How to Review a Seller's Financial Statements Before Buying

When you are thinking of buying a business, the seller's financial statements are usually the first thing you receive. They tell the story of the business's earnings, and the price you offer often rests on that story. Your job is to find out whether the story is supported by documents that someone other than the seller has seen.

This article explains which records to request, how to cross-check them against tax filings, and which warning signs to look for. It is general information for buyers in Ontario. An accountant should interpret the numbers, and a lawyer should make sure the purchase agreement protects you if the numbers turn out to be wrong.

Start by asking for the right records

The CRA's general rule is that records must be kept for six years from the end of the last tax year they relate to, so a seller should be able to produce at least that much history. Some records, such as share registers and information on long-term property acquisitions and disposals, must be kept indefinitely because they affect a sale, liquidation or wind-up. A reasonable request list therefore reaches back several years.

• Annual financial statements for each of the last several years, plus current year-to-date figures
• Filed corporate income tax returns (T2) and the notices of assessment that came back
• GST/HST returns for the same periods
• Payroll remittance records and employee lists
• Share registers and records of major asset purchases and sales
• Bank statements and the general ledger behind the statements
• A list of loans, leases and other obligations

Ask for the documents in their original form where possible, not summaries prepared for the sale. A seller who is reluctant to share source records is telling you something.

Cross-check the statements against the tax filings

Financial statements are prepared by or for the seller. Tax returns are filed with the CRA. Comparing the two is one of the simplest ways to test whether the earnings are real. The CRA publishes key dates for corporate financial statements and returns, including T2 filing and balance-due dates, so you can check whether the dates on the filed returns line up with the dates in the seller's financials.

GST/HST filings give a second angle. How often a registrant files depends on annual taxable supplies: $1.5M or less means an annual period (with monthly or quarterly optional), over $1.5M up to $6M means quarterly, and over $6M means monthly. Monthly and quarterly returns are due one month after the period ends, and annual filers are due three months after fiscal year-end. Because the filing frequency reflects the size of the business, it should be consistent with the revenue you are being told about.

Gaps are not always sinister. Timing differences and accounting choices explain many of them. The point is that every gap should have an explanation you can verify.

Red flags that deserve questions

No list is complete, and the right level of financial review depends on the size and type of business. These are common reasons to slow down and ask more questions.

• Statements that are unsigned, undated or prepared only for the sale
• Earnings that jump sharply in the year or two before the business is listed
• Revenue that does not match GST/HST filings
• Owner expenses mixed in with business expenses, making true profit hard to see
• Sales concentrated in one or two customers who could leave
• Late, missing or amended tax filings
• Payroll that seems too small for the volume of work
• Large amounts owed to related parties or to the owner personally

If the seller adjusts the earnings upward to show a better picture, ask for the detail behind each adjustment and for documents supporting it.

Look for hidden tax obligations

Some of the most important liabilities do not look like ordinary debts. Source deductions withheld from employees, the employer's share of CPP and EI, and GST/HST collected are deemed held in trust for the Crown. The CRA's claim is secured over all of the business's assets, including sale proceeds, regardless of security given to other creditors. It does not need to be publicly registered, so a PPSA search will not reveal it.

That makes the seller's remittance history important. Regular remitters send payroll deductions by the 15th of the month after the pay month, and a regular remitter is one whose average monthly withholding amount is under $25,000. Late-remittance penalties run from 3% for one to three days late up to 10% for more than seven days or nothing remitted, and 20% for a knowing or grossly negligent repeat failure. Statements that show payroll costs but no matching remittances, or a growing balance owing to the CRA, are worth a close look.

Whether you buy shares or assets also changes what you inherit, so read our companion material on tax due diligence before you finalize the deal structure.

What to do next

• Send the seller a written request list for several years of statements, returns, assessments and remittance records
• Ask the seller to authorize the release of CRA account information so you can see it directly
• Have an accountant compare the statements with the tax filings and explain any gaps
• List every question the review raises and get written answers
• Ask a lawyer to build representations, a holdback or an indemnity into the agreement for anything you cannot verify before closing
• Avoid signing a binding agreement until the review is complete, or make closing conditional on it

A lawyer can confirm how the findings affect the structure and terms of your purchase, and an accountant can tell you whether the earnings are reliable enough to support the price.

Frequently asked questions