Common Adjustments in the Due Diligence Process

Conducting Financial Due Diligence and Quality of Earnings Analysis

Financial due diligence and quality of earnings reports provide a third-party analysis of a target company’s current financial position and historical financial performance. When evaluating a potential business acquisition, it is crucial to understand the nature and magnitude of the business’ cash flows. Whether from the perspective of the buyer or seller, the earnings of the business are essential to determine an appropriate purchase price or multiple to be used in pricing the deal. Furthermore, it is in the best interest of both sides of a transaction to accurately represent and clearly understand the benefit stream(s) driving the pricing of the transaction. This article highlights some of the more common normalizing adjustments that are considered during financial due diligence.

Financial due diligence and quality of earnings reports provide a third-party analysis of a target company’s current financial position and historical financial performance. When evaluating a potential business acquisition, it is crucial to understand the nature and magnitude of the business’ cash flows. Whether from the perspective of the buyer or seller, the earnings of the business are essential to determine an appropriate purchase price. Furthermore, it is in the best interest of both sides of a transaction to accurately represent and clearly understand the benefit stream(s) driving the pricing of the transaction. To do so, professionals consider the application of normalizing adjustments to a company’s historical (or projected) cash flows to reflect the true economic position and results of operations of the target company. These adjustments are necessary to remove the effect of certain accounting principles that may contradict or imperfectly reflect economic reality as well as eliminate certain discretionary, non-operating, or non-recurring items that may distort the reported results of operations. Normalizing adjustments are particularly crucial with respect to evaluating the earnings potential of a company under the transaction scenario being contemplated by the parties (i.e., evaluating what the company’s financial results will most likely look like on a go-forward basis post-transaction).

Most commonly, financial due diligence includes procedures whereby normalizing adjustments are proposed to adjust the target’s earnings before interest, taxes, depreciation, and amortization (EBITDA).  EBITDA is a commonly utilized benefit stream in transactions as it considers a company’s financial performance before (1) interest expense and taxes to mitigate effects of varying capital structures and special tax situations; and (2) depreciation and amortization to adjust for varying levels of capital investment, variable amounts of depreciable/amortizable assets, and differing depreciation methods that may be used by companies.

The following list highlights some of the more common normalizing adjustments that are considered during financial due diligence:

–Discretionary/Personal Expenses: Are there discretionary expenses that management currently incurs that do not impact the day-to-day operations of the business? Are any personal expenses paid by the company on the behalf of a business owner that would not be necessary on a post-transaction basis?

It is important to note that many business owners can be hesitant to disclose certain personal/discretionary expenses; however, it is in these owners’ best interests to identify and assist in quantifying these amounts as they frequently represent incremental cash flows available to a hypothetical buyer. Moreover, these increases can have a meaningful impact on the purchase consideration as it is common for a hypothetical buyer to base a purchase price on an EBITDA multiple. For example, if the letter of intent stipulates a purchase price based on 5.0x the amount of trailing 12-month normalized EBITDA, every dollar that results from a normalization adjustment to EBITDA is multiplied by five, resulting in more money landing in the seller’s pocket.

–Executive Compensation: Are any officers paid amounts inconsistent with what the market would bear for a reasonable replacement? Does the letter of intent stipulate what the compensation for select officers will be post-transaction? Are there any officers that are not involved in the day-to-day operations (or any part of the business) who could be removed without affecting the company’s financial results? Are there family members who receive compensation but are not actively involved in the company’s operations?

–Related Party Transactions: Does the company have related party transactions that will not continue on a go-forward basis or will occur at higher or lower amounts? Does a related party own the real and/or personal property on which the subject company operates? Does the company currently have a “sweetheart” rent rate as a result of that related party relationship?

–Extraordinary/Non-Recurring Income and Expenses: Have any other income or expense items that are not expected to recur in the future or do not relate to the core operations of the business (e.g., legal settlements paid or received)?

–Out-of-Period Expenses: Have accounting entries, policies, and methodologies been consistently applied throughout the interim and year-end periods? Have accounting methodologies changed over the last several years? In addition, it is important to consider the impact of necessary closing entries that may or may not have been booked as of an interim date (e.g., bonuses are not accrued until year-end).

–Revenue Recognition: Because acquisitions are often priced based on earnings (which are a direct result of revenues), it is essential to understand how a business recognizes revenues and if its process is appropriate and consistent within its industry. The following areas frequently impact the way in which a buyer may look at a potential transaction:

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 financial statements prepared in accordance with generally accepted accounting principles 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 is more easily understandable, it allows for more simplified entries, it is beneficial for tax purposes, etc.).

If a company uses cash basis accounting, this means it will not report receivables or payables, which can impact EBITDA, 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.

Free on Board (FOB) Shipping Point and FOB Destination: FOB shipping point and FOB 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.

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 conducting a review of the company’s work-in-process schedule will help buyers better understand if revenue and expenses are being recognized correctly.

The aforementioned items are just a few of the normalizing adjustments that are frequently identified during a financial due diligence assignment. Each project requires the diligence team to have detailed discussions with management (and the company’s external accountants in many instances) to properly identify all applicable normalizing adjustments. Understanding these common due diligence adjustments, however, can aid all of the parties involved in a transaction in making sure the normalized performance of the target company is being appropriately measured.

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Sean R. Saari, CPA, ABV, CVA, MBA, is a Partner in Marcum’s Advisory Services group with a practice concentrated in the areas of business valuations, litigation advisory services, financial reporting, complex damages analysis and modeling, strategic planning, succession and estate planning, and mergers and acquisitions. 

Ashley DeCress, CPA, CVA, and Derek Oster, ASA, CV,A are Managers in Marcum’s Advisory Services group with similar areas of specialty. 

They authors can be contacted at (440) 459-5700 or sean.saari@marcumllp.com / ashley.decress@marcumllp.com / derek.oster@marcumllp.com.