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CA Final · Advanced Auditing, Assurance and Professional Ethics · Due Diligence, Investigation & Forensic Accounting

Sundaram & Co., Chartered Accountants, are engaged by a private equity fund to carry out financial due diligence on Kaveri Foods Pvt. Ltd., a target company. During the work, the team notices that the target's reported EBITDA includes a one-time gain of Rs 40 lakh from the sale of a warehouse. For the purpose of assessing the sustainable earnings of the target, what should the due diligence team do?

The team should normalise EBITDA by removing the one-time Rs 40 lakh warehouse sale gain. Quality of earnings analysis in financial due diligence adjusts for non-recurring and non-operating items so the buyer sees sustainable earnings and does not overpay based on inflated reported profit.

  1. AInclude the gain in maintainable EBITDA because it is part of reported profit
  2. BNormalise EBITDA by excluding the non-recurring gain from the maintainable earningsCorrect
  3. CExclude the gain only if the management agrees to the adjustment
  4. DIgnore the item since due diligence relies only on audited figures

Explanation

Financial due diligence includes a quality of earnings review, in which non-recurring and non-operating items are adjusted out to arrive at maintainable or normalised earnings. A warehouse sale gain is not part of recurring operations. Including it, as in the first option, would overstate the value the buyer should pay.

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