Reviewing accounts only part of an appropriate due diligence process, says expert

IT law specialist Iain Monaghan of Pinsent Masons, the law firm behind Out-Law.com, said that due diligence in outsourcing was reciprocal, as suppliers as well as contracts require to learn more about prospective partners before engaging in a relationship.

"Because the contract creates an on-going relationship and because most studies show that the health of that relationship is key to the success of the contract, both customer and supplier should conduct due diligence: the customer to determine whether the supplier is an organisation with which it wants to do business, the supplier to determine whether it can meet the customer’s expectations from the outsourcing," Monaghan said.

"That the other party has healthy finances will be important, but other factors will also be taken into account. The customer will want to examine the supplier’s track record in cost reduction and innovation and in reliable service delivery: the supplier will want to investigate any assets, employees, and contracts it is likely to inherit so that it can assess the cost of providing the required services," he said.

Monaghan was commenting after a shareholder of Hewlett-Packard (HP) launched a legal case in the US against Deloitte and KPMG, claiming that the auditors had "consciously disregarded numerous red flags" related to the value of UK firm Autonomy that caused HP to buy the software business at an inflated price last year, according to a report  by the BBC.

Last week HP reported that its purchase of Autonomy had cost its software business $8.8 billion, but attributed "the majority of this impairment" to "serious accounting improprieties, disclosure failures and outright misrepresentations at Autonomy" which it said "occurred prior to HP's [£7 billion] acquisition of Autonomy" in 2011 and which affected the "trading value" of shares, it claimed.

HP's claims prompted Dr Mike Lynch, Autonomy's former chief executive to fervently deny the allegations.

However, HP shareholder Philip Ricciardi is suing Deloitte and KPMG, among others, accusing the auditors of playing a part in the alleged misrepresentation of Autonomy's value.

Chris Wheeler, forensic accountant at Pinsent Masons, said that a full due diligence procedure is generally governed by bespoke terms of engagement that set out the processes involved, timescales for carrying them out and the limits of liability.

"Typically the terms of due diligence will include the conducting of an analytical review of financial performance; visits to key sites and interviews with key personnel," Wheeler said. "They will also include the assessment of management accounts and internal reporting; key customers and the book of business; key suppliers, terms and obligations; the control environment; and management attitude to risk."

"Those conducting due diligence will generally ask questions and challenge assumptions, taking the business apart and making an independent assessment of it, its future and its worth to the acquirer," Wheeler added. "You wouldn’t buy an expensive used car just on the strength of its service history – at the very least you’d want a mechanic to check it out."

"The financial statements can only ever provide some assurance that the historic performance as dictated by the accounting policies adopted by the company in their preparation was true and fair – in other words that the auditors were satisfied that the Directors had produced numbers and disclosure in accordance with the relevant accounting standards which was fairly stated within their view of what was material, and properly prepared in accordance with the Companies Act," Wheeler said.