Liabilities due diligence is beyond a doubt, one of the most important processes in the fast-moving world of Indian startups. It is a broad evaluation of the financial, secretarial, and other legal areas that are needed to make informed decisions and ponder over effective risk measures for a startup.
Let's dive into the key components of liabilities due diligence:
1. Share Capital
Accounting For Share Capital: Verify the separate recording of share capital and securities premium of each type of share with its series and allotment date in accordance with requirements from MCA.
Verification Of Share Capital: Match the company’s books of accounts with the Ministry of Corporate Affairs (MCA) records, financial statements, and tax returns and reconcile the issued paid-up capital with the fully diluted cap table post considering all the series of shares, conversion terms, and dilutive issuances.
Receipt Of Money: Reconcile shareholding pattern with accounting data, bank statements, and regulatory filings and ensure proper recording of share application money in the books of accounts, including refunds for short / excess amounts.
Issue Of Shares: Confirm the timely receipt of money towards share application and allotment. Also, verify that face values and names of shareholders in all corresponding records and filings for accuracy and consistency.
Compliance And Disclosures: Check the applicability of CARO, 2020, compliance relating to foreign investment, and accuracy of FLA returns. Also verify whether substantial shareholdings have been disclosed in the financial statements and tax returns, wherever required.
Valuation Reports: Obtain valuation report copies to evaluate any tax implications in case of secondary transfers, scrutiny with respect to down-rounds and understand underlying reasons for the same.
Shareholder-Equity Ratio: Benchmark the company's shareholder-equity ratio against industry peers, considering asset financing and leveraging strategies to get an insight into capital structure and ownership.
2. Reserves and Surplus
Accounting Of Reserves And Surplus: See that the company has clearly demarcated records for capital reserves and revenue reserves, with bifurcation under each head as needed.
Securities Premium Account: Verify the utilization of the securities premium account is in accordance with the Companies Act, 2013 for specified purposes only as mentioned therein.
Share Application Money Pending Allotment: Check the amount appearing in Share Application Money Pending Allotment ledger to verify whether the same gets has been transferred to share capital & premium on allotment, or refunded within the regulatory timelines.
Money Received Against Share Warrants: Verify warrant agreements and trace the amount received to the figures shown in the audited financial statements as well as underlying accounting data.
Surplus/Deficit In Profit And Loss Account: Ascertain that the profit / loss as per the Statement of Profit and Loss has been transposed properly and considered in the Reserve and Surplus schedule year on year.
Share Options Outstanding Account: If ESOP options have been granted by the company, verify that appropriate accounting entries have been passed as per the Guidance Note on Share-Based Payments and on the basis of an underlying valuation report.
3. Borrowings
Verification With Books: From the records, get a list of outstanding loans and verify the same against loan listings, which are found to agree with the outstanding loans appearing in the books of accounts.
Loan Agreements: Procure the loan agreement and study its content for purpose, interest rate, repayment schedule, and other critical covenants, and ensure proper disclosures as well as recording of the same in the books of accounts.
Compliance With Regulatory Limits: Ascertain whether the loans taken from directors, shareholders, or related parties are within the limits prescribed under the Companies Act, 2013.Also ensure that charges have been created in the case of secured loans and the register with ROC updated for the same.
Loan Repayment: Ensure that the borrower has obtained a 'No Dues' Certificate from the lender in respect of loans fully repaid during the review period.
Loan Converted To Equity: Make sure adequate and proper board resolutions have been passed as per the applicable laws and conversion is being made in accordance with the terms of executed documents upon the conversion of debt into equity.
Book Adjustments: Check whether outstanding loan balances have been offset against other receivables or by way of passing journal entries to reallocate the balance to separate accounts.
4. Provisions
Classification: Take the detailed schedule of provisions classified as 'Provisions' from the Tally data and analyze the nature and rationale behind creation of provisions.
Outstanding Dues: Check whether all dues outstanding during the period have been properly accounted for, particularly in instances where services have been rendered but the related invoices have not been received.
Trend In Amount Of Provisions: Review the trend in provisions and assess the appropriateness of provisioning quantum. Ensure that the long-term provisions are visited each year to provide for the best estimate of the possible liability.
Year End Provisions: Check the provisions made at year-end and whether such provisions have been reversed appropriately at the beginning of the next financial year or as and when the invoice is raised.
Provisions For Tax: Ensure separate tax provisions for each assessment year. Review the income tax portal for completed assessments, identify outstanding demands, and recommend provisioning for payment accordingly.
Compliance With Income Tax: Check that provisions created during the year are not considered while computing the taxable income. Moreover, under Section 43B, ensure that expenses whose deductions are admissible only on payment basis, including contributions to the employee welfare fund, bonus, and commission etc. have actually been paid.
Provision For Gratuity And Leave Encashment: Check whether an actuarial valuation report has been obtained for the provisioning of gratuity as well as leave encashment, and the amount appropriately recorded in the books of account.
5. Sundry Creditors
Ageing Report: Obtain the ageing report for Sundry Creditors and understand the reasons for long outstanding creditors. Prioritize discussing with the management the next steps in the process to expedite payment and to avoid any penalties or litigation.
Outstanding Proceedings Or Demands: Basis the amounts payable to professional and legal consultants, identify any outstanding legal proceedings or demands for which legal or professional assistance is being sought.
ITC Credit On Settlement: Verify whether payables to creditors have been settled within 180 days from the Invoice Date. In case the payment is made beyond the said period of 180 days, it shall result in reversal of Input Tax Credit claimed for said invoices. Such Input Tax Credit will be allowed only on the settlement of outstanding payable.
MSME Vendors: As per provisions of Section 43B(h) of the Income Tax Act, 1961, verify whether payments to MSME vendors have been made within the stipulated time to be eligible to claim deduction in the computation of income. Also, verify compliance with the provisions of MSMED Act, 2006 and ensure that the settlement to MSME vendors is being done in a timely manner.
Payment Terms: Verify the agreements for terms of credit on a sample basis and ensure that the payments are being made regularly to avoid any legal repercussions. Also, verify the PO copies, invoices, and understand the terms, and in case there is no agreement in place, recommend that an agreement is entered to document terms of the arrangement.
Tax Deducted At Source: In keeping with the Income Tax Laws, ensure TDS is deducted at the time of booking or payment, whichever is earlier. On occurrence of any delay, calculate the interest and penalty, as well as check for timely payment for the same.
Multiple Services From Same Creditor: In case the creditor has provided more than one service, verify that expenses have been properly recorded in the correct ledger, and ensure corresponding TDS deducted as well as GST ITC appropriately provided for in the books of accounts.
Creditors With A Debit Balance: In case of debit balance for creditors, understand the reasons for paying advances or for the non-receipt of services. Furthermore, confirm whether the payment to the creditor has been made net of TDS and recommend that the invoice be obtained from the creditor in order to claim timely ITC under GST.
6. Other Current and Non-Current Liabilities
Advance From Customers: Ensure that any payment received in advance for which associated goods or services are pending to be supplied to a customer are recognized as deferred or unearned revenue on the liabilities side. Also check that the applicable GST has been properly paid to the credit of the government on the receipt of advance and examine the terms of the contract or agreement, if any, to ascertain the reason for the advance received.
Accrued Expenses: Verify previous year accruals with audited financial statements to ensure accuracy. Further, by calling for sample invoices and agreements, understand the reason for non-payment of accrued expenses and verify the basis including payment of the same subsequently.
Payables To Employees: Check that no long outstanding dues are payable to employees; it should ideally not exceed one month's salary. Also verify the reimbursements basis supporting documents to understand its genuineness and reason-ability by comparing it with the limits approved by the management.
Lease Obligations: Verify the type of lease by going through the lease agreement and ensure accounting has been properly done for the same, i.e. basis nature of the lease (either an operating lease or a financing lease). In the case of an operating lease, the lease payments would be expensed out to the profit and loss account over the tenure of the lease. In case of a finance lease, the same should be recorded at fair value as an asset as well as liability.
Conclusion
One needs to go beyond the share capital, reserves, and surplus to examine carefully the provisions, sundry creditors, loans, and other liabilities. By doing so, you will be able to see where the risks are and build sturdy roots for growth. A thorough due diligence of liabilities assists in building a sustainable and compliant business in India
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