How do I review a company’s accounts before buying it?

If you are working out how to review accounts before buying a company, begin with a plain aim: decide how far you can trust the numbers, and what each number is built on. The financial statements are the seller’s record of how the business has performed. They do not prove themselves. Your task is to read them, learn who stood behind them, and test them against other records. An accountant of your own is the right person to do the detailed work. This guide explains what you will be looking at so that you can ask better questions and understand the answers.

Know the statements you are reading

BDC describes four main financial statements, and notes that the notes to the financial statements disclose the rules and assumptions made in preparing them. An income statement shows what a company earns, what it spends and whether it makes a profit over a specific period. A balance sheet summarizes assets, liabilities and shareholders’ equity at a specific point in time. A cash flow statement shows how money has moved through the business during the period, and a statement of retained earnings shows the cumulative earnings of the business after any dividends or distributions to shareholders. BDC adds that interim statements sometimes include fewer components than year-end statements, and may lack a cash flow statement and a statement of retained earnings. Read them side by side, and ask your accountant to explain how the profit on the income statement relates to the cash flow and the balance sheet.

Read the notes

The notes are not decoration. BDC says they disclose the rules and assumptions made in preparing the statements and help interpret and analyze the information. When you read them, look for the accounting policies used, any commitments or debts described, and anything that is explained in words rather than shown as a number. Ask your accountant to flag any note that changes how a figure should be read. If the statements come without notes, ask why, and what is being left out.

Find out who stood behind the statements

CPA Québec explains that chartered professional accountants provide three levels of service on financial statements: an audit, a review or a compilation. It says the nature and extent of the work has a direct impact on the level of assurance or credibility given to the statements. An audit provides reasonable assurance that the statements as a whole are free from material misstatement, whether due to fraud or error. CPA Québec adds that reasonable assurance is not absolute assurance, that a review is a limited assurance engagement, and that a compilation provides no assurance. Check which level, if any, applies, and read the accountant’s report that accompanies the statements, which CPA Québec says sets out the extent of work performed and the level of assurance expressed. BDC notes that the compilation engagement was formerly known as the notice to reader, so older statements may carry that label.

Test the figures against other records

BDC’s due diligence guidance says you are verifying that the numbers match the reality on the ground. It asks whether the figures match the information you are getting from the owner, and whether tax returns match the financial statements. Differences are not automatically a problem: BDC notes that there are significant differences between tax rules and accounting rules. They are a reason to ask. The tax filings you should review are covered separately. Record each difference, the explanation you received, and who gave it.

Consider a quality of earnings report

BDC says that to get a more detailed look at the finances, you can have an accountant prepare a quality of earnings report. It describes this as a thorough analysis by a third party that goes beyond standard financial statements to identify and adjust for non-recurring items, accounting irregularities and risks, and that assesses the accuracy and quality of historical results and the sustainability of future earnings. Ask your accountant whether one fits your deal and what it would cover. This is analysis of the past, not a promise about the future.

Keep your questions organized

Reviewing accounts produces many questions, and the answers can slip. Keep one list that records the question, who it went to, the answer, and any document that supports it. Bring the list to your lawyer and accountant before you finalize an offer, and ask them whether any unresolved item should be dealt with in the purchase agreement. The wider process is covered in documents to ask for when buying a business.

• Ask which level of assurance applies: audit, review or compilation
• Read the income statement, balance sheet, cash flow statement and notes together
• Compare the statements to the tax returns and to the owner’s figures
• Ask which items are non-recurring and who decided that
• Ask your accountant whether a quality of earnings report is worth commissioning