International Journal of Social Science and Business (IJSSB)

When large corporations buy, sell or merge, the due diligence is a monstrous task, performed by accountants and attorneys, leaving no stone unturned. The valuation of the target company is performed using audited financial data and plenty of comparable market based values. But when small businesses are changing hands, the potential buyers are often counseled to obtain at least the past five years of tax returns, depreciation schedules and physical inventory records from the sellers, from which a fair value will be derived. The rule of thumb has been that tax returns will portray the most conservative view of the target company’s results of operations, as owners are motivated to under-report earnings and over-report expenses to reduce taxable income. This article is a case study of an actual business purchase, subsequent forensic accounting and lawsuit, disguised for privacy, and demonstrates the risk in reliance on tax return information in the purchase of a small business. Further, practical strategies for additional due diligence that could have resulted in a stronger valuation are discussed.