Reviewing expenses during Due Diligence helps verify authenticity and accuracy of expense claims, identify major areas of spending, assess management’s financial discipline and controls. Further, it also helps to evaluate reasonableness of expense levels and trends for expenses. Let’s delve into how to conduct a due diligence of expenses:
Cost of Material Consumed
Nature Of Manufacturing Process: First understand the type of manufacturing process involved and then modulate the review process based on the same, including understanding of the nature of the processes—whether capital-intensive or labor-intensive, in-house, or job-work etc.
Purchase Registers: Review and reconcile the purchase register with the books of accounts, including appropriately identifying and verifying inventories handled by the company such as raw materials, packaging materials, consumables etc.
Cost Breakdown: Conduct a cost analysis by detailing the breakdown of landed costs for merchandise at the factory or in a warehouse, either by product type or by SKUs.
Production Cost Analysis: Compare product costs with industry benchmarks to identify areas of improvement and understand where efficiency can be increased.
Lead Time And Quality Check: Conduct lead time calculations to ensure timely availability of materials, followed by rigorous quality control protocols to uphold necessary standards.
Inventory Analysis: Ensure the breakup of opening and closing inventory is obtained and identify obsolete inventory with thorough detail. In addition, make an inquiry about the discrepancies and find out the reasons for differences.
Import Of Raw Material: Validate the accuracy and conformity of import purchase invoices, bill of lading, bill of entry, letters of credit, ocean freight invoices, and other relevant import documents with the company's records.
Employee Benefit Expenses
Salary Register: Ensure accuracy in the salary register by checking the details of basic salary, TDS, PF, and other deductions with the employment agreements. Also review this register with the accounting books to ensure uniformity as well as timely payments to employees are made. Further, examine compliance with TDS, PF, PT, ESIC, etc., for maintaining laws and financial integrity.
Employment Agreements: Verify the joining dates of employees and ensure proper recording of their salaries. This verification should extend to fixed and variable remuneration structures alongwith examining confidentiality, non-disclosure, and non-competition clauses to protect intellectual property of the company. Also identify costs incurred for employees with respect to product development, to enable proper capitalization of technology costs in the books of accounts.
Reimbursement To Employees: Thorough review of reimbursements, with all relevant supporting documents for the reimbursements made to employees, provides complete financial control, accuracy, and compliance with regulations in expense reporting. This assures integrity and operational efficiency in business.
Director Remuneration: Check the compliance with the withholding obligation regarding the remuneration of the Directors is in accordance with the provisions of the regulations. On the basis of facts, examine whether TDS shall be deducted under Section 192B or under Section 194J. Further, wherever TDS under Section 194J is to be deducted, also check whether compliance with RCM GST has been done.
Full And Final Settlement: Check the company's full and final settlement policy, which should include a sample for calculations of the deductions and recoverable amounts from employees. It is imperative that all financial obligations should be totally provided for at exit with no payments being made or payable thereafter.
Staff Welfare: Verify the amounts recorded under the head staff welfare expenses with actual invoices including health care, retirement contributions, insurance premiums, wellness programs, and work safety measures. This assessment gives surety of transparency and disclosure of costs incurred for the welfare of the employees.
ESOP:Examine the ESOP policy of the company. Check that the expenses are recorded on fair value basis and on the basis of a valuation report. Recording of ESOP expense should consider strike price, vesting schedule, and projected rates of exercise by employees in order to understand ESOP liabilities and their impact on books of accounts.
Finance Cost
Accounting Of Borrowing Cost: Ensure compliance with IND AS 23 or AS 16, as applicable, including verification of eligibility, suspension and cessation for capitalization of any borrowing cost.
List Of Borrowings: Obtain the overall schedule pertaining to loans and borrowings including secured loans, unsecured loans, debentures, bank overdrafts / cash credits, etc., and verify the same with agreement copies to ascertain compliance with loan terms and covenants.
Analysis Of Repayment Schedule: Verify the principal repayment schedule of loans availed, and ensure that interest is accrued in the books of accounts as per the agreed terms of the loan agreement. Match recorded interest against provisions, and ensure payment is being made and accounted for both principal and interest. Also ascertain whether the interest was paid on or before the due date of filing the return of income under Section 139(1) of the Income Tax Act, 1961, for the same to be eligible as deduction.
TDS On Interest Payment by Residents to Non Residents: Understand the applicability of Section 115A, relating to interest payable in case of borrowing in foreign currency from a non-resident, and compliance with withholding obligations in line with Section 195 as applicable, at rates in force or DTAA, whichever is beneficial.
Other Expenses
Marketing Expenses:Check the agreements with major providers of marketing services. Also verify TDS compliance for each party and review sample invoices (based on materiality) to verify accuracy and completeness.
Legal And Professional Charges: Verify the availability of signed engagement letters and the reasons for which legal and professional services have been availed. Also verify TDS and GST compliance and review sample invoices, considering RCM GST, if applicable.
Rent:Review all rent agreements for the period, including those for offices, furniture, equipment, laptops, etc., and ensure recording in the books of accounts in line with the terms of the agreements. On a sample basis, review bills / invoices to check whether TDS and GST provisions for all concerned parties have been complied with.
Subscription Charges: Check sample bills to understand the subscriptions being availed and evaluate compliance with TDS provisions. Further, as part of this, ensure that subscription services paid for and to be availed for a period greater than one year are recorded as prepaid expenses and are periodically charged to the Profit and Loss account as an expense. With respect to subscriptions from foreign service providers, check for compliance with the reverse charge mechanism under the GST and filing of Form 15CA / 15CB under the Income Tax laws.
Traveling Expenses:Check that the traveling expenses incurred by employees and Key Management Personnel are for business purposes and review supporting documents for the same. Also identify ineligible GST credit claimed on items such as staff welfare or hotel accommodation in another state, and suggest actions for proper reversal of the same.
Gateway Charges: Go through the agreements entered into with the payment gateway service providers and verify the commission / fees charged. Moreover, verify applicability of TDS on charges deducted and review sample invoices based on materiality.
Insurance: Review the insurance policies of the company to ensure premiums are paid and properly recorded in the books of accounts. If the premium is paid for a period more than one year, see that the same is properly recorded as prepaid expenses in the books of accounts. Also verify compliance with GST law, and identify any blocked credits availed with respect to insurance policies not obligatory as per law.
Disclosures:Ensure that every exceptional, prior period, or non-recurring items are adequately disclosed and comply with the regulatory requirements. As an industry best practice, transactions in excess of one percent of revenue or INR 1,00,000, whichever is higher, are disclosed.
Conclusion
Due Diligence on the expenses of Indian startups is vital to ensure that all expenses are accounted for appropriately, following applicable regulations, and depicting the correct picture of the financial health of the business. Our meticulous examination of expenses help to:
Identify potential financial risks
Ensure regulatory compliance
Attract investors with confidence
Make informed strategic decisions
Reach out to us today to safeguard your financial future!
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