Canada: Quality Check Your Investments

Last Updated: May 19 2014
Article by John Caggianiello

Thorough investigation into the quality of earnings helps buyers decide if the price of a business is right.

When it comes to buying a business, paying too much for it can have serious ramifications, affecting financing along with the future revenue of your business. That's why it's so critical to understand whether the amount of earnings the vendor is claiming the business earns is sustainable—and the quality of those earnings—before you finalize the deal.
Being aware of the quality of earnings isn't just about looking at the numbers, although that's an important indicator. It requires developing a thorough understanding of the target's business.

"We spend several hours talking with management of the target company before we even look at the detail behind the financial statements," says John Caggianiello, CA, Senior Vice President and Director, MNP Corporate Finance in Toronto."That conversation gets us the information we need to determine the risk areas for our client: the corporation or the Private Equity firm planning to buy the business, or the Bank or alternative lender wanting information for decision-making purposes."

Various areas of the business are explored in the meeting, such as how the target company acquires customers, how sales are made, what kind of capitalization policy is used and how inventory is handled. "You also want to ask questions that can bring things to light that you'd never otherwise discover, such as what keeps them up at night or how they would grow the business if money was no object," says John.

The idea is to learn how the business operates so that financial, customer and vendor analyses can be done with an understanding of where the risks lie. "A quality of earnings review doesn't need to look at every single little thing. That's not cost- or time-effective," says Vic Kroeger, CA, Senior Vice President and Director, MNP Corporate Finance in Toronto. "You need to look at the right things. We tailor the investigation to focus on specific areas, those of highest risk for the buyer."

While the process always involves pinpointing certain areas, how you look at those areas will change depending on the type of business. For example, Accounts Receivable Aging will always be examined but, says Vic, if you know, through a conversation with the management of the target company, that one customer makes up 75 per cent of sales, you can focus your work on how quickly that customer pays, calculate the percentage his purchases have increased or decreased, determine how vulnerable the company is to their existing orders, etc. and perform a cursory review on the rest.

Uncovering The Truth

Every quality of earnings investigation turns up something the buyer is better off knowing. If it impacts the value of the business, the buyer and vendor are usually able to renegotiate the deal in the buyer's favour.

The buyer can benefit even when information is uncovered that would raise the price of the business. "On one file, we found a $150,000 error to the seller's advantage," says Vic. "If the seller knew about it, he could have increased the price by the five times multiple totalling $750,000." But the seller didn't get to read the report the buyer had engaged MNP to complete. "That meant the buyer knew they were getting a deal and had $750,000 in their pocket to negotiate with," says Vic.

Even serious issues can be resolved if they are brought to light before the deal is finalized. In one case, the vendor's General and Office category in the financial statements jumped from $5,000 one year to $30,000 the next. Delving in, MNP discovered that overtime was being put into General and Office because the company was paying cash.

Had the buyer purchased the business unaware of this fact, potential tax issues, issues with the union, or even a lawsuit in the future could have been costly. Such serious issues often cause a deal to fall apart, but in this case, a solution was found. "The vendor left more money on the table, in the form of a take-back note, just in case there was future exposure," says Vic.

In some cases, information about quality of earnings is uncovered that drastically reduces the value of the company. John offers the example of a seller claiming $1 million of normalized earnings; the buyer agreed to pay $5 million based on those earnings. But due diligence uncovered a significant cut-off problem: the vendor was pre-reporting revenue, entering sales into the year on which the price of the business was based instead of in the year when the revenue was actually earned. Taking out the prerecorded revenue resulted in a 40 per cent decrease in earnings.

The deal didn't go through, but the buyer avoided a host of problems. "If we didn't go in, the buyer already had assumed that the accounting records were being reported properly, and would have done the deal. And next year, when the financial statements were done properly, there would have been a big surprise that would have put him offside on all his financial covenants with his lenders," says John. "He could have lost the business."

While it's possible to have your internal accounting team check the quality of earnings, John warns that there are certain instances when it's important to have an independent third party specializing in transaction advisory do the work for you. This is especially important when you are seeking financing.

Using a third party is also an efficient way to get a labour intensive process completed without draining your internal resources. Performing due diligence often takes two to three weeks to complete and involves working long days. Buyers also need to consider what they will do if a serious issue is uncovered, as they will want to access the right advice to renegotiate as quickly as possible.

Done properly, due diligence to check quality of earnings is like insurance for buyers. Accurate information in hand, they can understand the issues ahead of time, renegotiate the deal based on the earnings that are really there and complete the transaction successfully.

This article was originally published in PCMA Private Capital Markets Magazine, Spring 2014

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.