A target reports Rs 15 crore of total provisions: Rs 5 crore for bad debts, Rs 4 crore for warranties, Rs 3 crore for litigation and Rs 3 crore for employee obligations. The provisions are audited, compliant with Ind AS 37 and supported by management’s estimates.
The diligence question is not whether the provisions exist. It is whether they are adequate. Because a provision that understates the actual obligation by Rs 10 crore is a liability the buyer inherits but that the balance sheet does not show. The Rs 10 crore shortfall is, in economic terms, additional purchase price: the buyer pays the agreed amount plus the unrecognised obligation.
In Northrop Management Private Limited’s due diligence experience, provision shortfalls of 30% to 60% are found in the majority of mid-market transactions where provisions are tested against evidence rather than accepted at book value.
The Provision-by-Provision Test
Bad-debt provisions
Reported: Rs 5 crore against Rs 80 crore of receivables (6.25% provision rate).
Test: Age the receivable book by counterparty. Calculate the historical write-off rate by age bracket over five years. Compare the provision rate for each bracket to the actual write-off rate.
If the historical write-off rate for receivables over 180 days is 45% and the provision rate for that bracket is 20%, the provision is understated by 25 percentage points on every rupee in that bracket. For Rs 15 crore of receivables over 180 days, the shortfall is Rs 3.75 crore.
Evidence to request: Receivable ageing by counterparty (not summary, counterparty-level). Five-year write-off data by age bracket. Post-balance-sheet collection data (how much has actually been collected since the reporting date?). Customer credit assessments for the top 20 receivables.
Red flags: Provision rate declining while ageing deteriorates. Large receivables from related parties with no provision. Receivables reclassified from “trade” to “other current assets” to avoid ageing disclosure.
Warranty provisions
Reported: Rs 4 crore.
Test: Calculate warranty cost as a percentage of warranted revenue for each of the last five years. Compare the provision to the historical average.
If actual warranty claims have averaged 3.2% of revenue (Rs 6.4 crore at Rs 200 crore warranted revenue) and the provision is Rs 4 crore, the shortfall is Rs 2.4 crore.
Evidence to request: Warranty claim data by product and period. Warranty terms by product. Historical provision-versus-actual comparison. Customer complaint logs.
Red flags: Provision declining while product volumes increase. New product launched without warranty provision. Known quality issues not separately provisioned.
Litigation provisions
Reported: Rs 3 crore for “various legal matters.”
Test: Obtain the complete litigation register (not the summary in the notes). For each case: claimed amount, stage, counsel’s probability assessment, management’s estimate.
A litigation register showing 12 cases with aggregate claims of Rs 45 crore, provisioned at Rs 3 crore, requires explanation. If even 15% of the claimed amounts are probable, the provision should be approximately Rs 6.75 crore.
Evidence to request: Full litigation register with individual case detail. External legal opinions for cases above Rs 1 crore. Historical settlement data: how did prior settlements compare to provisions?
Red flags: Cases classified as “possible” where evidence suggests “probable.” Cases with claimed amounts 10x the provision. Cases that have been on the register for years without reassessment. Regulatory proceedings with no provision.
Tax exposures
Test: Review all pending tax proceedings (income tax, GST, transfer pricing). For each: disputed amount, authority’s position, current stage, management’s assessment, external counsel’s opinion.
A transfer pricing adjustment of Rs 25 crore provisioned at Rs 2 crore implies management expects 92% of the adjustment to be reversed. If the historical success rate on similar appeals is 60%, the provision should be approximately Rs 10 crore.
Evidence to request: Schedule of all pending tax proceedings. Disputed amounts and current status. External tax counsel’s probability assessment.
Employee obligations
Test: Compare actuarial assumptions (discount rate, salary escalation, attrition) to market benchmarks. Compare leave encashment provision to actual leave balances at current salary rates.
If the actuarial valuation uses a discount rate 100 basis points above the market benchmark, the gratuity obligation is understated. The sensitivity: for a Rs 20 crore gratuity obligation, a 100-basis-point discount rate difference may understate the obligation by Rs 1.5 to Rs 2.5 crore.
Onerous contracts
Test: Identify contracts where unavoidable costs exceed economic benefits. Long-term supply agreements at above-market prices. Leases for premises no longer used. Service contracts where delivery costs exceed the contract price.
A five-year supply agreement at 15% above current market rates, with three years remaining and annual volume of Rs 10 crore, creates an onerous contract exposure of approximately Rs 4.5 crore. If no provision exists, the buyer inherits the above-market commitment.
The Aggregate Impact
Sum the shortfalls across all provision categories:
Bad debts: Rs 3.75 crore shortfall. Warranties: Rs 2.4 crore shortfall. Litigation: Rs 3.75 crore shortfall. Tax: Rs 8 crore shortfall. Employee obligations: Rs 2 crore shortfall. Onerous contracts: Rs 4.5 crore shortfall. Total provision shortfall: Rs 24.4 crore.
The target’s reported net assets are overstated by Rs 24.4 crore. The reported EBITDA may be overstated to the extent that inadequate provisioning has reduced the P&L charge. The enterprise value, calculated on overstated earnings and overstated net assets, may be Rs 24 crore to Rs 240 crore higher than the economic reality supports (depending on which provisions affect EBITDA versus balance sheet only, and the applicable multiple).
The board that approves the price without seeing the provision shortfall has approved a transaction whose actual cost is higher than the stated purchase price by the amount of the inherited, unrecognised obligations.
The Transaction Impact
For each provision category: reported provision + identified shortfall = adjusted provision. The aggregate shortfall should be: negotiated as a price reduction, addressed through a specific indemnity in the SPA, included in the completion-accounts mechanism or factored into the valuation as an additional risk discount.
Ashish Chaudhary, frames the diligence standard directly: “For each provision, the diligence team should connect: reported provision to underlying assumption to supporting evidence to potential shortfall to transaction impact. A provision accepted at book value is a provision accepted on trust. The buyer who tests it against evidence, historical outcomes and external assessments determines the actual exposure and negotiates accordingly.”
Questions for the Boardroom
- For each major provision category, how does the target’s provision compare to its own historical actual costs over the last five years?
- What is the total provision shortfall across all categories when tested against evidence rather than accepted at book value?
- Has the litigation register been reviewed at the individual-case level, with external legal opinions on cases above Rs 1 crore?
- Are there any pending tax proceedings where the provision is materially below the probability-weighted exposure?
- Has the aggregate provision shortfall been presented to the investment committee alongside the purchase price, and has it been reflected in the SPA through a price adjustment, indemnity or completion-accounts mechanism?
Practical Checklist
Request: Complete provision schedules with supporting calculations. Five-year provision-versus-actual comparison for each category. Full litigation register with counsel assessments. Tax proceedings schedule. Actuarial valuation report. Long-term commitment schedule.
Test: Each provision against historical adequacy. Each assumption against external benchmarks. Each contingent liability classification against probability criteria.
Quantify: Shortfall for each category. Aggregate provision adjustment. Impact on net assets, EBITDA and enterprise value.
Negotiate: Aggregate shortfall as a price reduction, specific indemnity or completion-accounts adjustment.
Closing Implication
Provisions are management’s estimates of future obligations. The estimates can be optimistic, neutral or conservative. The buyer who accepts them at face value accepts management’s judgment as the basis for the purchase price. The buyer who tests them against evidence, historical outcomes, external opinions and subsequent events, determines the actual exposure. The difference, Rs 24 crore in this example, is the cost of trusting versus testing. And in every transaction, the cost of trusting is higher.