Acquisition War Story: What Accounting Reveals
Businesses either use cash or accrual accounting. You should be cognizant of which accounting style is being used during your due diligence process.
As long as I've been participating in this industry, any business I’ve encountered that claims to use accrual accounting has been lying. In reality, they’re running a system that is accrual-ish at best. Once a seller says that they use accrual accounting, you need to ask how they define it. You need to find out what they’re actually doing. In most cases, they’ll have a bookkeeper who has a background in accrual accounting, but what they’re really doing is some hybrid method of matching cost and revenue.
In accrual accounting, an owner can push revenue into the system with a bunch of purchase agreements that may or may not be real to increase their revenue and Accounts Receivable. This promised revenue may never materialize after your deal is done. The business might just not happen. Meaning that a customer wanted a product or service but doesn’t honor the purchase agreement and doesn’t pay. After buying the business, you may also owe work that revenue has already been recorded for. Someone, perhaps a friend of the seller, will show up with paperwork and you’ll owe them the work. With accrual-ish accounting financials, it’ll be harder to recognize when a seller is pushing revenue through the system.
One time, I was doing a deal where we found a credit agreement by accident. The seller didn't want to show it to us. It was basically an order for $250,000 that the company had booked as revenue, but that hadn’t been delivered yet. You might see this with subscription models. Not just software, but cleaning or travel services as well. With the pandemic, a customer may only use up part of the services they paid for so you might owe that person something at the tail end of the year.
Be careful with accrual accounting. Sellers can be creative with it. If you're good at reviewing financials or your accountant is decent, you'll find a lot out about the company. With messy financials, you have to do so much to just get them in order that your 90-day period might not give you enough time to unravel anything that's off.
Most of the companies that you encounter will use cash accounting. In this type of company, costs go out the door in payroll and expenses. Even if you have a widget company, you need to pay overhead on where you operate and pay payroll. Those costs go out in the present, but revenue comes in on terms of 30, 60, or 90 days. Conversely, in accrual accounting, costs are in the current period and revenue is from three months ago.
Companies with cash accounting raise different concerns If the company is about to fall off a cliff revenue-wise, you might not realize it. They’re recognizing revenue as cash comes in. In cash accounting, you need to be careful that the company has enough pipeline and accounts receivable to be on par with performance from previous years. While accrual accounting is more tricky, don’t get caught in the lull of cash accounting.
A Quality of Earnings report will help you understand the accounting of the company that you want to buy. My guide helps you understand how to interpret a QoE report to learn everything you need to about your prospect. Get it here.