Transaction readiness involves both quantitative and qualitative assessments of many facets of the business: strategy, operations, customers, market demand and supply, legal, tax, accounting, and future projections and forecasts. It often involves many players, including lawyers, accountants, investment bankers, and valuation and due diligence professionals.

The current state of the books and records, along with the future projections, are the main drivers behind enterprise valuations and have a huge impact on the exit/sale price of the business. It is imperative to have, among other things, financial statements for at least the last two preceding years that are well-prepared and materially consistent with U.S. Generally Accepted Accounting Principles (GAAP), in addition to information on customers, pipeline, etc.

Companies that are family- or owner-owned entities that have experienced rapid business growth may find that their finance and accounting function may not have scaled proportionate to the growth, and most of the bookkeeping duties are still performed by a function that may lack the sophistication to scale or help the company through a successful sale or exit. Consider whether outside support is needed to fill the gap.

The majority of buy-side diligence professionals expect a target company to have financial statements that are accruals-based, complete, accurate, and directionally compliant with GAAP. The bridge from cash or modified cash basis to accruals/GAAP-based accounting might sound simple at first glance. However, the transition is based on many factors, including the current state of the books and records, and the degree of GAAP adjustments needed to get them ready for a quality of earnings (QoE).

Companies that have a disciplined close process, including performing bank and other reconciliations in a timely manner, reviewing the financials for major variances, and making timely changes to the financials to maintain good health, have an easier path to transitioning.

The GAAP adjustments are based on the business and complexity of the businesses. Companies in the services industry, for example, might have less accounting complexity than manufacturing entities. At the highest levels, factors to consider would include revenue recognition, inventory, leases, and activities within the equity accounts. Other considerations would include classification of direct and indirect expenses, as these tend to impact the margins – a key performance measure for potential buyers.

Companies going through this process will quickly realize the benefits of tightening GAAP compliance, including matching income with expenses in the respective periods they are incurred. This transition often turns up things that the company might not have previously considered or thought through, but that are essential for accurate reflection of results. 

A good example is capitalization of inventory costs. GAAP allows companies to capitalize direct and certain indirect expenses incurred in bringing the product to its existing condition and location. Most organizations that are a retailer or distributor and not on GAAP basis typically capitalize only direct product and freight costs. A close analysis of other costs, including warehouse labor, rent, insurance, and procurement, can result in capitalizing additional costs to inventory that could have a ratable effect on EBIDTA as against expensing them when incurred. This is just one of the many impacts on account of the conversion from cash to GAAP basis.

Another example is consistent capitalization and depreciation of assets. Companies on cash basis may not have a policy to capitalize assets or do so consistently. Conversion to accruals would include a thorough review of expenses above a particular threshold for capitalization of such purchases.

All these adjustments need to be carefully reviewed and documented, as they need to withstand the scrutiny of a QoE. They may have a positive impact on EBDITA, especially the ones related to inventory and fixed assets.

Given the complexity of transaction readiness and the many considerations involved, companies that are contemplating a transaction in the near horizon should start the process early to best position themselves for transaction success.

How CohnReznick can help

Involving third-party accountants to do a rapid diagnostic and develop and implement a conversion roadmap can go a long way in facilitating a smooth QoE and reducing surprises and significant adjustments.

Often, pending sale of a business, our work would focus on equipping the existing in-house accounting team with the right tools and processes, including establishing monthly reporting cadences and developing a checklist of things to do to covert from cash to accrual-based accounting. In other instances, companies end up outsourcing the entire accounting function to our Client Advisory and Office of the CFO groups while they focus on business growth.

In addition, our Due Diligence and Office of the CFO professionals work together to offer companies a full suite of services, including conversion support, buy- and sell-side diligence, valuation, and post-close integration support services.

Reach out to learn more and start planning your next steps.