Financial Due Diligence Checklist

Trace Every Earnings Adjustment to a Document

The earnings figure a deal is priced on is a stack of adjustments, each one an argument that something in the past will not repeat, or that something absent should be counted. The Quality of Earnings review goes beyond the accounting standard by adjusting for non-recurring items, normalizing revenue and establishing a baseline for projections and valuations. That work belongs to the accountants, and so do its conclusions.

What the deal team owns is the trail. Every adjustment should name the document that supports it.

• Non-recurring items. The invoice, the settlement letter, the board minute that authorized the one-off.
• Owner compensation and discretionary spending. The payroll record, plus what replaces the role after close.
• Capitalized development spending. The capitalization policy and the payroll allocation behind it. Ask the accountants what the earnings look like under one consistent policy across the whole period, and why.
• Savings not yet realized. A signed contract, a terminated role, or nothing. The third is common.

While the schedules are open, split capital spending into maintenance and growth, and ask management which line keeps current revenue running. That split decides how much of the stated earnings actually reaches cash, and it is what an investment committee asks for last and should have asked for first.

An adjustment with no document behind it is a negotiating position. Mark it as one.

Follow Revenue From Contract to Cash

Revenue is the line every other line rests on. Test the policy against the revenue standard that applies to the company, then test the policy against the contracts.

Under that standard, revenue is recognized to depict the transfer of promised goods or services to the customer, in an amount reflecting the consideration the company expects to be entitled to. The sequence runs contract, performance obligations, transaction price, allocation, recognition. Read a sample of contracts with that sequence in hand and ask, obligation by obligation, when control actually passes.

Then follow a single month end to end, in one direction: contract, invoice, ledger entry, cash receipt. Pick a month that matters, such as the one before a period end where growth accelerated.

Where policy and contract tend to part company:

• Multi-year contracts billed upfront. What is revenue this period and what sits in deferred revenue.
• Variable consideration: usage, rebates, discounts granted late in a quarter to close a deal.
• Services bundled with software and recognized together when the obligations are distinct.
• Cut-off at period end. Invoices dated inside the period for work delivered after it.
• The largest accounts. Contract end dates, notice periods, and whether renewal is automatic or negotiated.

Concentration is read here too, not as a count but as a dependency. If the loss of one account changes the plan, the plan belongs to that account.

Set a Normal Working Capital Level From Monthly History

The price adjusts against an agreed working capital level, the peg. Build it from monthly history, and expect it to be negotiated rather than calculated.

Lay out receivables, inventory, payables and accruals month by month across the scoped period, and read the shape before the average. A business with a seasonal build needs more working capital in some months than in others. A peg set on a quiet month hands the buyer a business short of the cash it needs to trade on day one.

Then ask what distorts each month:

• Collection pushes before a period end, which flatter receivables for a few weeks.
• Payables stretched to hold cash, visible as supplier days drifting out.
• Inventory built for a launch that has not happened.
• Items that sit inside the peg on one reading and outside it on another: accrued bonuses, deferred revenue, customer deposits.

Write down what would otherwise be assumed: the accounting principles the peg is computed under, and the definition of every account inside it. Disputes after close usually trace to a definition nobody wrote, such as how a receivable reserve is set, when revenue is recognized, or which accruals count. Deal counsel drafts the mechanism. The deal team supplies the history it rests on.

Schedule Everything That Behaves Like Debt

Funded debt is the easy part: term loans, lines of credit, shareholder notes, finance leases, each with a payoff letter naming what is due at close.

The argument is about the rest. Debt-like items are typically non-interest-bearing liabilities treated similarly to debt for purchase price purposes, and anything reclassified out of working capital and into that column reduces what the seller receives. So both sides push, and the pushing happens in the definitions.

Schedule every candidate, and name its document.

• Deferred revenue and customer deposits: cash already collected for work still to be delivered.
• Accrued bonuses earned across the year and paid after close.
• Accrued income taxes, and payroll taxes withheld but not yet remitted.
• Pending legal settlements, and claims not yet settled.
• Unfunded pension and deferred compensation obligations.
• Earn-outs, deferred purchase price and other commitments left over from earlier transactions.

This page does not say how any of these should be treated, because the treatment depends on facts the schedules only begin to show. The question to put to the accountants is narrower and answerable: how is each item placed in the net debt schedule and in the peg, and why. Get those definitions into the letter of intent early. Reclassification late in a deal moves money, and the side it moves away from will say so.

Ask the Tax Advisers Where the Exposures Sit

Tax is the step where a buyer's instinct is most often wrong, so run it as questions put to the people who answer them for a living.

Ask the tax advisers to read:

• Filing history and open years in every jurisdiction where the company has activity.
• Worker classification. A business that classifies an employee as an independent contractor with no reasonable basis may be held liable for employment taxes for that worker. The contractor payment records and the agreements behind them are where the exposure shows.
• Sales and use tax, and whether selling into a state the company does not file in has created an obligation to collect.
• Payroll tax wherever remote staff actually sit, as against where the entity is registered.
• Transfer pricing and intercompany charges, where more than one entity is involved.
• The attributes the deal assumes it inherits: losses carried forward, credits, basis, and what the chosen structure does to each.

Then ask the question the deal needs answered. Which exposures belong in the price, which belong in a specific indemnity, and which need an opinion before signing. That allocation belongs to counsel and the tax advisers. The deal team's job is to make sure every exposure gets one, in writing, before the committee votes.

The same discipline applies to the people records, which carry their own exposures: see HR due diligence.

Test the Forecast Against the Record It Came From

A forecast is a claim about behavior, and the company has already given evidence on it. Ask for the budgets management set in prior periods, then set them beside the actuals that followed.

Ask management to explain the variances, one period at a time. The explanations are the finding. A team that missed and can say which assumption broke is forecasting. A team that missed and attributes it to the market is guessing. Consistent conservatism is information too, and so is a plan revised upward mid-year every year.

Next, take the forward plan apart into its drivers and check each against the history already verified: pricing, volume, conversion from pipeline, retention, the hiring plan and what it assumes about output per head. Every driver should trace to something observed rather than to a growth rate applied to last year.

A few questions do most of the work:

• Which assumption, if wrong, breaks the plan.
• What would have to be true for the central scenario, and is any of it true yet.
• Which part of the plan depends on the people who wrote it staying.

The market side of the same plan belongs to commercial due diligence. For a venture stage company, the spending side reads through the burn multiple.

Carry Each Finding Into the Price and the Agreement

A finding with no destination is a note. Each one should land somewhere.

• Price. The adjusted earnings, and what the valuation rests on.
• The schedules. The peg and the net debt definition, where the working capital and debt-like findings land.
• The agreement. Representations, specific indemnities, escrow, and anything a known exposure needs covered by name.
• After close. The integration plan, which inherits everything diligence found and did not resolve. See the post-merger integration checklist.

Then the mechanism that carries the arithmetic. With completion accounts, the parties agree a preliminary price at close and establish the final one afterwards, and any difference between the two is settled through a purchase price adjustment. With a locked box, the price is fixed on a historical balance sheet and there is no post-completion adjustment, so the buyer negotiates protection against value leaking out of the business between that date and completion.

Neither is safer in the abstract. What differs is where the diligence has to be strongest. Completion accounts put the weight on the definitions. A locked box puts it on the quality of the historical balance sheet the price is struck on. Deal counsel decides how the findings enter the agreement.

The checklist's job is narrower: that none of the findings arrive unevidenced, and that the sequence sits inside the wider due diligence process.