In a number of recent financial due diligence engagements, RubinBrown's advisors noticed probable misstatements of a target's reported revenue. Revenue misstatements usually result in a reduction to revenue (and EBITDA), but not always. The following is a list of revenue misstatements that have been uncovered, as well as the usual direction of any adjustment necessary to bring a company's reported revenue in line with reality.
Businesses in a number of industries receive cash payments but do not always record the associated revenue. When it comes time to sell the business, the owner will claim this revenue exists, but usually cannot substantiate such receipts. Rarely, if ever, will a buyer factor these amounts into projections and calculations of purchase price; however, if such cash receipts do exist, they represent a benefit to the buyer that the buyer is not directly paying for when making an acquisition based on a multiple of revenue or EBITDA.
Adjustment: Increase revenue to the extent unrecorded revenue can be substantiated.
In companies that are experiencing rapid sales growth or decline or otherwise realizing significant sales in the first or last few days of each month, revenue cut-off issues can be material to a company's bottom line. Whether it's the result of an oversight, such as recording a sale FOB shipping point when the terms of sale dictate FOB destination, or a more complex GAAP revenue recognition violation, such as bill and hold transactions or multiple element arrangements, even companies with robust accounting resources can inadvertently record sale transactions in the wrong reporting period.
Adjustment: Generally, a company with consistent sales which has not changed its revenue recognition policy will have the lowest likelihood of having material revenue cut-off issues, since a period with overstatements would most likely contain understatements on the other side of that period. From this baseline, then, it follows that a company with revenue cut-off issues that is enjoying sales growth is likely overstating its period revenue; the opposite is true for a company with declining sales. In any event, each situation should be considered on its own circumstances for materiality concerns.
Lack of Accrual for Sales Returns
Many companies will record sales returns as they are incurred. For a business that has infrequent returns, this is reasonable. However, for a company with a history of product returns and/or a generous product return policy, this is probably not appropriate. Instead, such companies should be accruing for sales returns with each sale (or monthly, at least) in order to recognize anticipated product returns in the periods these sales were made.
Adjustment: For each period, increase revenue by the amount of actual sales returns and decrease it by the estimate. Thus, net revenue is effectively increased by a decrease in the required sales return reserve, and vice versa.
Change in Revenue Recognition Criteria or the Underlying Estimates
A change in accounting policy is always a red flag, and the first question that comes to mind is "What is management's motivation for changing its revenue recognition criteria (or the underlying estimates)?". For instance, if a company begins bill and hold sales arrangements during the most recent fiscal year (thereby accelerating revenue recognition), it is only natural to ask what fundamental changes in the business have caused this to be a more appropriate method for recognizing revenue. Similarly, a business using the percentage of completion method which has taken a more aggressive approach to recognizing revenue in the current period should be evaluated for either the historical misapplication of this method or a recent fundamental change in costs or margins. Moreover, any changes in the underlying estimates should be scrutinized, since revenue recognition is much more subjective in percentage of completion scenarios.
Adjustment: In situations where a change in revenue recognition criteria appears to have accelerated revenue recognition without merit, decrease revenue to the extent of the acceleration. Similarly, cost of goods sold should be adjusted with changes in revenue, as appropriate.
Hybrid of Cash and Accrual-Based Revenue Recognition
We have encountered situations in which a company will record its sales on a cash basis, but the result is actually a hybrid of the cash and accrual bases of accounting. For instance, consider a business that accepts co-pays (from patients) and third party reimbursements (from their insurance provider). The co-pay is recorded at time of treatment, while the reimbursement may not be collected for 60 days. In this situation, the cash payment is recorded appropriately under either the cash or accrual bases of accounting, but the reimbursement is strictly cash basis. Depending on the skew of co-pays to reimbursements, the effective basis of accounting for revenue can vary widely. This also complicates reported gross profits, since such businesses are likely to record their costs of sale in the period of the transaction.
Adjustment: Ideally, the company will maintain records of its transactions/appointments/prescriptions filled and the amount sought for reimbursement. With a simple analysis, the expected reimbursements can be calculated and placed onto the balance sheet (as receivables) at each period end, thereby giving an indication of revenue (and gross profits) on an accrual basis.
Somewhat infrequent, but still pervasive are misrecorded sales. In one situation, the company had a series of similar account names for both revenue and cost of goods sold. As a result, it recorded a number of sales entries into cost of goods sold (as contra-account entries), and also recorded costs of sale into revenue accounts (again, as contra-account entries). Each of these misrecorded entries resulted in a reduction to gross revenue or gross cost of goods sold while also causing gross margin percentage to be misstated, but had no impact on gross profit.
Adjustment: Identify the misrecorded entries, and reclassify the amounts to the correct income statement accounts.
One-off sales, proceeds from the sale of equipment, insurance proceeds, unusually high levels of scrap income, and other non-recurring sources of cash are most certainly not recurring revenue. However, we have encountered businesses trying to inflate operating income by including the above sources of income as revenue. (Operating income is important to both parties in a transaction because most calculations of EBITDA are premised on operating income, where operating income is "E", or earnings.)
Adjustment: Decrease recurring revenue to the extent of the one-time / unusual sources of income, and place such amounts into other income (i.e., below the operating income line).
Clearly, this list represents only a fraction of the ways in which a company's reported revenue can differ from reality, whether purposeful on the part of management or not. If you are considering an acquisition, RubinBrown can help you investigate and analyze a target's financial statements and records to determine if revenue is being reported accurately.
RubinBrown has a dedicated team of M&A professionals that can assist you at any point in your business' lifecycle, whether you are considering making an acquisition, divesting a business line or product, or readying your business for sale. RubinBrown has the experience to help your organization from the initial thought of buying or selling to the critical post-closing and integration activities that must occur. Our comprehensive approach maximizes the value of the transaction for our clients.
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