Financial Reporting in Due Diligence
Most business owners have a good grasp on their internal financial statements and ask their outside accountant to prepare the company tax returns. As a result, most business owners are less familiar with the nuances of their tax return, and may not be aware that the information in the tax return might be different than their internal financial statements.
A business owner recently asked me, “Why do you need to meet with my accountant and review the tax returns?” It’s a good question. Why review both the financial statements and the tax returns? Isn’t this a duplication of effort?
The answer is that the reconciliation between the two is a material aspect of due diligence. Tax returns are often more reliable than internal financial statements. They are prepared with an eye towards being audited by the IRS instead of just for internal use. The exercise sometimes brings to light useful information.
In addition, tax regulations and accounting regulations often differ on certain aspects. For example, the tax return may use accelerated depreciation whereas the financial statements may use a straight line depreciation method. This will create a book/tax difference. Also, many business owners are not accounting experts and might not fully understand the differences between the two statements.
I’ll give you a recent example:
During negotiations, the owner of a business said his salary was $150,000 and that he wanted to continue that going forward as an employee of Newco. This made sense to us and we agreed. We entered into a letter of intent based upon the company’s income statements which we assumed included the $150,000 salary. But what we learned after reviewing the tax returns was that the owner’s $150,000 salary was in fact a distribution and as a result, the $150,000 cost was not included in the income statements. So our understanding of the cash flow of this business was overstated by $150,000. Said another way, the $150,000 salary lowers EBITDA by $150,000. Using a 5X multiple, this equates to $750,000 of enterprise value. Not a small number. The owner wasn’t intentionally trying to mislead us, but without digging in and comparing the income statements to the tax returns this may have slipped through.
1719 Partners is an experienced buyer and understands the importance of thorough due diligence. If you are interested in selling your business and want to better understand the diligence process, or if you are a management team seeking to purchase a business, please contact us. We would be happy to share our thoughts with you.
