Buying a Small Business: A Financial Due Diligence Checklist for Messy Accounts

A small business can have loyal customers and a business, whilst having poor or messy financial records. The seller may send annual accounts, a spreadsheet of monthly sales and a folder of bank statements, with no obvious connection between them. Before committing to purchase a business, a buyer needs to establish whether the numbers in the accounts are correct and reliable, when compared with their original third party sources, such as bank statements.

A financial due diligence checklist helps turn that collection of records into actual evidence. Whilst there is always the possible that fraud can occur, this is generally the best way to ensure that the figures in the accounts are materially correct.

Define the business and period being reviewed

Start by agreeing what is being acquired. A share purchase and an asset purchase can have different financial and legal consequences. Establish which entities, assets, employees, contracts and trading activities fall within the proposed transaction, and involve the relevant advisers in confirming the scope.

The main differences between the two structures are:

• What is bought: a share purchase buys the company itself; an asset purchase buys only selected assets, such as equipment, inventory and goodwill.
• Liabilities: a share purchase inherits all historic liabilities, so the buyer relies on warranties and indemnities; an asset purchase lets the buyer choose what to take on.
• Due diligence: a share purchase requires a review of the whole company; an asset purchase focuses on the assets acquired and the earnings they generate.
• Employees and contracts: in a share purchase, both stay with the company, subject to any change-of-control clauses; in an asset purchase, staff may transfer automatically under local employment law and contracts usually need the counterparty’s consent to transfer.
• Tax: a share purchase may attract transfer taxes and often suits the seller; an asset purchase can give the buyer tax relief on assets but may involve sales or property transfer taxes and a double tax charge for the seller.
• Price: a share price is adjusted for cash, debt and working capital; an asset price usually covers the specified assets only.

Make the initial information request

Start with a short initial request to the seller. These items give an overview of the business’s trading before the detailed requests in the next section:

• Access to the accounting system: where the seller uses software such as Xero, Sage or QuickBooks, read-only access is usually the best route. The buyer can then review ledgers, invoices, aged receivables and payables and bank reconciliations directly, removing the need to request many of the reports listed in the next section.
• Annual accounts: the last three years, where available.
• Management accounts: monthly figures for the latest two years and the current year to date, including the equivalent prior-year months so that seasonality is visible. Often though, small businesses won’t prepare management accounts. This is okay. Instead ask for a “Year to date Trial Balance”. This will give you their figures for where they are up to now.
• Trial balance and general ledger: for each relevant period.

Gather a complete set of records

Once the initial information has been reviewed, follow up with requests for the detailed supporting records. If the buyer has access to the accounting system, many of these can be pulled directly rather than requested. Use the following checklist to track them. Keep an owner, due date and status beside each request, and distinguish missing information from information received but not yet checked.

Where bank statements arrive as PDFs, Accounts Draft can convert bank statements into Excel, giving the buyer or their accountant a starting transaction schedule for the cash review. Keep the original statements alongside the export and check the extracted dates, amounts and descriptions before using it in the analysis.

Conclusion

Messy accounts do not have to rule out a purchase, but they do mean the buyer cannot take the seller’s figures at face value. Agree what is being acquired, start with a short initial request (ideally including access to the accounting system), then follow up with the detailed records needed to test each important number against bank statements and other third-party evidence.

The aim is not to explain every penny, but to be confident that sales, costs, assets and liabilities are materially correct. Any gaps that remain should be recorded and reflected in the price or the transaction terms before the buyer commits.