Chapter 12

Due Diligence Guidelines –

Financial

4. Financial Review Process (Overview)

4.1 Standards

4.1.1 Regarding the preparation of a listing document, a sponsor should examine and consider the accuracy and reliability of the financial information, including reviewing the financial statements of major subsidiaries, internal financial records, tax certificates, regulatory filings and public records. [Paragraph 17.6(d)(v) of the Code of Conduct]

4.1.2 Paragraph 12(b) of Practice Note 21 similarly provides that typical due diligence inquiries in relation to the new applicant’s compliance with the qualifications for listing include reviewing material financial information, including:

(i) financial statements of the new applicant;

(ii) financial statements of all subsidiaries of the new applicant and other companies that are material to the group’s financial statements; and

(iii) the internal financial records, tax certificates and supporting documents to the tax certificates for the trading record period.

4.1.3 Paragraph 12(b) further provides that such review would in most cases include interviewing the new applicant’s accounting staff and internal and external auditors and reporting accountants and, where relevant, obtaining comfort from the new applicant’s external auditors or reporting accountants based upon agreed procedures.

4.1.4 Paragraph 13(e) of Practice Note 21 provides that typical due diligence inquiries in respect of each new applicant and the preparation of its listing document and supporting information include undertaking a physical inspection of material assets, whether owned or leased, including property, plant, equipment, inventory and biological assets (for example, livestock or crops) used or to be used in connection with the new applicant’s business.

4.1.5 Paragraph 13(e) further provides that where, in the reasonable opinion of the sponsor, assessment of an asset, including as to its extent, quality, quantity and use, genuinely cannot be achieved without the use of an expert (for example, in undertaking the physical inspection the sponsor becomes suspicious that the asset does not exist as to the extent represented or exists but is not used for the purpose claimed) the sponsor should ensure that the new applicant instructs an appropriately qualified independent expert to conduct all or part of the inspection. In such cases the sponsor should ensure the expert is required to provide a written report in respect of the inspection.

4.2 Guidance

4.2.1 Financial due diligence is an iterative exercise conducted by the sponsor with significant assistance and input from the Reporting Accountant and lawyers.

4.2.2 It is a holistic exercise, significantly dependent upon information provided by the listing applicant’s management.

4.2.3 Sponsor financial due diligence is not an audit or accounting review.

4.2.4 It does not normally involve direct examination of the listing applicant’s financial systems and records by the sponsor.

4.2.5 Modeling is not a prescribed or essential part of the review, but can assist with the sponsor’s understanding of financial presentation and underlying trends.

4.2.6 The sponsor does not perform or (typically) re-examine the combination or consolidation exercise involved in creation of the listing applicant’s combined / consolidated financial statements.

4.2.7 Site visits provide prima facie verification of the physical existence of the listing applicant’s operations and operating assets. Beyond that, the sponsor’s financial due diligence process does not normally extend to quantum based physical checks or forensic enquiry of the nature performed during an audit. General business and operational due diligence may involve some visual verification of (for example) production or sales operations. (See Chapter 8 “Due Diligence Guidelines – Business Model and Chapter 21 “Due Diligence Guidelines – Inspection of Assets and Property Valuers’ Reports”).

4.2.8 In parallel with the sponsor’s own investigations (and discussions with the listing applicant’s management), the sponsor’s overall financial due diligence encompasses parallel interdependent due diligence streams principally comprising (i) Reporting Accountant “comfort”, (ii) Reporting Accountant diligence interviews and (iii) the internal controls review. (See Chapter 20 “Due Diligence Guidelines – Accountants” and Chapter 13 “Due Diligence Guidelines – Internal Controls”.

4.2.9 Although not mandatory (and not always feasible), involvement of team members with specialist sector experience will often assist in the effective performance of the sponsor’s due diligence.

4.2.10 The key objectives of the sponsor’s financial review are:

(a) To understand the underlying financial profile of the business, both in its own right and (so far as feasible) in comparison to peers and competitors (and consistency of the listing applicant’s financial performance with the sponsor’s expectations from its business due diligence);

(b) To understand significant trends affecting (i) the listing applicant’s overall business and financial condition and (ii) material segments / product-lines;

(c) To understand the listing applicant’s accounting presentation relative to its underlying financial profile; and

(d) To identify any “red flags” (see section 12 “Red Flags and Similar Irregularities” below).

4.2.11 In overview, the process normally entails:

(a) Preliminary information requests and desk top review (including against peers and competitors);

(b) Management presentation(s) (to provide core information on business and finances, and responsive to the sponsor’s preliminary questionnaire);

(c) Examination of the listing applicant’s financial statements (and other materials received in response to information requests), and preparation of a detailed questionnaire to facilitate line item analysis and preparation of MD&A;

(d) Detailed discussion sessions with management;

(e) Accounting due diligence interviews with the Reporting Accountant; and

(f) Audit due diligence interviews with the Reporting Accountant (invariably combined with accounting diligence).

4.3 Preliminary Information Requests

4.3.1 As a starting point for formal due diligence, it is common for the sponsor to submit information requests for high level but directionally significant input with respect to (i) the listing applicant’s business and (ii) its financial condition, performance and presentation.

4.3.2 In combination these requests (i) inform content of the ensuing management presentations, and (ii) pave the way for the sponsor’s more detailed financial diligence described in the following Sections of this Chapter.

4.3.3 The preliminary financial requests (which are normally tailored to the listing applicant’s business sector, and any other factors known to the sponsor from prior dealings / familiarity with the listing applicant) will typically cover:

(a) Background and General

(i) Historic consistency of performance compared to budget.

(ii) Recent reorganisations (acquisitions, disposals, carve-outs, etc).

(iii) Trends and expectations (including risks and uncertainties).

(b) Financial Statements (including management accounts) for the track record period.

(c) Internal Controls and Accounting Presentation (description, known deficiencies and remedial measures).

(d) Profit and Loss / Income Statement Line Items (including segment and product breakdowns, seasonality, finance costs and taxation).

(e) Balance Sheet Line Items (including receivables and intangibles).

(f) Cash Flow (including capital expenditure).

(g) Financing Arrangements (and derivatives).

(h) Working Capital.

(i) “Off-Balance-Sheet” Matters.

4.3.4 In parallel there will be a legal due diligence request which is usually extensive, and has some financial content. There is therefore some overlap, but it is the sponsor’s business and financial request list(s) which are most important to the financial due diligence stream.

4.3.5 Business due diligence requests are addressed in detail elsewhere (see Chapter 8 “Due Diligence Guidelines – Business Model”).

4.3.6 Financial diligence is also informed by the outcome of the legal and regulatory review, which will reveal any restrictions / constraints to which the listing applicant is subject under applicable laws (or permits) or under its constitution, or any contracts to which it is party.

4.4 Initial Management Presentation(s)

4.4.1 Formal management presentations are the usual starting point for the organised due diligence process which also drives preparation of the listing document.

4.4.2 There may be one or more initial presentations covering business and financial matters, responsive to the preliminary information requests and providing a picture of the listing applicant’s profile which will be reflected in the listing document.

4.5 Review of Sector and Peers

4.5.1 The sponsor should always review information on the listing applicant’s sector and its peers and competitors.

4.5.2 This should normally include obtaining analyst reports on the sector and on specific industry competitors. This review should normally include an evaluation of overall industry trends, key macro-economic factors and an understanding of common accounting practice. This forms a basis for evaluating the listing applicant’s relative performance.

4.5.3 It is to be noted however that an accurate comparison of (for example) accounting practices is dependent on key information not in the public domain (and confidential to the companies concerned) so that a sponsor’s ability to make accurate comparisons of this nature is subject to material limitations. (For similar reasons, audit firms are unwilling and unable to discuss questions on this sort of topic in course of Reporting Accountant due diligence interviews).

4.6 Detailed Financial Review

4.6.1 The more detailed financial review process described in the next section leads to determination of the financial content of the listing document based on the fuller and more detailed information gathering process.

4.7 Group Entities

4.7.1 Due diligence enquiries should always cover the listing applicant and its subsidiaries (although the scale of substantive diligence enquiries on subsidiaries will be dependent on materiality).

4.7.2 Enquiries should extend to associates material to the listing applicant’s business and financial performance. The level of inquiry will vary significantly depending on (i) the level of control or influence over the associate enjoyed by the listing applicant and (ii) the applicable level of materiality. This should be assessed at an early stage on a case-by-case basis.

4.7.3 Where the listing applicant has listed associates, the nature of disclosure and the possibility to conduct due diligence will fall to be determined on a case-by-case basis. There will normally be significant constraints on due diligence, and on disclosure extending beyond publicly available information.