Financial Due Diligence Case Studies for Interview

Financial due diligence (FDD) is a critical process in mergers, acquisitions, and investments. It involves thoroughly reviewing and analysing the financial records of a company to assess its overall financial health and risks. For professionals preparing for interviews in finance, understanding real-world FDD case studies can be the key to standing out. In this article, we will explore seven practical FDD case studies that illustrate key challenges and legal considerations in the process, which will help you build a solid foundation for your next interview.

1. Case Study: Identifying Ghost Employees

Context
One of the most common issues during financial due diligence is the discovery of ghost employees—individuals who appear on the payroll but do not exist. This fraudulent practice is often used to divert funds for personal gain. In one case, a target company presented its payroll records during due diligence, but discrepancies were found upon closer inspection.

Steps Taken in Due Diligence

1. Verification of HR Records
   To begin, the due diligence team cross-referenced the payroll with HR records. They examined appointment letters, employee attendance logs, and resignation records to confirm each individual’s employment status.
2. Bank Reconciliation
   Payroll disbursements were also checked against the bank statements to ensure that the listed salaries matched actual disbursements.
3. Legal Implications
   • Fraudulent Activity: Falsely inflating the payroll to divert funds is a clear violation of the Indian Penal Code (IPC). Sections 420 (cheating) and 405 (criminal breach of trust) would apply in such cases.
   • Civil Actions: The company could seek restitution through civil remedies under the Specific Relief Act, 1963.

Interview Tip

• When discussing this case in an interview, focus on the importance of verifying all employee records and emphasise the role of legal compliance in preventing such fraudulent practices.

2. Case Study: Using Excel for Financial Analysis

Context
In another instance, a due diligence team was tasked with reviewing a large set of financial data stored in an Excel sheet. This data included various revenue streams, costs, and working capital changes. The team needed to ensure the accuracy of this data and check for errors or discrepancies.

Steps Taken in Due Diligence

1. Formula Audit
   Excel formulas were audited using the ‘Trace Precedents’ and ‘Trace Dependents’ functions to verify correct linkages between cells. The team also ensured that there were no hard-coded values that might distort data analysis.
2. Version Control
   The team checked the version history of the Excel file to ensure it was consistent with the target company’s management reports and board minutes.
3. Legal Considerations
   • Data Privacy Compliance: Since the data contained sensitive personal information (such as employee salaries), it was essential to comply with the Information Technology (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules, 2011.
   • Audit Requirements: Any discrepancies or tampering could be grounds for legal action under the Companies Act, 2013, which mandates accurate financial disclosures.

Interview Tip

• Emphasise your ability to work with large datasets and discuss the importance of maintaining data integrity during financial analysis. Highlight your knowledge of legal requirements regarding data privacy and security.

3. Case Study: Impact of Salary Increments on Financial Statements

Context
During the due diligence of a company, the team discovered that the target had recently made significant salary increments across various departments. The team needed to assess how these increments would affect the company’s long-term financial stability.

Steps Taken in Due Diligence

1. Trend Analysis
   The team reviewed historical salary trends to assess whether these increments were in line with revenue growth. They also analysed the impact of these increments on the company’s cost structure.
2. Compliance Check
   The team also checked whether the salary increments complied with the Payment of Wages Act, 1936, and the Payment of Bonus Act, 1965. It was crucial to ensure that statutory contributions to the Provident Fund (PF) and Employees’ State Insurance (ESI) were accurately calculated on the new salary base.
3. Sustainability Analysis
   The team projected future cash flows, considering the higher salary base, to determine if the company could sustain these costs without negatively affecting profitability.

Legal Implications

• Labour Law Compliance: Any failure to comply with labour laws may lead to penalties under the Payment of Wages Act, 1936. Non-compliance with social security contributions could attract fines under the Employees’ Provident Funds and Miscellaneous Provisions Act, 1952.
• Breach of Contract: If salary increments were not approved by the company’s board or deviated from contractual obligations, employees may claim a breach of contract.

Interview Tip

• Discuss how you would assess the long-term impact of salary increments on a company’s financial health, ensuring that all legal requirements are met.

4. Case Study: Revenue and Cost Adjustments

Context
In one case, the target company reported a large one-time gain from the sale of an asset. The due diligence team had to adjust the financial statements to normalise revenue and cost figures, reflecting only recurring items.

Steps Taken in Due Diligence

1. Identification of Non-Recurring Items
   The team reviewed the notes to the accounts and flagged one-time items, such as the sale of assets and legal settlements. These were not part of the company’s regular income or expenses.
2. Adjustment of Financials
   The team recalculated EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) and net profit after excluding the non-recurring items. They also provided pro forma financial statements for the acquirer.
3. Disclosure Requirements
   The adjusted financials were disclosed in accordance with Indian Accounting Standards (Ind AS), particularly Ind AS 1 on Presentation of Financial Statements.

Legal Implications

• Misrepresentation: Failure to correctly adjust for non-recurring items could lead to accusations of misrepresentation under the Indian Contract Act, 1872. The aggrieved party could seek contract rescission under Section 19 of the Act.
• Regulatory Breach: For listed companies, improper disclosures may violate the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, leading to penalties.

Interview Tip

• Focus on your ability to identify and adjust for non-recurring items, ensuring that your adjustments are legally compliant and properly documented.

5. Case Study: Cost of Repatriation

Context
A multinational company was looking to repatriate profits from its Indian subsidiary. The due diligence team had to calculate the total cost of repatriation, including withholding tax, foreign exchange (FX) charges, and the compliance requirements under the Foreign Exchange Management Act (FEMA).

Steps Taken in Due Diligence

1. Withholding Tax Calculation
   The team reviewed the Double Taxation Avoidance Agreement (DTAA) between India and the foreign country to determine the applicable tax rate. They ensured that the company filed the necessary forms (15CA and 15CB) with the Reserve Bank of India (RBI).
2. FEMA Compliance
   They checked that the repatriation was compliant with FEMA regulations, ensuring that all remittances were reported to the RBI.
3. Foreign Exchange Costing
   The team also evaluated the impact of FX fluctuations on the repatriation amount and calculated potential costs due to currency movements.

Legal Implications

• FEMA Compliance: Failure to comply with FEMA can lead to penalties under Section 13 of the Act.
• Tax Litigation: Incorrect withholding tax can result in income tax assessments and penalties under the Income Tax Act, 1961.

Interview Tip

• Demonstrate your knowledge of FEMA and DTAA regulations, and how you would ensure full compliance during the repatriation process.

6. Case Study: Constant Currency Analysis

Context
During due diligence, the team noticed that fluctuations in the Indian Rupee (INR) had impacted the company’s financial results. To get an accurate picture, they performed a constant currency analysis to remove the impact of currency fluctuations.

Steps Taken in Due Diligence

1. Choosing the Right Rates
   The team selected average exchange rates for the comparative period to restate prior-year figures.
2. Restating Financials
   They adjusted the revenue and expenses of the target company to reflect constant currency, providing a clearer comparison between periods.
3. Disclosures
   The restated figures were presented in the footnotes of the financial statements, with the methodology clearly explained.

Legal Implications

• Audit Issues: If constant currency adjustments are not clearly explained or adequately documented, auditors may qualify their opinion, leading to potential legal and regulatory consequences.
• SEBI Regulations: For listed companies, unclear currency adjustment disclosures may violate SEBI’s disclosure requirements.

Interview Tip

• Explain how you would conduct a constant currency analysis, ensuring compliance with accounting standards like Ind AS 21.

7. Case Study: Price and Volume Variance Analysis

Context
In a manufacturing company, the due diligence team had to investigate the reasons behind a decline in profit margins. They separated the impact of price and volume variances to understand the underlying causes.

Steps Taken in Due Diligence

1. Variance Calculation
   The team calculated the price variance (difference in price multiplied by actual volume) and the volume variance (difference in volume multiplied by the standard price).
2. Investigating the Causes
   They looked into changes in pricing policies, discounts offered, and production capacity constraints that might have affected volumes.
3. Reporting
   The findings were presented in a dashboard format, showing the breakdown of each variance.

Legal Implications

• Competition Law: If pricing policies or volume changes violate the Competition Act, 2002, the company could face penalties.
• Inventory Issues: Volume changes affect inventory levels and may violate Ind AS 2 on Inventory if not properly accounted for.

Interview Tip

• Be ready to walk through the calculation and analysis process of price and volume variances, and explain their legal significance in terms of competition law and inventory accounting.

Conclusion

In preparing for interviews focused on financial due diligence, it is important to understand both the technical and legal aspects of the process. By exploring these seven case studies, you can develop a comprehensive approach to identifying financial risks, legal violations, and ensuring compliance. Focus on explaining your analytical techniques and the legal considerations that guide your decisions. Whether it’s fraud detection, regulatory compliance, or financial adjustments, mastering these concepts will make you a strong candidate in any FDD-related interview.