Chris Hatten Explains a Quality of Earnings Statement
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Jen: This is the PKF Texas Entrepreneur’s Playbook. I’m Jen Lemanski, this week’s guest host, and I’m back again with Chris Hatten, one of our audit directors on our Transaction Advisory Services Team. Chris welcome back to the Playbook.
Chris: Appreciate it Jen.
Jen: So I’ve heard you talking about quality of earnings statement; what is that and what do you need to know about it if you’re doing a transaction?
Chris: One of the main ones is identification of risk areas. There’s really no cookie cutter template that can be applied to every transaction and so from whether it’s a tech industry or manufacturing, we’re going to go in and take a different approach to it and identify those risk areas. Some of those being where management’s estimates are involved because they’re very subjective and as the operator of the business your allowance for accounts receivables is probably going to be a little bit lower than it otherwise might be.
Next one might be your accounting at interim period versus annual periods. If you’ve never had an auditor review we want to make sure that your financial statements are in accordance with GAAP, as well as during interim periods sometimes companies don’t do a hard close and so a lot of those adjustments that they make at year end aren’t being done at interim periods and so if you’re doing a transaction during the summer months there are going to be a lot of adjustments that need to be made because again, the transactions are being based off some multiple earnings or revenue. And so you want to make sure the income statement is indicative of what it would be on an annual basis.
Jen: So now is this something that you pull into like a due diligence process, either on the buy side or the sell side?
Chris: Definitely. Obviously if we’re on the buy side we’re going to be going in and doing this stuff on the behalf of a buyer and doing that deeper dive on the income statement. The next point I’d probably say is just what you want to do is you examine some of the seller’s numbers. A lot of times in these closely held businesses the seller is running their personal stuff through the company or stuff that might not be part of the business going forward and so as a buyer you want to get that information pulled out and have an adjusted set of numbers so that you know exactly what the business is going to look like on a go forward basis.
And sometimes I guess another example of that would be the seller having a higher salary than let’s say a CEO who is going to be brought in to run the business, and so you want to make sure that you’re examining those numbers and get those straight. And then obviously the most important one is probably revenue recognition. Again, some of these companies haven’t been reviewed or audited and so their financial statements and revenue isn’t going to be on a GAAP basis, but as the buyer you also want to make sure that you’re identifying any risks.
Jen: You want to have a clear picture of what all is going on in the business that you’re buying.
Chris:Exactly and some of these companies have concentrations where they might have five customers who make up 80% of revenue; and some of it is seasonal and some of it is cyclical and so you want to make sure that the numbers are reliable and predictable in that the revenue, is it going to be on a recurring basis or is this something that they’re having to go and generate on an annual basis?
Jen: Wow, well that sounds like really they need to get you guys in there so that everybody’s got a clear picture moving forward in a transaction.
Chris:We like to be involved as early as possible.
Jen: Perfect. Well we’ll get you back to talk a little bit more about that.
Chris:We can do that, thanks.
Jen: To learn more about how we can assist you with potential transactions visit PKFTexas.com/transactionadvisoryservices. This has been another Thought Leader production brought to you by PKF Texas The Entrepreneur’s Playbook. Tune in next week for another chapter.