Complete Guide to Due Diligence in Accounting M&A

Would you buy a house based solely on a curbside view, without ever stepping inside to check the foundation, the plumbing, or the wiring? It sounds absurd, yet in the high-stakes world of mergers and acquisitions, we see accounting firm leaders approach deals with surprisingly similar optimism. They see a strong top-line revenue number, a charismatic partner, and a decent location, and they assume the rest will fall into place.

The reality is often far more complex. M&A in the accounting sector is booming due to an aging partner demographic and private equity interest, but the success rate of these deals hinges entirely on what happens before the ink dries. Due diligence in accounting M&A is not merely a box-checking exercise; it is a forensic investigation into the past, present, and future viability of a business combination.

We’ve seen successful firms acquire practices that looked perfect on paper, only to discover six months later that the client relationships were non-transferable or the "proprietary technology" was actually a patchwork of Excel spreadsheets. Conversely, we’ve seen buyers walk away from goldmines because they didn't know how to interpret the data correctly. In this guide, we will walk you through a comprehensive framework for due diligence—moving beyond the balance sheet to uncover the true value and risks of an accounting practice acquisition.

The Strategic Philosophy of Due Diligence

Before diving into document requests and financial ratios, it is critical to adopt the right mindset. Due diligence is effectively risk management. It is the process of validating your investment thesis. If your thesis is that acquiring Firm X will expand your advisory capacity, your due diligence must prove that their staff actually possesses advisory skills, rather than just tax compliance capabilities.

Industry data suggests that cultural misalignment and poor integration strategies are the leading causes of deal failure, yet most diligence checklists focus 90% of their energy on financials. While the numbers must add up, the "soft" assets—people and clients—are what you are actually buying in a professional services firm. Therefore, a modern due diligence approach must be holistic, covering four distinct pillars: Financial, Operational, Client/Cultural, and Legal.

Financial Due Diligence: Validating the Economics

Financial due diligence is the bedrock of the process. However, in accounting M&A, reviewing tax returns and P&L statements is rarely enough. The goal here is to determine the Quality of Earnings (QoE). You need to answer a fundamental question: Is the profit shown on the P&L sustainable, repeatable, and transferable?

Normalizing EBITDA

Most small to mid-sized accounting firms are run to minimize tax liabilities for the partners, not to maximize reported EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). As a buyer, you must recast the financials to see the true operating performance.

We recommend creating a "Pro Forma" P&L that adjusts for:

• Owner Compensation: Replace the selling partner's actual draw (which might be artificially low or high) with the market rate cost to replace them with a salaried CPA.
• Non-Recurring Expenses: Remove one-time legal fees, moving costs, or personal auto expenses run through the business.
• Rent Adjustments: If the seller owns the building, are they paying fair market rent? If not, adjust the expense to reflect reality post-acquisition.

Understanding these metrics is crucial when applying various valuation methods to determine a fair price. A multiple applied to an unadjusted EBITDA can lead to a valuation gap of hundreds of thousands of dollars.

Revenue Analysis Table

When assessing revenue quality, break down the income streams. A firm with $2M in revenue derived from 500 recurring tax returns is fundamentally different from a firm with $2M in revenue derived from 10 large consulting projects. Consider the following comparison:

Operational Due Diligence: Workflow and Technology

What if you acquire a firm only to find their workflow depends entirely on one partner's memory and a stack of physical routing sheets? Operational due diligence assesses the "engine" of the firm.

The Technology Stack Audit

In the modern accounting landscape, buying a firm with antiquated technology is akin to buying a fixer-upper home. You must budget for the "renovation" costs of migrating data and training staff. Key questions include:

• Are they cloud-based or server-based?
• What practice management software do they use?
• Is their data structured and accessible, or is it siloed in individual inboxes?

Tools like Firmlever Signal enable firms to visualize operational data, helping buyers understand if the target firm's workflow compatible with their own. If the seller is using desktop Quickbooks and paper files while you are on Xero and Karbon, the integration timeline will double.

Capacity and Utilization

You need to know if the staff is overworked or underutilized. High realization rates are good, but if staff are consistently working 60-hour weeks outside of busy season, you are buying a burnout factory. Analyzing historical time and billing data helps reveal the truth about capacity.

Real-world scenario: We observed a merger where the buyer assumed the acquired staff could take on 20% more work. However, operational diligence revealed that the staff was already spending 30% of their time on administrative tasks due to poor software. By identifying this early, the buyer planned an immediate tech upgrade, freeing up the necessary capacity post-close.

Client and Cultural Due Diligence

Accounting is a relationship business. If the clients leave, the revenue leaves. If the staff leaves, the capacity leaves. This section of due diligence is notoriously difficult to quantify but essential to get right.

The "Good Will" Stress Test

Client retention is the biggest risk in accounting M&A. You must analyze the client list for retention risks. Look for:

• The "Friends and Family" Plan: Clients who are personally attached to the selling partner and pay below-market rates. These clients often churn when fees are normalized.
• Demographic Misalignment: If you are a digital-first firm and the target's client base consists of non-tech-savvy individuals who prefer in-person meetings, friction is inevitable.
• Fee Structure: Are they used to being billed in arrears or on a subscription model? Changing billing psychology is harder than changing software.

According to the AICPA’s succession planning resources, client retention rates can drop significantly if the transition is not handled with a clear communication strategy. Diligence helps you draft that strategy before the deal closes.

Staff Assessment

Would you believe that many acquisitions fail simply because the acquired staff refuses to adopt the new firm's culture? During diligence, you should aim to interview key staff members (if the deal stage permits) or analyze anonymized HR data.

Look for tenure, compensation relative to market, and skill gaps. Platforms such as Firmlever Signal help accounting practices benchmark productivity metrics, allowing you to see if the target firm's Senior Accountants are performing at the same level as your existing team. If there is a disparity, is it a training issue or a talent issue?

Legal and Regulatory Compliance

This phase is about protecting yourself from inherited liabilities. You are not just buying assets; you are potentially buying past mistakes.

The Liability Check

Ensure that the firm is in good standing with all relevant tax authorities and state boards. Common red flags include:

• Pending lawsuits or malpractice claims.
• History of disciplinary action by the State Board of Accountancy.
• Compliance with data security regulations (e.g., IRS Publication 4557).

For detailed guidance on professional standards and ethics during transfer, referring to IRS Circular 230 is highly recommended to ensure the practice you are buying has maintained ethical compliance.

A Phased Approach to Due Diligence

Trying to do everything at once will stall the deal. We recommend a three-phase approach to keep momentum while managing costs.

Phase 1: Preliminary Review (Pre-LOI)

This occurs after the Non-Disclosure Agreement (NDA) is signed but before a Letter of Intent (LOI). Keep it high-level.

• Review of last 3 years of tax returns and financial statements.
• Anonymized census of staff and clients.
• General discussion of firm history and selling motivation.
• Goal: Determine if the firm is worth making an offer on.

Phase 2: Confirmatory Diligence (Post-LOI)

Once the price and terms are agreed upon in principle, the deep dive begins.

• Detailed QoE analysis.
• On-site (or virtual) operational review.
• Review of workpapers and client files (sample audit).
• Tech stack assessment.
• Goal: Verify the assumptions made in the offer. Retrade price if necessary based on findings.

Phase 3: Pre-Closing Verification

The final weeks before the wire transfer.

• Client consent regarding transfer of files.
• Final AR/WIP true-up.
• Employment agreements for key staff.
• Goal: Ensure a smooth Day 1 transition.

Red Flags That Should Kill the Deal

Sometimes, the best deal is the one you don't do. Throughout our experience, certain findings serve as immediate stop signs. If you encounter these, pause immediately:

1. Declining Revenue Trend: Unless there is a clear, fixable reason (e.g., partner illness), a shrinking firm is a falling knife.
2. Toxic Culture: If you find evidence of harassment, high turnover, or a partner who speaks poorly of their clients, walk away. Culture is incredibly difficult to fix.
3. Data Integrity Issues: If the bank statements don’t match the tax returns, or if the WIP report seems fabricated, you cannot trust any of the numbers.
4. Unwillingness to Change: If the selling partner insists on staying on for 3 years but refuses to adopt your firm’s software or processes, the merger will likely fail.

Frequently Asked Questions

How long should the due diligence process take?

Typically, thorough due diligence in accounting M&A takes between 30 to 60 days after the Letter of Intent is signed. Rushing this process increases risk, while dragging it out beyond 90 days often causes deal fatigue and uncertainty among staff.

Who pays for due diligence?

Generally, the buyer absorbs the cost of their own due diligence (financial analysts, legal counsel, tech consultants). However, if the buyer discovers that the seller’s financials were grossly misrepresented, they may negotiate to have the seller cover some professional fees or adjust the purchase price accordingly.

How do we perform due diligence without alerting the staff?

Confidentiality is paramount. Most site visits are conducted after hours or on weekends. If meetings must happen during business hours, buyers are often introduced as "consultants" or "strategic partners" looking at process improvements. Staff should generally not be informed until the deal is unconditional or signed.

What is the difference between an Asset Sale and a Stock Sale regarding due diligence?

In an asset sale (most common in small accounting M&A), you are buying the client list and goodwill, leaving liabilities with the seller. Diligence focuses on revenue quality. In a stock sale, you step into the seller's shoes, inheriting all past legal and tax liabilities. Stock sales require significantly more legal and regulatory diligence.

Should we review every single client file?

No, that is impractical. We recommend a sampling method. Review the top 20 clients by revenue thoroughly, and then take a random sample of 5-10% of the remaining client base to check for work quality, file completeness, and fee consistency.

Conclusion: Diligence as an Investment

It is tempting to view due diligence as a hurdle—a series of hoops to jump through before you can pop the champagne. However, the most successful acquirers view it differently. They see it as the first step of integration. The knowledge you gain during this process forms the blueprint for how you will run the acquired firm on Day 1.

By rigorously analyzing the financials, operations, and culture, you aren't just protecting yourself from downside risk; you are identifying upside potential. You are finding the hidden inefficiencies you can fix and the under-priced services you can adjust. With the right approach and robust analytics platforms like Firmlever Signal providing data visibility, you can proceed with confidence, knowing exactly what you are buying and how you will grow it.