What’s the Difference Between Due Diligence and an Audit?

Due diligence and audit are both critical processes in the financial and business worlds, though they serve distinct purposes. Due diligence involves a comprehensive appraisal of a business or individual prior to signing a contract, or an investment decision, emphasising a thorough risk assessment. An audit, conversely, is a formal examination of an organisation’s or individual’s accounts or financial situation, typically conducted to verify accuracy and compliance with statutory requirements. Both terms have been in regular use since the early 20th century and are predominantly applied in financial transactions, mergers and acquisitions, and corporate governance.

Despite their seeming similarities, understanding the differences between the two is essential for business professionals, investors and stakeholders to ensure transparency and informed decision-making. In order to see these differences, it is useful to define the nature and application of both processes in a little more depth  

Due diligence (DD) is a critical investigatory process carried out by potential investors or parties before engaging in business transactions. It involves a meticulous assessment of all relevant aspects of the past, present and predictable future of the business in question. This process is not merely about verifying financial statements, but also includes a detailed look at the company’s operations, legal obligations and market position.

In financial assessments, due diligence scrutinises the accuracy of financial records and evaluates the sustainability of revenue streams. It also explores liabilities that could affect future profitability and stability. Legally, it includes reviewing contracts, litigation risks, intellectual property rights, and compliance with applicable laws to ensure there are no hidden legal pitfalls that could undermine the investment. Operationally, it examines the company’s internal processes, supply chain, IT systems and human resources to assess operational efficiency and the capability to sustain and grow the business.

As an example, in the context of mergers and acquisitions, due diligence might include a deep investigation into the target company’s customer contracts to understand long-term revenue sustainability, or an examination of the physical assets in a real estate investment.

Auditing is a systematic process designed to independently evaluate the financial, operational and legal aspects of an organisation to ensure the accuracy and conformity of records and practices. It plays a critical role in maintaining corporate transparency and trust among investors, stakeholders and regulatory bodies.

In financial audits, auditors examine the integrity and accuracy of financial statements to verify that they present a true and fair view of the company’s financial status. This involves checking data entries, accounting practices and financial controls. Legal audits focus on ensuring compliance with laws and regulations, identifying legal risks that could impact the business. Operational audits assess the effectiveness and efficiency of organisational operations, including internal processes and controls.

Audits are categorised into internal and external audits. Internal audits are conducted by an organisation’s own audit department and are aimed at internal review and improvement. External audits are performed by independent auditors and focus on financial reporting and compliance for external stakeholders. Compliance audits specifically examine adherence to regulatory standards.

An example of audit usage in the business world is the annual external audit required for publicly traded companies, which ensures transparency for investors. Another example is compliance audits in the healthcare sector to ensure adherence to patient data privacy laws.

So, What are the Differences?

The differences between the two processes are described here in terms of seven different elements.  These can probably be considered the main sources of difference, although there are, of course, many others, especially in terms of the actual practical conducting of either process.  This delineation emphasises that while both processes evaluate financial and operational health, their purposes, scopes and impacts cater to different business needs and stakeholder expectations.

Strategic Purpose

An audit is primarily compliance-driven, aimed at verifying financial records to ensure they accurately represent a company’s financial status as per statutory requirements. Its strategic purpose is largely geared towards credibility and reliability for shareholders, lenders and regulatory bodies. In contrast, due diligence is conducted with a strategic intent to support decision-making in potential investments, mergers or acquisitions. It is proactive, designed to unearth underlying risks and validate the operational and financial metrics of a target company, thus guiding strategic investments and business expansions.

Scope

The scope of an audit is relatively fixed, focusing on financial statements and compliance with prevailing accounting standards over a defined period. Audits scrutinise past financial data to ensure adherence to legal and fiscal standards. Due diligence, however, encompasses a wider spectrum, varying significantly by case. It not only evaluates financial data but also delves into legal, environmental, market and operational conditions of the prospective company. Its expansive scope is tailored to the specific concerns and objectives of the acquiring or investing entity.

Procedures and Depth of Analysis

Auditing procedures are standardised, guided by accounting principles like Generally Accepted Accounting Principles (GAAP) or  International Financial Reporting Standards (IFRS). Auditors perform tests such as analysing financial transactions, checking compliance, and evaluating internal controls. The depth is consistent but limited to financial accuracy and compliance. Due diligence, on the other hand, involves customised, thorough investigations into every aspect of the business. This includes financial audits, legal reviews, market analysis and environmental scans, providing a deep, holistic view of the target entity’s health and prospects.

Participants

Audits are conducted by certified public accountants (CPAs) or audit firms, who must maintain independence from the company being audited. Internal audits might also be conducted by a company’s own audit department. Due diligence is typically carried out by a diverse team including financial analysts, legal experts, market consultants and sometimes technical specialists depending on the business nature. This team collaborates closely with the company pursuing the acquisition to tailor their investigation to specific informational needs.

Costs

The cost of conducting an audit is generally predictable and is influenced by the company’s size, industry and the complexity of its financial structures. It is considered a regular business expense. Due diligence can be significantly more expensive due to its extensive nature and the need for various specialised experts. The costs are also influenced by the size of the deal and the depth of information required.

Regulatory Requirements

Auditing must adhere to strict regulatory frameworks such as the Sarbanes-Oxley Act in the U.S., which dictates how audits should be conducted and reported. Due diligence, while not regulated through a specific framework, must comply with relevant legal standards to ensure that all material facts about the target company are accurately disclosed and that the investigation itself does not violate any laws (like privacy laws).

Outcomes and Usage of Results

Audit results in a formal report assessing the accuracy and compliance of financial records, critical for stakeholders like regulators, investors and creditors. In contrast, due diligence culminates in a comprehensive report or a series of reports that inform strategic decisions such as proceeding with, renegotiating or withdrawing from a potential deal. Investors use due diligence findings to assess risk, potential return on investment and strategic fit, whereas regulatory bodies might use audit reports to ensure compliance and financial transparency.

While auditing and due diligence are distinct processes with unique objectives, both serve the essential purpose of assessing a company’s financial and operational health. Each process plays a crucial role in ensuring transparency and informed decision-making, thereby safeguarding stakeholder interests and facilitating sound business practices.