Acquisitions are often priced based on earnings, which are directly impacted by revenues. During the course of financial due diligence for a potential acquisition, there are several considerations that merit close attention. One area in particular is the reporting of revenue by the target company. In this case, it is critical to understand how a business recognizes revenues and how its process aligns with industry standards and norms.
The following areas frequently impact the way in which a buyer may look at a potential transaction:
1. Cash vs. Accrual Basis of Accounting
Under accrual basis accounting, revenues are recorded when they are earned regardless of when the money is received. The cash basis, on the other hand, records revenue when cash is received (and expenses when cash is paid). Although GAAP (Generally Accepted Accounting Principles) financial statements require companies to use accrual accounting, many small and middle-market businesses operate under the cash basis for various reasons (e.g., small or no accounting department exists within the business, it’s more easily understandable, it allows for more simplified entries).
If a company uses cash basis accounting, this means it will not report receivables or payables, which can impact profitability, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), working capital, etc. When performing a due diligence engagement, the cash basis may not fairly reflect the true profitability of a business year after year. Furthermore, the target company’s financial results may not be consistent with the industry, which is important for pricing the deal. For example, say your business pays an annual fee of $6,000 in June for a one-year subscription. Under the cash basis, the month of June will reflect a higher expense level than all other months ($6,000 of expense is recorded in June, and $0 is recorded in the rest of the year). Under the accrual basis, the $6,000 is evenly spread over the 12 months the subscription is utilized ($500/month). Additionally, a trailing twelve-month period may pick up additional expenses or not capture an expense, which could create a distorted view of the financials.
2. FOB Shipping Point and FOB Destination
FOB shipping point and destination indicate the point that the title of the goods transfers from the seller to the buyer. FOB shipping point transfers to the seller when placed in delivery, whereas FOB destination transfers to the seller once the goods reach the seller. These milestones, depending on the contract between the buyer and the seller, are frequently utilized in the recognition of revenue.
From a due diligence perspective, it is important to understand if the company is applying its selected method consistently. If not, there may be revenue cutoff issues from one period to another, resulting in distorted revenue results. It is also essential to understand if the company’s revenue recognition policies are followed each month or less frequently (e.g. quarterly or annually). For example, if a business has an FOB destination agreement with a customer and the goods are shipped on the last day of the month, but not delivered until the following month, they should not be relieved from inventory until the goods have been delivered to the destination because risk of loss still resides with the seller until delivery. If the company does not consistently apply this method on a monthly basis, financial adjustments may be necessary.
3. Percentage of Completion
Percentage of completion is a common accounting method in the construction industry, which recognizes revenue and expenses of long-term contracts as a percentage of work completed during the period.
One potential diligence issue is that this method is susceptible to misuse in the interest of boosting short-term results (e.g., a project is actually only 10 percent complete but reported as 80 percent complete so that revenues are inflated in the current period). Revenues and expenses that are accounted for in an incorrect period could skew profitability and create unreliable numbers. Understanding the appropriateness of estimates historically and the review process of the company’s WIP (Work-in-Process) schedule will help to better understand if revenue and expenses are being recognized correctly.
As discussed above, due diligence procedures can be designed to evaluate the consistency of application of accounting methods, cut-off between periods, accrual accounting, etc. In addition, as the new revenue recognition standard moves into effect, the issue of revenue recognition will be crucial in evaluating potential deals.
If your business, or the business you are looking to purchase, has not adopted the new standard, you should assess the implementation costs to be incurred as well as the time and resources needed. It is also important to look at how the new model will affect contracts with customers or shifts in pricing or marketing strategies. These changes may impact performance metrics, working capital adjustments, EBITDA or even earnouts and debt covenants.
Do you have questions about revenue recognition and how it relates to due diligence, or other transaction advisory-related matters? Please contact Freed Maxick at 716.847.2651, or click on the button for a contact form.View full article
Companies who do business in industries like construction, manufacturing and real estate are heavily impacted by the new revenue recognition rules imposed by the Financial Accounting Standard Board (FASB), effective January 1, 2019 (for annual reporting – and in 2020 for interim periods). As these rules removed the ability to apply separate accounting rules to contractors, many companies may be unsure how best to proceed under the new rules.
The reason for the change in accounting standards stems from a need for an approach that more accurately portrays the transfer of promised goods and services. The new standards apply to any entity entering into a contract for the transfer of goods or services – or the transfer of nonfinancial assets – unless the contract falls within the scope of other accounting standards.
What the Accounting Change Means for the Construction Industry
When it comes to accounting for revenue recognition, the construction industry has long been held to separate accounting principles due to the nature of long-term contracts. That all changed when the Financial Accounting Standards Board (FASB) issued the new standard, Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers. In issuing its new revenue recognition standards, FASB effectively swept away all preexisting GAAP in the area of revenue recognition, including the separate accounting principles specific to contractors.
The Five-Step Model
The new accounting principle will be achieved using the following five-step model:
- Identify the contract with a customer
- Identify the performance obligations
- Determine the transaction price
- Allocate the price to the performance obligations
- Recognize revenue with the satisfied performance obligation
Key Industry Considerations
There have been a number of interpretations regarding the new revenue recognition standard, and some of those can be misleading. With that in mind, here are a few clarifications:
- Contrary to some assumptions, revenue recognition under the new standard will be similar to the percentage of completion method used today. The new standard allows for the use of input or output methods to determine the percentage complete.
- Many construction contracts may have only one performance obligation—it will be up to contractors to evaluate each contract for separate performance obligations and document their conclusions.
- FASB included language to allow contractors – in certain circumstances – to recognize revenue equal to the cost of uninstalled materials if the customer obtains control of the goods.
- If the company has claims or unapproved change orders on a contract, the revenue associated is recorded based on the company’s estimate of the expected amount of claim that will be received, if it is probable that a significant reversal of revenue will not occur in the future.
- Warranties purchased separately by the customer may represent separate performance obligations that require their own revenue recognition treatment. Warranties included as part of the company’s normal contract may represent additional costs to include in the company’s cost-to-cost revenue recognition method.
Despite these challenges, now is the time to become organized so that your business can be in compliance with the new standards. Delaying will only result in a greater time investment to make adjustments during a year-end audit or review.
Do you have questions about how to become compliant with the new revenue recognition standards? Please contact us directly at 716.847.2651.View full article