Business Detective Work – Part I
We have written before on the subject of buying and selling businesses.
Copies of those newsletters are available elsewhere on this website.
This time we will focus on a sometimes overlooked aspect of buying a business --
the detective work necessary to investigate a business prior to purchase.
Remember that the first thing which needs to be decided upon is should you
purchase the assets of the business or the stock?
There is a separate newsletter devoted to that subject.
See Tax & Business Insights,
November/December 1999.
Regardless of whether you are buying stock in a company or the assets
themselves, much, if not all, of the detective work is essentially the same.
Regardless of whether you are buying stock in a company or the assets themselves, much, if not all, of the detective work is essentially the same.
Do not seek guidance from the professionals currently assisting the business you are about to buy, because they may be involved in some of the decision-making relating to the sale of the business. More importantly, they are representatives of the seller and are oriented towards assisting the seller as opposed to you, the buyer.
While it may be expensive to bring in another accountant and attorney to assist you, the buyer, it is often money well spent. Since most people do not have the requisite accounting or legal backgrounds to evaluate a business, the assistance of professionals is usually money well spent.
One should begin by looking at the information about the business that has been provided to governmental agencies (such as taxing authorities) and the information that is available in public records.
As a prospective buyer, you should first get copies of the business=s tax returns and any available financial statements from the seller. If the business is incorporated, the tax returns for the business will be prepared on Form 1120 or 1120S. If it=s an LLC with one or more members, there will be partnership tax returns prepared on Form 1065. If it=s a one-person limited liability company or sole proprietorship, the business’s profits and losses will be reported on the owner’s individual tax returns prepared on a Form 1040 with a Schedule C attached.
Whatever the type of entity, ask for the previous three years’ tax returns. If the current owner of the business refuses to provide copies of the tax returns, that alone should cast serious doubts about the purchase of that particular business.
If the business is a corporation or partnership, its tax returns may include a balance sheet on Schedule L of the appropriate tax return. Some business are not required to complete a balance sheet on Schedule L.
If a balance sheet (Schedule L) is available, one should then compare the three years of tax returns, laying them out on a table and taking a ruler and reading across each line to see what has increased or decreased. For example, if salaries have gone up or down, the question should be asked why. If there has been a reduction in corporate retained earnings, questions should be asked about that. Substantial changes in assets or debt should also be questioned.
Let=s say that the business which you’re considering to purchase is a cat obedience school trading as “Cat-Os.” Of course, it goes without saying that one of the things that should be checked is gross receipts. How much is being billed for cat obedience? Another important item is the salaries. What salaries are being paid to whom, etc.?
The financial statements, if any, should match roughly the tax returns. Any significant discrepancies should be questioned.
If, for example, a business has inflated sales for purposes of getting a loan, the inflated sales may show up on the financial statement and not be on the tax return. Of course, any inconsistencies could also be indication of under-reporting of taxable income which is a serious matter.
In the next issue, we will look at a number of other matters to investigate, including checking public records to find out as much as possible about a business.
In the meantime, if you would like assistance buying a business, contact us.
Copyright 2005
Published by the law firm of Newland & Associates, PLC
9835 Business Way
Manassas, VA 20110
Call us at (703) 330-0000 for a full range of business law and
tax-related services.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Newland's Business Notes is expressly prohibited without the written permission of Newland & Associates, PLC.
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