Mergers and Acquisitions: An Accounting Due Diligence Checklist

Before closing a merger or acquisition, both buyers and sellers must undertake thorough due diligence. Due diligence is the process of reviewing a target company’s financial, tax, legal, and operational records before a transaction to confirm value and uncover riskskalfalaw.com. In Canada (and Quebec in particular), this process is essential for small and mid-sized business owners to ensure there are no costly surprises post-closing. A comprehensive due diligence not only verifies what’s being purchased, but also informs deal terms – findings can justify price adjustments, holdbacks/escrows, added warranties, or in extreme cases, a decision to walk awaylexpert.ca. The checklist below outlines the key accounting and related areas to scrutinize in the Canadian/Quebec M&A context, each followed by how diligent review in that area helps protect your interests.

1. Quality of Earnings Analysis

One of the first priorities in financial due diligence is analyzing the target’s quality of earnings (QoE). Rather than accepting the income statement at face value, a QoE review digs into how “real” and sustainable the earnings are. This involves verifying that revenues and profits are recurring and derived from core operations – not artificially inflated by one-time events, aggressive accounting, or timing anomalies. For example, you’ll want to adjust for any non-recurring items (like a big one-off asset sale or lawsuit settlement) and normalize discretionary expenses (such as excessive owner bonuses or personal expenses run through the business). A quality of earnings report “assesses the accuracy and quality of historical results as well as the sustainability of future earnings,” going beyond standard statements to identify and adjust for irregularitiesbdc.ca. Key steps include:

• Validate Revenues: Ensure sales are genuine, earned in the proper period, and not overly concentrated in a few customers or tied to soon-expiring contracts.

• Normalize Expenses: Add back unusual expenses (or remove unusual gains) that won’t continue under new ownership (e.g. relocation costs, one-time professional fees).

• Check Accounting Policies: Review revenue recognition methods, inventory valuation, and expense accruals for consistency with Canadian GAAP (ASPE or IFRS). Divergent policies can misstate earnings when comparing different companies.

• Assess Earnings Drivers: Identify what drives profitability (e.g. a high-margin product line) versus underperforming areas. This helps judge if current earnings are repeatable.

How Due Diligence Helps: A thorough QoE analysis gives a clear picture of the company’s true profitability. By identifying adjustments and separating recurring vs. one-time impactsalphabridge.co, due diligence ensures the buyer isn’t overpaying for fluky earnings bursts, and the seller can credibly back up their EBITDA with facts. In short, it provides confidence that the earnings being valued are realistic and sustainable – a crucial foundation for price negotiation and post-merger performance expectations.

2. Working Capital & Cash Flow

Beyond earnings, working capital is the lifeblood that keeps day-to-day operations running. In an acquisition, buyers often require the target to leave a “normal” level of working capital at closing, so examining those needs is critical. Working capital due diligence means scrutinizing the target’s current assets and liabilities – cash, receivables, inventory, payables – to see how much working capital the business uses in practice and whether any account balances might be misleading.

Focus areas include accounts receivable (Are they collectible or are there old doubtful debts?), inventory (Is it properly valued and not obsolete?), and accounts payable (Any past-due bills or stretched supplier payments that signal cash stress?). It’s also important to evaluate cash flow cycles: Does the company experience seasonal swings in working capital? For instance, many Quebec businesses face a slow period in summer or ramp up inventory before winter holidays – such seasonality must be factored inalphabridge.co. By analyzing historical working capital levels and trends, you can set an appropriate target working capital peg in the purchase agreement.

How Due Diligence Helps: Rigorous review of working capital ensures the buyer knows “the true capital required to operate post-close.”alphabridge.co It prevents unpleasant surprises like discovering a cash crunch immediately after takeover because the company’s working capital was propped up by unusual measures (e.g. delaying payables). Due diligence highlights any working capital requirements (e.g. a need to inject cash to cover payroll during slow months) and uncovers window-dressing tricks (such as aggressively collecting receivables or slashing inventory right before closing). This allows both parties to agree on a fair working capital adjustment and ensures the business can continue running smoothly on Day 1 under new ownership.

3. Tax Compliance and Exposures

In Canada, tax compliance is a critical part of M&A due diligence – especially in Quebec, where businesses face both federal (CRA) and provincial (Revenu Québec) tax regimes. A buyer must review income tax returns, GST/HST and QST filings, payroll source deductions, and any other tax obligations of the target company. The goal is to identify any tax exposures: unpaid or underreported taxes, aggressive tax positions, or missed filings that could result in liabilities or penalties. Remember that in a share purchase acquisition, “all of the target’s assets and liabilities remain with the company”, meaning the buyer inherits any outstanding tax debts or compliance issues – even those discovered after closingbdo.ca. This makes thorough tax due diligence indispensable.

Key items on the tax checklist include:

• Income Taxes: Verify the last several years of corporate tax returns, notices of assessment, and that taxes were paid. Look for red flags like recurring losses (which might be disallowed later) or large non-capital loss carryforwards – due diligence should confirm these are valid.

• Sales Taxes (GST/HST/QST): Ensure the company correctly charged and remitted sales tax on taxable sales. Failure to charge GST/HST or QST on sales when required can lead to a hefty payable if auditedbdo.ca.

• Payroll Taxes and Deductions: Check that payroll withholdings (CPP/QPP, EI, income tax) have been remitted and that any contractors are properly classified – a common risk for SMEs is treating workers as contractors when by law they’re employees, which can create retroactive payroll tax liabilitiesbdo.ca.

• Provincial Taxes & Credits: In Quebec, confirm the company filed required declarations (e.g. the CO-17 provincial return) and complied with any tax credit programs it benefited from. For example, if the business claimed R&D tax credits or Investissement Québec incentives, ensure it actually met the criteria – otherwise those credits could be clawed back.

• Unresolved Audits or Disputes: Review any correspondence with tax authorities. Any ongoing audits, reassessments, or appeals should be fully disclosed, as they may result in future payments.

How Due Diligence Helps: A tax due diligence review will “identify exposure to tax risks, penalties, or regulatory gaps” before the deal is sealedalphabridge.co. This allows the buyer to either require the seller to resolve issues (e.g. pay back-taxes or obtain tax clearance certificates) or negotiate protections (like lowering the price or adding indemnities for known risks). Catching problems such as unremitted sales tax or payroll errors upfront can save a buyer from inheriting a potentially significant liabilitybdo.ca. In short, due diligence on taxes ensures that the business you acquire is clean in the eyes of the CRA and Revenu Québec, or that you have a plan to handle any skeletons in the tax closet.

4. Contingent Liabilities and Legal Risks

Not all liabilities show up on the balance sheet. Due diligence must therefore probe for contingent liabilities and legal risks – obligations or exposures that may materialize in the future due to past events. These can range from pending lawsuits and regulatory penalties to off-balance-sheet commitments. In Canada, a typical legal due diligence will review all significant contracts, lawsuits, and regulatory compliance records to uncover such issuesmeqlaw.commeqlaw.com. For example, does the company have any threatened litigation from customers, suppliers, or former employees? Are there product warranties or guarantees that could cost money later? Has the company complied with environmental regulations and workplace safety laws (important for industrial businesses) or could fines be looming? In Quebec, one unique area to check is compliance with the Charter of the French Language – if the target hasn’t followed French language requirements in its operations, there may be legal and financial consequences post-transaction. For instance, since 2023 Quebec law mandates that customers and employees be offered French versions of standard form contracts and documents, and if the target failed to do so, those contracts could even be annulled by the courtslexology.com – a serious risk that due diligence should flag.

Common categories of contingent liabilities and legal risks to investigate include:

• Pending Litigation or Disputes: Obtain a list of all ongoing or threatened lawsuits, arbitration, or claims against the company. Evaluate their merits and potential financial impact. Even past settled lawsuits are worth reviewing for any continuing obligations (e.g. settlement payment plans or injunctive relief).

• Regulatory Compliance: Check for any past violations or investigations (e.g. environmental infractions, health and safety citations, privacy/data protection breaches, or language law (OQLF) complaints in Quebec). Prior fines or warnings could indicate areas of risk. Ensure the company holds all required licenses and permits to operate – missing permits can become the buyer’s headache after closing.

• Contracts and Off-Balance Sheet Commitments: Review major contracts for onerous clauses – like a client agreement that allows termination upon change of control, or lease agreements with hefty restoration obligations at end of term. Also identify off-balance-sheet items such as operating leases, long-term purchase agreements, or guarantees the company has given (e.g. cosigning a loan for an affiliate). These may not appear in financial statements but legally bind the company.

• Contingent Tax and Financial Liabilities: In addition to the tax issues in section 3, consider other financial contingencies – e.g., an unresolved insurance claim, or an upcoming increase in pension plan funding requirements if the company has a defined benefit pension.

How Due Diligence Helps: By performing targeted inquiries and searches, due diligence will “identify contingent liabilities and off-balance sheet items” that the target may not have formally recordedmeqlaw.com. Uncovering these issues allows the buyer to quantify potential costs and negotiate remedies. For example, if due diligence finds a contract non-compliance in Quebec that could void key customer contracts, the buyer can insist the seller fixes it (by providing French versions or other compliance measures) before closinglexology.com. If a lawsuit is pending, the buyer might negotiate an escrow to cover that contingent liability, or ensure the purchase agreement specifically makes the seller responsible for it. Essentially, due diligence shines a light on hidden risks so that there are no nasty surprises after the acquisition, and it gives the buyer leverage to demand solutions or price concessions as needed.

5. Integration & Post-Merger Risks

Finally, a truly robust due diligence process doesn’t end at identifying what exists today – it also looks forward to post-merger integration. Especially for small and medium-sized enterprises, the transition period after an acquisition is critical. Issues here include how the two companies’ operations, cultures, and systems will meld together. In fact, many mergers fail to achieve their expected benefits because of integration problems. Studies have found that over 70% of post-merger integrations fail to capture the planned synergies and value, largely because buyers underestimate the effort required to merge organizations and don’t plan integration early enoughrsmus.com. To avoid becoming part of that statistic, it’s wise to evaluate integration risks during due diligence and prepare accordingly.

Key integration considerations include:

• Financial Systems & Controls: Assess whether the target’s accounting system is compatible or can be smoothly consolidated with the buyer’s. If the buyer uses IFRS and the target uses ASPE (common in Canada for private companies), plan for converting the target’s financials to IFRS post-acquisition. Similarly, identify any weaknesses in the target’s internal controls or reporting practices that need strengthening – integrating two firms is easier when you aren’t also fixing basic accounting issues. (Many accounting firms, including Mackisen, offer post-deal integration insights to align financial reporting and controls after the transactionalphabridge.co as part of their due diligence services.)

• Workforce and Culture: For many SME deals, the seller (often the founder) and a few key employees carry significant know-how and customer relationships. Due diligence should gauge whether those people will stay on and how to retain them – e.g. through earn-outs or employment agreements. As one expert put it, “The biggest risk in an acquisition is typically the transition risk” – if the owner leaves and along with them go the customers or institutional knowledgebdc.ca. Planning for leadership succession and employee communication in advance mitigates this risk. Also, consider company cultures: differences in management style or workplace culture can cause friction. An integration plan should address how to blend teams, possibly including French-English bilingual integration in Quebec workplaces.

• IT and Data Integration: Identify any major IT systems (ERP, CRM, etc.) that need merging. Migrating data and shutting down duplicate systems can be complex and should be scheduled with minimal disruption. Also, verify data privacy compliance when merging customer databases (especially under laws like Quebec’s updated privacy regulations).

• Customer and Supplier Transition: Review whether key customers or suppliers will be affected by the change in ownership. In due diligence, you may conduct select outreach (with permission) to critical partners to ensure continuity. Many deals arrange transitional services or introductions to major clients to smooth the handover.

How Due Diligence Helps: Incorporating integration planning into due diligence sets the stage for a successful merger. It allows the buyer to start working on Day-1 readiness during the deal phase – as experts note, the integration process should ideally begin “during the due diligence phase — before the deal is completed,” not afterrsmus.com. By identifying integration challenges early (be it IT incompatibilities, cultural mismatches, or regulatory hurdles for combining operations), the buyer can develop a 100-day post-merger plan to address them. This proactive approach greatly increases the likelihood of actually realizing the synergies that justified the deal. In short, due diligence that goes beyond fact-finding – to also strategizing the *“how” of combining two businesses – helps ensure the merged company will deliver the value that both parties expect from the transaction.

Conclusion: Mackisen – Your Partner in M&A Due Diligence and Integration

Navigating an M&A transaction in Quebec or anywhere in Canada is a complex undertaking – but you don’t have to do it alone. Mackisen CPA is a Montreal-based firm with over 35 years of experience advising Quebec businessesmackisen.com through audits, financings, and acquisitions. We bring an integrated team of seasoned CFOs, CPA auditors, accountants, and analysts who collaborate to cover all aspects of due diligencemackisen.com. This means our clients get a one-stop solution for financial analysis, tax review, and risk assessment, delivered in a coherent report that lenders and investors trust (thanks to our CPA-certified approach).

Mackisen provides valuation and deal support for mergers and acquisitions, ensuring you know exactly what a target business is worth and what to watch out formackisen.com. Our due diligence services dive deep into quality of earnings, working capital, tax compliance, and legal exposures – all tailored to the Canadian and Quebec regulatory landscape. We also excel at post-transaction support: from negotiating purchase agreement terms based on our findings, to helping integrate the acquired company’s finances. For example, if a deal involves transitioning a company from Canadian ASPE to IFRS standards (perhaps for a cross-border expansion or IPO down the line), our team can manage that conversion and financial reporting integration seamlesslymackisen.com.

At the end of the day, Mackisen’s goal is to make your merger or acquisition as successful and stress-free as possible. We combine local Quebec expertise with broad M&A knowledge to protect your interests at every step – from initial due diligence, through deal closing, to post-merger integration. With Mackisen as your partner in M&A, you gain peace of mind knowing no stone has been left unturned in the review, and you have experienced professionals by your side to guide you through negotiations and the smooth melding of your new businessmackisen.commackisen.com. We pride ourselves on delivering evidence-backed insights and practical solutions that help our clients make confident decisionsalphabridge.co. Whether you are contemplating selling your company, acquiring a competitor, or merging with a strategic partner, our team is ready to ensure the financial due diligence is thorough and that the transition that follows is built on solid ground.

Your next step: Before you sign on the dotted line of any transaction, reach out to Mackisen for a free consultation. With our support in accounting due diligence and transaction advisory, you can proceed knowing you have checked everything on the list and are truly getting the deal you bargained for. Here’s to a successful transaction and a prosperous post-merger future!

Sources:

1. Lexpert – The complete mergers and acquisitions due diligence checklistlexpert.calexpert.ca

2. Kalfa Law – Navigating the M&A Due Diligence Process for Small to Mid-Sized Businesseskalfalaw.com

3. BDC – How to conduct due diligence when buying a businessbdc.cabdc.ca

4. Alphabridge Advisors – Financial Due Diligence Servicesalphabridge.coalphabridge.coalphabridge.coalphabridge.co

5. BDO Canada – The importance of tax due diligence when buying a businessbdo.cabdo.ca

6. MEQ Law (Ontario) – Legal Checklist for M&A Due Diligencemeqlaw.commeqlaw.com

7. Lexology – Quebec’s Language Laws and Due Diligencelexology.com

8. RSM – Post-merger integration planningrsmus.com

9. Mackisen CPA – CFO Advisory & Financing Services (Montreal)mackisen.commackisen.commackisen.commackisen.com