Why it matters
A business's accounts and its tax returns rarely match line for line, and that is normal. Tax rules treat some items differently: equipment is often written off on a different schedule, some expenses cannot be deducted, and the return may cover a different period. A competent accountant can list these differences and reconcile one profit figure to the other.
The flag is a gap that nobody can reconcile. If the accounts you have been shown report more profit than the tax returns, one of two things is usually true. Either the accounts have been inflated for the sale, or income has not been declared for tax. In the first case, the earnings you are paying for may not exist. In the second, there may be tax, interest and penalties to pay, and in a share sale (a stock sale in the US) those stay with the company you buy.
Financing is affected too. Many acquisition lenders underwrite from tax returns, and some check them against transcripts or copies obtained from the tax authority. If the returns do not support the earnings, they will not support the loan either.
Loupe treats this as a deal breaker until the gap is explained in writing and checked by your own accountant. The valuation tool also reduces the multiple for known legal, tax or compliance issues: by 10% at its starting settings where there are some, and by 30%, with confidence set to low, where they are significant. This is general information, so take advice from a qualified accountant on any reconciliation you are given.
In an asset sale you buy selected assets of a business; in a share sale (a stock sale in the US) you buy the company itself, with its full history. The choice shapes risk, tax and what needs consent.
How to spot it
Lay the tax returns and the accounts side by side for the last three years and compare revenue, cost of sales, wages and profit before tax. Then look for:
- Lower revenue or profit in the returns than in the accounts or the listing.
- Management accounts and spreadsheets offered readily, while filed returns are slow to appear.
- Returns filed late, amended, or still in draft for a year the listing relies on.
- A seller who talks about "the real numbers" as something different from what was filed.
- VAT or sales tax returns that imply different revenue from the accounts.
- Bank deposits that match neither set of figures.
Net profit before tax is what a business earns after all its costs, including interest and depreciation, but before tax on its profits. It is the starting point for SDE and EBITDA.
Questions to ask the seller
- Can your accountant prepare a written reconciliation between the accounts and the tax returns for each of the last three years?
- What explains each difference?
- Have any returns been amended, queried or investigated by the tax authority?
- Are all returns filed and all tax paid to date?
- Would you authorise my lender or accountant to obtain copies or transcripts of the returns directly from the tax authority, where that is possible?
- Who prepares the accounts, and who prepares the tax returns?
Documents to request
- Filed tax returns for the last three years, with all schedules
- Filed or signed accounts for the same years
- A reconciliation of profit between the two, prepared by the seller's accountant
- Correspondence with the tax authority, including enquiries, assessments and penalties
- VAT or sales tax returns for the same period
- Business bank statements for the same period