Due Diligence India — Financial, Tax & Forensic DD

Due Diligence in India — Overview

Due diligence is the backbone of any well-structured acquisition, investment, or merger. In the Indian context, DD has additional layers of complexity — GST compliance history, FEMA regulatory adherence, income tax assessments and pending appeals, and the prevalence of related party transactions that can mask the true picture of a business. A credible DD report from an experienced CA firm is what separates informed deal decisions from costly surprises post-acquisition.

Virtual Auditor's DD team is led by CA V. Viswanathan (FCA, ACS, CFE, IBBI Registered Valuer) — our CFE credential means we approach every DD with a forensic mindset, not just a compliance-checking exercise.

Financial Due Diligence

Quality of Earnings (QoE)

The cornerstone of financial DD. We analyse 3 years of P&L data to normalise EBITDA by identifying and adjusting:

• One-time income/expenses: Insurance claims, asset disposals, litigation settlements, COVID relief received
• Owner's personal expenses: Personal travel, family salaries above market rate, cars, club memberships charged to company
• Non-arm's-length related party transactions: Purchases from promoter-owned entities at above-market prices; sales to promoter entities at below-market prices
• Accounting policy differences: Revenue recognition, depreciation rates, inventory valuation, provisions for bad debts
• Missing accruals: Rent, interest, leave encashment, gratuity — provisions that should exist but were not made

Net Working Capital Analysis

We calculate the target's normalised working capital (receivables + inventory - payables) and compare it to the purchase price benchmark. If the closing working capital is below the normal level, the buyer is entitled to a price adjustment. This is one of the most contentious post-closing adjustment mechanisms — our analysis pre-empts disputes.

Net Debt Analysis

We identify all debt-like items — not just bank loans, but also: preference shares with redemption obligations, unfunded gratuity liability, security deposits received from customers (long-term liability), deferred revenue, contingent liabilities from warranties, and pending statutory dues. These reduce Enterprise Value to arrive at the equity value the buyer is paying.

Tax Due Diligence

Income Tax Exposure

• Review of income tax returns for last 6 years
• Status of pending assessments and appeals (CIT(A), ITAT level)
• Cash credit additions (Section 68) and unexplained investments (Section 69) history
• TDS compliance review — is TDS being deducted on all vendor payments, rent, professional fees?
• Transfer pricing — if target has related parties or foreign transactions, TP documentation compliance
• Section 43B(h) — MSME payment compliance (new from FY 2023-24)

GST Exposure

• Cumulative ITC mismatch — difference between ITC claimed in GSTR-3B and eligible ITC per GSTR-2B
• GST on advances — was GST paid on advances received (pre-supply)?
• Blocked credits (Section 17(5)) claimed inadvertently
• E-way bill violations, classification disputes
• Export LUT status — is LUT current for each year?
• Pending SCNs and demand orders — status, likelihood of adverse outcome, quantum

Indirect Tax and Excise (Pre-GST Legacy)

For companies operating pre-2017, we review service tax, VAT, and excise legacy exposure. These can surface years later as department audits continue. The GST DRC-01 demand can include pre-GST era demands transitionally.

FEMA and Regulatory Due Diligence

• FDI compliance: All FC-GPR filings complete? UINs available? Any FDI in prohibited sector?
• FC-TRS history: All past share transfers properly reported?
• FLA returns: Annual FLA returns filed for each FY where FDI exists?
• ODI compliance: If target has overseas subsidiaries, are ODI Part I and APR filed?
• SEBI compliance: If promoters are directors in listed entities, any disclosure violations?
• RBI approvals: Any transactions requiring RBI approval that were done without?
• Environmental/sector licences: All operating licences current and transferable?

Forensic Due Diligence

Our CFE team applies forensic analytics to identify fraud risk flags:

• Benford's Law analysis on journal entries and vendor invoices
• Related party transaction analysis — are all RPTs disclosed? Are prices arm's-length?
• Round-tripping detection — does cash leave and return via shell entities?
• Customer/vendor concentration risk — high concentration with related parties
• Inventory and asset verification sampling
• Bank statement reconciliation vs books of account
• Promoter background check — CIBIL, MCA director defaults, litigation history

DD Report Structure

Our DD report follows a clear, investor-grade structure:

1. Executive Summary — key findings, risk rating (High/Medium/Low), deal recommendation
2. QoE and normalised financial statements
3. Tax exposure schedule — issue description, quantum, probability, recommended treatment (escrow/indemnity/price reduction)
4. FEMA/regulatory findings
5. Forensic findings (if applicable)
6. Working capital and net debt analysis
7. Key risks and recommendations

Frequently Asked Questions

Red Flags That Emerge in Indian M&A Due Diligence

Indian DD has some recurring patterns that are distinct from global DD:

• Related party revenue inflation: Sales to promoter-controlled entities at inflated prices to show higher revenue — check if related party customers are genuine third-party buyers or entities controlled by the same promoter
• Unrecorded liabilities: "Off the book" trade creditors, employee dues (gratuity, leave encashment not provided), security deposits from tenants not in balance sheet
• Promoter "management fees": Large payments to promoter-controlled consulting entities at above-market rates — QoE normalises these out but they indicate control/integrity issues
• Unexplained cash deposits: Large cash deposits in current accounts that don't trace to revenue — Section 68 risk in income tax, PMLA risk in extreme cases
• FEMA time bombs: Companies that raised FDI but never filed FC-GPR — the FEMA violation is not on the balance sheet but the compounding liability is real
• GST ITC accumulation: Large ITC balances that are overstated due to claiming from cancelled/suspended suppliers — may require reversal post-acquisition
• Phantom employees: Payroll entries for employees who don't exist, or "employee" payments that are disguised promoter withdrawals

Data Room Setup — What Sellers Must Prepare

For efficient DD, sellers should prepare a structured virtual data room (VDR). A well-organized data room reduces DD time by 30–50% and gives buyers confidence in the seller's preparedness. Standard India M&A data room structure:

1. Corporate documents: CoI, MOA, AOA, board minutes, shareholder agreements, cap table
2. Financial statements: 3 years audited + last 6 months management accounts, all notes
3. Tax: ITR, 26AS, tax assessment orders, pending appeals, GST returns, demand notices
4. FEMA: FC-GPR certificates, FLA returns, ODI filings (if any)
5. Contracts: major customer agreements, supplier agreements, employment contracts (key management)
6. Legal: all litigation, regulatory notices, IP documents, property documents
7. HR: headcount list, salary register, PF/ESI compliance, ESOP plan and grants
8. Real estate: lease agreements, property documents
9. Compliance: all licences, registrations, regulatory approvals

Representations and Warranties — DD Informs the SPA

The findings of our DD report directly inform the representations and warranties in the Share Purchase Agreement. Each major DD finding becomes either: (a) a specific warranty required from the seller (e.g., "no FEMA violation other than disclosed"), (b) a price adjustment (e.g., GST ITC reversal risk is deducted from purchase price), (c) an escrow holdback (e.g., 10% of purchase price held in escrow for 18 months to cover tax demand claims), or (d) a deal breaker (exit if the finding is too severe). Our DD report is structured to map directly to W&I (warranty and indemnity) structuring.

Post-Acquisition Integration Planning — DD Informs Day-One Actions

A DD report is not just a decision-making tool — it is a roadmap for post-acquisition integration. Each DD finding should map to a specific Day-30, Day-60, or Day-90 action:

• Day 1 actions: File any delayed FEMA reports (FC-GPR, FLA) to avoid further compounding liability; register GST amendments (address, authorized signatory); update bank mandates
• Day 30 actions: Implement new purchase approval controls; address ITC mismatch with key suppliers; file delayed TDS returns if any
• Day 60 actions: Restructure related party transactions at arm's length; complete any pending NCLT filings; resolve vendor/customer GSTIN issues
• Day 90 actions: Complete first management accounts under new ownership; implement new MIS structure; conduct first internal audit under new control environment

Our DD reports include a post-acquisition integration action plan as a standard deliverable — not just a list of risks, but a prioritised remediation roadmap.

DD in MSME Acquisitions — Specific Considerations

Acquiring an MSME (Micro, Small, Medium Enterprise) has unique DD considerations:

• Section 43B(h) risk: As of FY 2023-24, payments to MSME vendors beyond 45 days (15 days if no credit period specified) are disallowed — check the target's MSME vendor payment track record
• Udyam Registration: Verify the target's own MSME registration is current and correctly classified (micro/small/medium) — misclassification affects buyer's Section 43B(h) obligations post-acquisition
• Government contracts: Many MSME-specific government tenders have supplier eligibility requirements — acquisition by a non-MSME buyer may disqualify the target from these contracts
• Priority sector lending: If the target has PSL (Priority Sector Lending) status for its bank loans, acquisition by a larger entity may change its lending terms

Related Services

• M&A Advisory
• Forensic Accounting
• Valuation Services
• Startup Valuation
• FEMA Compliance