16-02 DUE DILIGENCE HANDBOOK
Financial Controls and Exchange Transactions - Forms 16-05 And 16-06
The quality and thoroughness of a firm’s internal controls are a major focus of the due diligence process.
Entire books have been written on the subject of financial controls. The most complete and easy to understand
treatment the author has come across is:
James D. Wilson and James P. Colford. Controllership. Fourth Edition. New York: John Wiley &
The review of the financial control function generally follows the sequence in which subjects appear in the bal-
ance sheet and the income statement. The forms are in a question and answer format. In most cases the preferred
response is obvious. Therefore, it is not necessary to repeat the detailed questions in this portion of the document.
Form 16-06 on Foreign Exchange is self explanatory.
Audit Function - Form 16-07
An internal audit function is essential for all but the smallest nonpublic companies. This does not require that
the firm have a fulltime staff devoted to this activity. The internal audit activities can be performed on a part-
time basis by knowledgeable accounting personnel auditing activities that are not part of their regular duties.
As in the case of the financial controls, the thoroughness and accuracy of the internal audit process are impor-
tant to the due diligence investigation.
And Budgeting - Form 16-08
The distinction between financial budgeting and planning is subject to local interpretation. As the terms are
used here, the budget process involves considerably more detail, such as actual headcount projections and
detailed material requirements.
The vast majority of companies budget on an annual basis. However, there is an increasing trend to extend
the detailed budgeting process out a second year.
A financial plan usually extends out three to five years and relies heavily on the use of ratios to project rev-
enues, expenses, cash flows and balance sheet accounts. Most plans also establish nonmonetary goals.
WHAT TO LOOK FOR
The due diligence team should review the internal audit reports for a minimum of the past three
years, and preferably for the last five years. The actions taken as a result of these audits should
be discussed with both the internal accounting staff and the outside auditors to assure that the
recommended controls are in place and working efficiently.
It is extremely important that the individual, or individuals, heading up this function have free
access to the Chief Executive Officer and the Audit Committee of the Board of Directors.
WHAT TO LOOK FOR
Do the financial controls appear to be generally adequate?
Where do the controls need improvement?