Introduction
In the course of our M&A advisory work, we frequently hear the same concern: “We carried out thorough financial due diligence (DD), yet after closing, we discovered liabilities we never anticipated.” Years after an acquisition, a buyer may suddenly face a retroactive claim for unpaid overtime, or discover that restoring a leased store to its original condition will require a substantial outlay. Off-balance-sheet liabilities tend to erode investment returns quietly, but surely. Domestic and international reports alike are full of cases where a promising acquisition ultimately fell through, or where the buyer was forced to record a significant impairment loss shortly after closing. Look closely at the background of these cases, and a surprising number of them share the same underlying cause: off-balance-sheet liabilities.
Why do such risks slip through due diligence, even when professional advisors are engaged? The answer is not simply insufficient investigation or oversight. Rather, it reflects structural issues rooted in the business environment and commercial customs specific to Japanese small and medium-sized enterprises (SMEs). This article first examines the mechanisms behind these blind spots, then introduces the checkpoints we apply in practice during financial due diligence. We hope it will help investors both in Japan and overseas, as well as business owners considering an acquisition, understand just how difficult it can be to identify these risks without specialist support.
1. Why Off-Balance-Sheet Liabilities Go Overlooked in Japanese SME M&A
Off-balance-sheet liabilities do not necessarily arise from a seller’s deliberate concealment. In fact, in most cases, even the seller is unaware that a given arrangement could become a liability in the future. Three structural factors specific to Japanese SMEs lie behind this.
1) Verbal Promises Rooted in “Trust” Rather Than Contracts
At many Japanese SMEs, particularly those that have long been run by a founder-owner, arrangements such as supplementary retirement payments or profit-sharing with family members are often agreed upon verbally, at the discretion of the company president, rather than documented in a formal contract. Built up over years of personal trust, such understandings feel entirely natural to the parties involved — yet they leave no trace in the company’s books. For a buyer, with no written record to review, there is simply no way to detect that such an arrangement exists.
2) Financial Statements Prepared Primarily for Tax or Lending Purposes
SME financial statements are often prepared with tax filings or bank reporting in mind, rather than with M&A-specific purposes such as business valuation or future cash flow analysis. As a result, the fact that financial statements are accurate does not necessarily mean that every risk relevant to an acquisition has been captured within them.
3) The Buyer’s “Excessive Good Faith” and Time Constraints
Eager to avoid prolonging negotiations, buyers sometimes accept a seller’s assurance that “there are no particular issues” at face value. In addition, within a limited DD period, it is rarely realistic to review every contract and supporting document in full, and buyers are often forced to rely on sample testing instead. This time constraint is, in fact, one of the single biggest reasons off-balance-sheet liabilities go undetected.
2. Typical Sources of Off-Balance-Sheet Liabilities That Financial DD Must Not Miss
Below, we introduce the typical sources of off-balance-sheet liabilities that we pay particularly close attention to in actual financial due diligence engagements. None of these are purely financial issues — each sits in a gray area, closely intertwined with legal and labor matters, yet ultimately affecting the financial statements.
1) Labor-Related: Unpaid Overtime and Retirement Benefit Reserves
This is among the risks we encounter most frequently in SME due diligence. It is not uncommon to find discrepancies between timecard records and actual working hours, or so-called “managers in name only” — employees classified as management but whose actual duties do not meet the legal threshold. Unpaid overtime of this kind can result in retroactive claims from employees, sometimes spanning several years, after the acquisition closes — and depending on company size, can develop into liabilities ranging from tens of millions to several hundred million yen.
2) Operational and Commercial: Restoration Obligations for Stores and Factories (Asset Retirement Obligations)
When a leased store or factory is eventually vacated or closed, restoration costs are typically incurred. Yet it is rare for these costs to be estimated in advance and reflected in the financial statements. Depending on the scale of the property, restoration obligations alone can represent a burden of tens of millions to several hundred million yen — and the impact of overlooking them should not be underestimated.
3) Guarantees and Litigation Risk: Joint and Several Guarantees for Related Parties
Cases in which the target company has provided a joint and several guarantee for the debts of the president personally, of a group company, or of a business partner also warrant close attention. If an acquisition closes without sufficiently thorough contract review, the buyer may later be called upon to fulfil that guarantee obligation. Because such guarantee arrangements are often difficult to identify from financial statement footnotes alone, particular care is required.
4) Contractual and Commercial: Penalty Clauses and “Change of Control” Provisions
Some key business contracts include provisions that are triggered by a change in ownership — requiring the payment of penalties or the immediate repayment of outstanding loans. These are known as “Change of Control” clauses, and because the act of completing the M&A itself can trigger new liabilities or cash outflows, they represent a risk that must never be overlooked.
It should be noted that some of these issues — such as the legal assessment of unpaid overtime claims or the interpretation of contractual clauses — cannot be fully resolved through financial due diligence alone. The purpose of financial DD is not to reach a final legal conclusion on these matters, but rather to identify indications that may affect financial figures, quantify them where possible, and, where warranted, hand off to further investigation by lawyers, labor and social security attorneys, or other specialists.
3. A Practical Approach to Detecting Signs of Off-Balance-Sheet Liabilities in Financial DD
To identify these risks, we outline below the approach we apply in our financial DD engagements. Reading through it, you may find yourself thinking, “Is it really necessary to go this deep?”
Reviewing Leases and Key Contracts
We review every real estate lease agreement individually to confirm whether a restoration clause exists and, if so, what it requires. It is equally important to verify whether restoration costs — based on estimates obtained from contractors — have been appropriately reflected in the accounts, such as through an asset retirement obligation.
Reviewing Board and Shareholder Meeting Minutes
We carefully read through the wording of board of directors’ and shareholders’ meeting minutes from the past three to five years, checking for any indications that could point to contingent liabilities. A single, seemingly unremarkable line can often be the first clue to a significant risk.
Reviewing Full Bank Account Statements
We examine the complete transaction history of every bank account over the past three years, carefully tracing any suspicious transfers not reflected in the books, as well as changes in loans to and from directors. Cash flows often reveal far more than management’s own explanations.
The Importance of Cross-Checking
We apply professional judgment to test whether explanations obtained through management interviews are logically consistent with objective evidence such as contracts and bank statements — and to identify any discrepancies between the two. This cross-checking process frequently brings unexpected off-balance-sheet liabilities to light. For example, in one case, an analysis of trends in director and employee compensation revealed a significant increase in the amount paid to a particular employee at the time of their departure. Further interviews confirmed the existence of an unwritten practice of supplementary retirement payments.
This illustrates a broader point: in financial due diligence, it is not the figures alone that matter, but the sense that “something doesn’t quite add up” when the numbers move in unexpected ways. Tracing the background of that discrepancy through contracts, meeting minutes, and interviews is key to uncovering the risks that financial statements alone do not reveal.
Conclusion
In financial due diligence, mechanically reviewing every single document is not necessarily the most effective approach. What matters more is forming hypotheses about where risk is likely to reside — based on the target company’s industry, business model, number of locations, labor management practices, and transactions with the owner — and then using those hypotheses to guide and deepen the scope of investigation.
At the same time, off-balance-sheet liabilities do not necessarily stem from a deliberate act of concealment on the part of management. In many cases, they arise instead from factors specific to Japanese SMEs that even the seller has not recognized. For precisely this reason, preventing such risks requires financial due diligence conducted with a fine-grained, granular approach — grounded in a deep understanding of how Japanese SMEs actually operate.
If, after reading this article, you find yourself wondering whether your organization alone could conduct due diligence to this level of depth, we would be glad to discuss the matter with you.