assess the Goodwill of brand name may have any impact in offsetting the impact of
discount.
viii. Review the subsequent sales trend to analyze the magnitude of loss of sales and
measures taken by management accordingly.
ix. Review the subsequent IMS/ third party sales report to assess the increase in market
share of competitor due to discount.

Distribution Model:
The existing central distributor model of DPL is nonexclusive so DPL can also change its model
by involving regional distributors considering the business rationale, commission rates, credit
period, product portfolio, distributor claims, etc.

DPL also needs to determine the distribution model to be adopted for SHPL by carrying out the
cost benefit analysis and considering the group synergies created by both models especially
when SHPL’s existing regional model yields saving in commission rates and have favorable
credit terms as compared to DPL central model.

Additional procedures:

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i. Review the existing distribution agreements of SHPL with regional distributors to
determine the terms of agreement are aligned with national distributor.
ii. Inquire from the management of DPL, whether the information management system in
DPL can cater multiple distributors.
iii. Perform the cost benefit analysis considering the product portfolio of SHPL for
difference in commission rates, payment terms, product expiry claims, product
availability, frequency of sale reporting and increase in administrative cost.
iv. Review the forecast prepared by management based on existing distribution model to
assess the impact of change in distribution model.

Q. 3
You are an audit manager in Pointer & Co, a firm of Chartered Certified Accountants which
offers a range of assurance services. You are responsible for the audit of Vizsla Co, a company
which provides approximately 10% of your firm’s practice income each year. The finance
director of Vizsla Co has recently contacted you to provide information about another company,
Setter Co, which is looking to appoint a provider of assurance services. An extract from the
email which the finance director of Vizsla Co has sent to you is shown below:
‘One of my friends, Gordon Potts, is the managing director of Setter Co, a small company which is
looking to expand in the next few years. I know that Gordon has approached the company’s bank
for finance of $6 million to fund the expansion. To support this loan application, Gordon needs to
appoint a firm to provide a limited assurance review on the company’s financial statements. He
would also want the appointed firm to provide tax planning advice and to prepare both the
company’s and his personal tax computations for submission to the tax authorities. I have asked
Gordon to contact you, and I hope that Pointer & Co will be able to provide these services to Setter
Co for a low fee. If the fee you suggest is too high, and unacceptable to Gordon, then I will
recommend that Gordon approaches Griffon & Co instead, and I would also consider appointing
Griffon & Co to provide the audit of Vizsla Co.’
Griffon & Co is a firm of Chartered Certified Accountants which has an office in the same town as
Pointer & Co.
You have done some research on both Setter Co and Gordon Potts and have confirmed that the
company is small enough to be exempt from audit. The company is owner-managed, with the
Potts family owning 90% of the share capital. Gordon Potts is a director and majority
shareholder of three other companies. An article in a newspaper from several years ago about
Gordon Potts indicated that one of his companies was once fined for breach of employment law
and that he had used money from one of the company’s pension plans to set up a business
abroad, appointing his son as the managing director of that business.
Required:
In relation to Pointer & Co’s potential acceptance of Setter Co as a client of the firm:
Explain the importance of obtaining customer due diligence and recommend the
information which should be obtained. (16 marks)

Ans. 3
The importance of obtaining customer due diligence and the information which should
be obtained
Customer due diligence (CDD), also called know your client procedures, is needed as part of
anti-money laundering regulations, which all audit firms should have in place when accepting
new clients. It refers to the firm obtaining information to be able to identify who the prospective
client is and verify identity by reference to independent and reliable source material. This is a

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crucial part of risk assessment when taking on a new client and allows the firm to understand
not only the identity of the prospective client, but also the nature of the business and its source
of funds.
Specifically, the firm should address the following as part of customer due diligence:
▪ Identify the customer and verify their identity using documents, data or information
obtained from a reliable and independent source.
▪ Confirm the identities of all shareholders, including the specific family members who
collectively own 90% of the company’s share capital, and the other shareholder(s) who
own the remaining 10%.
▪ Identify any beneficial owner who is not the client. This is the individual (or individuals)
behind the client who ultimately own or control the client or on whose behalf a
transaction or activity is being conducted.
▪ Where a business relationship is established, understand the purpose and intended
nature of the relationship, for example, details of the customer’s business or the source
of the funds.
Businesses must also conduct ongoing monitoring to identify large, unusual or suspicious
transactions as part of CDD. All of the documents obtained for the purpose of carrying out CDD
checks must be retained for a minimum of five years from the end of the business relationship.
In this scenario, the information which should be obtained includes:
▪ To confirm the identity of Gordon Potts, photographic evidence, for example his
passport, should be seen and a copy taken, along with other means of identification
showing his address, for example, recent utility bills or bank statements.
▪ In relation to Setter Co, the company certificate of incorporation should be seen, to
confirm its legal status and the date and place of incorporation.
▪ A Companies House search (or equivalent) on Setter Co should take place, this will
confirm the existence of the company, the shareholders and directors and will provide
some financial information. This will confirm that Gordon Potts is the ‘beneficial owner’
of the entity – i.e. that he is the person who owns or controls, directly or indirectly, more
than 25% of the shares or voting rights or who otherwise exercises control over the
directors.
▪ The identity of the other companies controlled by Gordon Potts should also be found,
and searches on them conducted, to confirm their existence and the nature of the
relationship with Setter Co.
▪ The latest financial statements of Setter Co, and the other companies in which Gordon
Potts has an interest should be reviewed. This will help Pointer & Co to understand the
businesses and their relationship with each other, identify the sources of income and
whether there are significant transactions between the companies.
▪ Identify the source of funding for the company, whether there are bank loans or other
providers of finance, and the nature of the finance provided in terms of when it is
repayable, whether any company assets are provided as collateral for the debt, and
whether Gordon Potts or other shareholders have made personal guarantees in respect
of any sources of company finance.
▪ While not strictly part of confirming the identity of Gordon or his companies, Pointer &
Co would clearly need to obtain further information about the breach of employment
law, and confirm the facts surrounding the situation.
▪ Currently the only information available is from a newspaper article and this may not be
a credible source.
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