Question

What does Circular 230 mean by "due diligence"?  Does due diligence mean auditing all of a clients records? Does the level of review depend on the circumstances?

Answer 1

You must exercise due diligence in preparing and filing tax returns and other documents/submissions, and in determining the correctness of representations made by you to your client or to the IRS. You can rely on the work product of another person if you use reasonable care in engaging, supervising, training, and evaluating that person, taking into account the nature of the relationship between you and that person.You generally may rely in good faith and without verification on information furnished by your client, but you cannot ignore other information that has been furnished to you or which is actually known by you. You must make reasonable inquiries if any information furnished to you appears to be incorrect, incomplete or inconsistent with other facts or assumptions.Due diligence is an investigation or audit of a potential investment or product to confirm all facts, such as reviewing all financial records, plus anything else deemed material. It refers to the care a reasonable person should take before entering into an agreement or a financial transaction with another party.

Due diligence became common practice (and a common term) in the U.S. with the passage of the Securities Act of 1933. Securities dealers and brokers became responsible for fully disclosing material information related to the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution. However, creators of the Act understood that requiring full disclosure left the securities dealers and brokers vulnerable to unfair prosecution if they did not disclose a material fact they did not possess or could not have known at the time of sale. As a means of protecting them, the Act included a legal defense that stated that as long as the dealers and brokers exercised "due diligence" when investigating companies whose equities they were selling, and fully disclosed their results to investors, they would not be held liable for information not discovered during the investigation.

A standard part of an initial public offering is the due diligence meeting, a process of careful investigation by an underwriter to ensure that all material information pertinent to the security issue has been disclosed to prospective investors. Before issuing a final prospectus, the underwriter, issuer and other individuals involved (such as accountants, syndicate members, and attorneys),will gather to discuss whether the underwriter and issuer have exercised due diligence toward state and federal securities laws.

After you finish auditing all your client’s business and financial processes, you must perform due diligence before you issue your audit report. Due diligencemeans that you hunt for any issues that weren’t addressed during the audit of the financial statements — issues that may have an impact on the way people interpret those financial statements.

For starters, you look at what has happened in the life of your client since the balance sheet date. Certain events require financial statement adjustments, and other events require disclosure through a footnote to the financial statements, which is part of your audit report.

Also, you review your client’s contingent liabilities, which are existing situations, such as lawsuits, that hinge on an event that hasn’t yet happened. Another part of due diligence is determining whether your client can continue as a going concern — whether it can stay in business for another year.

You may also need to discuss certain audit issues with the people responsible for overseeing your client’s financial system, which in a larger company means an audit committee. This step is required if your client has an existing audit committee or is regulated by the Securities and Exchange Commission (SEC).

So, Due diligence generally does not mean auditing of client records but it has an broader approach and the level of review usually depends on the circumstances rather than fixed review.