25.01.10

IFRS As A Tool For Due Diligence
Maxim Grishin, Fellow of the Association of Chartered Certified Accountants (FCCA),
Senior Audit Manager, Alinga Consulting Group

Due diligence investigation is an integral part of the M&A process. The purpose of financial due diligence is to identify and quantify the target’s exposure to financial risks.

Indications of these types of risks can generally be found in the IFRS financial statements. However, the majority of the companies in Russia use only Russian Accounting Standards (RAS) and do not prepare IFRS accounts. If these companies were to become a potential target for M&A, the exposure can still be successfully assessed by converting the Russian financial statements to IFRS.

IFRS provides a number of specific methods, guidelines, and tools which can be applied to measuring, presenting and disclosing the financial data.

In this article we will examine how following IFRS standards can form the basis of a financial due diligence review. We will briefly discuss recognizing revenues, record-keeping, devaluation of tangible assets, and recognizing full consolidation in a group of companies and estimated liabilities.

Revenue recognition

International Accounting Standard (IAS) #18, “Revenues,” establishes that specific conditions have to be satisfied in order to recognize revenues. Of these, the most important are:

• A transfer of risks and rewards has to take place,
• The amount of revenues can be measured reliably,
• The costs can be measured reliably.

Following these rules will allow one to arrive at the amount of revenues, one of the key performance indicators (KPI) used by investors to make investment decisions. Applying IAS 18 allows one to reliably determine  the amount of revenues.

Impairment of Production Assets

One of the investor’s major areas of concern is establishing the condition of the target’s major production assets. It is essential to determine whether there may be a need for impairment provision with respect to these assets and therefore also to determine whether the target will be able to provide output in the quantity and quality stated in its business plan.

Applying IAS 36, “Impairment of Assets” during the Financial Due Diligence investigation will allow one to determine whether there are indications that an asset is impaired and whether reserves should be generated. In general, there are external and internal indicators of the impairment. External impairment indicators may be the declining market and aging technology. Internal indicators are obsolete equipment and poor production performance.  Applying the impairment tests as established by IAS 36 can determine the need for an impairment provision and to adjust the carrying amount of the assets if necessary.

Financial Leases

IAS 17 “Leases” is also applicable in a DD investigation. One of the major differences arising between RAS and IFRS statements is the recognition of the assets and the respective liabilities on the balance sheet. It is rare that the leased assets are capitalized by the lessee before the end of the financial lease term. The major reason for that is the property tax bill, which is assessed on the carrying value of the assets and, in Russia, is generally paid by the lessor, who gets it back from the lessee as part of the lease payment.

If RAS is used to assess the target, the financial lease liability would not be reflected on the balance sheet; this is of particular importance because it influences the amount of net debt, which is a KPI used by investors. Applying IAS 17 helps to determine the adjustment to the net debt that must be made.

An additional disclosure requirement established by the standards with respect to the financial lease liability is presenting the amortization plan or the schedule of the future repayments of the liability. This information is essential for investors to forecast the cash outflows in the financial periods to follow. RAS does not require disclosure of such information. If these future lease payments are not disclosed in the target’s business plan, the cash flow position in a certain period might be misleading.

The Group Structure

In assessing the major transactions of the target, it may be determined that the target deals with certain so-called “special purpose entities (SPE).” These may be: trading companies, which buy the significant portion of the target’s output and resell it to distributors and dealers; supply or service firms dealing with the majority of the target’s purchases; and outstaffing companies, which provide the target with a certain volume of production or administrative workforce. The existence of such entities and the nature of such a relationship are usually due to tax optimization schemes. The entities are generally owned by the target’s managers or their relatives, meaning that they are formally not related. However these entities are by substance controlled by the target.

The investor expects to see the full financial position and results of the target as a business. Analyzing the accounts of the target in isolation from the special purpose entities does not generally reflect the full situation.

Applying IFRS 3, “Business Combinations,” will help to determine whether the target, by substance, exercises control over its SPEs and whether they should be treated as subsidiaries and consolidated with the target. Standing Interpretations Committee (SIC) 12 “Special Purpose Entities” establishes the characteristics of SPEs and gives specific examples of SPEs and the treatment of transactions with SPEs.

When the consolidated financial statements, as required by IFRS 3, are prepared, the financial position of the group and additional liabilities may be recorded upon consolidation. These changes may affect the amount of net debt, and thus affect the investors' KPI.  Applying IFR 3 and SIC 12 will allow one to determine the real structure of the target’s group of companies and to assess the full amount of net debt. 

Provisions

As noted above, one of the KPIs of high interest to investors is the size of the net debt.

Recording provisions in the target’s financial statements as a result of applying IAS 37 “Provisions, Contingent Liabilities and Contingent Assets” may have a negative effect on the amount of net debt.

In accordance with IAS 37, a provision should be recorded in the event that an entity has a present obligation as a result of past events, the obligation is probable, and its amount can be reliably estimated. Examples of provisions are warranty provisions recorded at the point of sale of a product and tax provisions recorded upon completion of a tax audit by the tax authorities. Applying IAS 37 will prevent underestimation of the target’s net debt.

IFRS and Russian Targets

Applying IFRS principles and guidelines in converting RAS reports can give investors a clearer picture of the investment target for an M&A deal in Russia, especially in terms of how much net debt should be accounted for when determining KPI.

For M&A everywhere, financial due diligence is an essential tool to determining the true value and financial risk of a target. In Russia, IFRS conversion by a skilled professional is no less essential.

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