Deals die for a variety of reasons, but the most frustrating are the ones that are entirely preventable. One such example is the application of an appropriate revenue recognition policy.
While difficult to understand, failing to implement correct practices can (and does) kill deals. Because of the complexity of the accounting rules around this topic, many deals struggle to get through economic due diligence due to sellers’ lack of understanding of revenue recognition. The result is often that after an external review, buyer’s accountants appropriately (but unexpectedly to the seller) restate the earnings of a selling company, significantly changing the valuation of the company.
Effective Revenue Recognition Policies
Revenue recognition is the accounting analysis of when to properly recognize revenues and expenses in a company’s profit and loss statement. Although it is an arcane topic, business owners planning to sell should strive to understand it and implement an appropriate strategy, as the timing of costs and revenues repeatedly causes troubles for middle market transactions.
In essence, an appropriate revenue recognition policy matches up the costs and revenue associated with services or projects that take a long time to complete. While not particularly important to companies with discrete transactions, sellers with significant revenue associated with long-term projects or services need to be particularly aware of the appropriate standards.
As an example, in the IT services space, a single contract may include the purchase of equipment, engineering services, and long-term services. The contract may include payments with a variety of timing, including at contract signing, throughout the work, at completion, and also over the course of the maintenance period. On the cost side, equipment could be purchased up front, while labor costs are recorded over time. It is important to make sure that these payments and costs are matched up, and also matched up with the contract for the work. If these payments and costs spread out over multiple accounting periods, the issue can become even more magnified.
Other construction and project related companies (as well as any company with revenue derived from long term contracts) suffer from similar questions regarding the recognition of revenues and expenses, and ultimately, the profit that derives from them.
Consequences of Poor Revenue Recognition
I’ve personally been involved in a couple of transactions that suffered from a seller’s inability to understand and implement an appropriate revenue recognition policy.
In the worst case, the company’s books showed wild gyrations of monthly profitability, due solely to its failure to apply any sort of timing rules to its revenue and expense. The company booked progress payments when received and equipment costs when incurred. Since project contracts often spanned over two (or sometimes even three) years, the company didn’t really know how profitable it was in any given 12 month period. Not surprisingly, while the buyer worked hard (and spent a lot of money) to figure out what the company’s true profitability was (and when the profit should have been earned), the buyer ultimately got frustrated enough to walk away from the transaction.
While buyers understand that many middle market companies don’t maintain their books to Generally Accepted Accounting Principles (GAAP), the issue of revenue recognition is one that a selling company needs to have its arms around to successfully take a company through the sale process. Sadly, with effort, the company I mentioned above could have implemented a system that would have satisfied the buyer, but ultimately, it didn’t and the transaction failed.
How to Avoid the Same Problem
Unfortunately, implementing an appropriate revenue recognition policy isn’t easy! In addition to being generally counter-intuitive to business owners who focus on what cash goes into their pockets, until recently, the Financial Accounting Standards Board (FASB) had reported that there were over 200 specialized and/or industry-specific revenue requirements under GAAP. Clearly a minefield for even the most sophisticated lower middle market business.
Now the good news (and the bad news). The good news is that to reduce confusion and clarify the area, on May 28, 2014, the FASB and the International Accounting Standards Board (IASB) issued new guidance on recognizing revenue in contracts with customers. The bad news is that the guidance is 156 pages long and befuddling to those that aren’t experts in the space.
Unfortunately, despite the complexity of revenue recognition, this is an issue I’ve personally seen destroy transactions.
Make sure you’ve worked this issue through with your team well before you start the sale process.