Key Takeaways:
• Recent changes in accounting standards, particularly in lease accounting (ASC 842) and revenue recognition (ASC 606), along with evolving bank oversight practices, have complicated the M&A due diligence process for smaller and medium-sized businesses.
• Lease accounting now requires leases to be listed on the balance sheet, affecting perceived debt levels; bank oversight has shifted, reducing audit requirements but still necessitating thorough financial reviews for M&A; revenue recognition standards enforce uniform revenue reporting, impacting financial statement presentations.
• Business owners looking to sell should ensure accurate financial records, consider independent audits or reviews, and evaluate operational management to enhance their company’s attractiveness to potential buyers during the M&A process.
New Accounting Standards and Bank Oversight Have Changed the Game
Mergers and acquisitions (M&A) have a profound impact on financial reporting and compliance, and recent changes to accounting standards and banking practices have complicated the M&A due diligence process, particularly for smaller and medium-sized businesses.
The changes generally fall into three broad areas: lease accounting, revenue recognition and bank oversight.
Lease Accounting
Accounting standards governing leases were established to minimize the potential for financial statement fraud, and to address the lack of debt transparency in reporting. The latest Financial Accounting Standards Board (FASB) standard on lease accounting, ASC 842 (ASU2018-11), took effect for private companies and nonprofit organizations for reporting periods beginning after December 15, 2021, and for public companies, reporting periods beginning after December 15, 2018.
The new lease accounting standard has had a significant impact in that it places leases on a company’s balance sheet, showing the cost of the lease as a liability that is offset by the right-to-use the leased equipment as an asset. Previously, leases were included as footnotes in financial statements.
For many smaller and medium-sized businesses, the new standard has caused balance sheets to pick up a lot of debt, now that the lease obligations are transparent. In turn, this has created issues with their banks’ loan covenants because it appears there is more debt than equity on the balance sheets. Most banks understand the impact of the new lease accounting standard, but they also now see in black and white the impact of lease obligations on their customers’ balance sheets, and may be tempted to revisit loan covenants over time.
During the due diligence phase leading to a company sale, it is essential to make sure leases are being accounted for correctly. In some cases, it’s not clear whether a company is following generally accepted accounting principles (GAAP). Some companies follow tax basis accounting or some type of hybrid method. In those cases, the accounting methods they are using must be evaluated and aligned with GAAP because potential buyers want to know they’re comparing apples to apples. Any company that is using non-GAAP accounting should consider having an outside CPA prepare a financial statement for them that brings them in line with GAAP accounting standards before taking the company to market.
Bank Oversight
Over time, banks have generally reduced their requirements that smaller and medium-sized businesses get independent audits in order to obtain business loans and lines of credit. As the banking industry has become more competitive, banks have found that they can bring in more business lending if they don’t require customers to obtain audits, since audit services represent a significant cost for smaller and medium-sized businesses. For most companies, banks are more comfortable today getting a reviewed (rather than audited) financial statement to support a loan application.
But for companies that have a lot of inventory – particularly manufacturers, distributors and retailers – audited financial statements are still usually required. That being said, some banks offer a more flexible, less costly alternative called a “collateral review,” which involves the bank sending a third-party representative – often a CPA – to the company to analyze the inventory and the inventory system.
In certain other industries, audits are required and there are no alternatives, particularly if a company does business with the federal government and is required to obtain an audit under government accounting rules.
The impact on M&A of changing bank oversight can fall particularly heavily on smaller and medium-sized businesses that are taking their companies to market. A business that has never had to obtain a financial statement audit will need one for the due diligence phase. Very few potential buyers will forgo the requirement for audited financials. And a first-time audit for a company that has never had one is more costly than an audit for a company that has routinely been audited.
So, while softening oversight requirements on the part of banks may be good news in the short term for smaller and medium-sized businesses, when it comes time to take the company to market it can create some additional due diligence costs in both time and money.
Revenue Recognition
Prior to the implementation of the lease accounting standard, another major new standard also had an impact on the presentation of financial information in M&A situations – ASC 606 Revenue Recognition.
In short, ASC 606 stipulates how and when revenue is to be recognized. The revenue recognition principle using accrual accounting requires that revenues be recognized when realized and earned – not when cash is received. The ASC 606 standard provides a uniform framework for recognizing revenue from contracts with customers.
It also provides a bit more work during the due diligence phase of a merger or acquisition. In many cases, the revenue recognition standard has little to no effect on financial performance as shown in financial statements. But in certain industries – particularly those like construction contracting, where work is performed in phases and over several quarters or years – the revenue recognition standard can raise issues that make certain M&A functions challenging. It impacts the Quality of Earnings analysis, particularly if the buyer decides to have the seller restate numbers according to revenue recognition standards. A restatement requires clarity on which period is being recognized and when the matching of expenses is being picked up between the two methods.
The revenue recognition standard also requires much more detailed disclosure in financial statements, such as sources of revenues and matching expenses like commissions.
One benefit of the revenue recognition standard is that it helps during the due diligence phase of a merger to recognize the extent to which a company has an over-concentration with certain customer groups or certain business divisions or product lines. Such concentrations are red flags to potential buyers and must be addressed during negotiations.
What Should Business Owners Do?
Due diligence in the M&A space is more analytical and requires a deeper dive into a company’s financial and operational performance than it did 20 years ago. On the plus side, there are better tools available today such as ERP systems and accounting platforms. And new tools are starting to use artificial intelligence (AI) for data analytics. We’ll continue to see growth in those tools.
But the reality is that the tools themselves – because they enable us to access more robust and detailed information – are creating higher expectations for forward-looking performance data that buyers can rely on to guide their investments.
That being said, there are no guarantees in life. The tools themselves don’t make a company better unless the owners and managers use them to produce real-time financial and operational analytics that can help make the best business decisions.
Owners who are looking to sell their businesses in the next two to three years should start working today to prepare. Here are a few items on the to-do list:
- Get your books in order. It makes the due diligence process much easier. Start by getting any personal expenses off the books. Personal expenses create a lot of noise in the financials and become a distraction during negotiations.
- Create a financial statement if you don’t already have one, and get it reviewed by an independent accountant. Depending on the size and complexity of your business, and the needs of potential buyers, it may be wise to prepare for a financial statement audit. An independent review or audit makes it easier to analyze the numbers and present an accurate picture that tells the story of your company’s value drivers.
- Evaluate who is driving the business on a day-to-day basis. Is the management of the company concentrated on you, the owner, perhaps with help from one key manager? Or is operational oversight distributed among a group of experienced, key managers? If a business is successful primarily because of an exiting owner, the buyer needs to evaluate more seriously things like customer relationships, management talent and employee relationships. The buyer will want assurance that a structure can be put in place to transfer that value upon completion of the transaction.
If you are considering taking your company to market in the next two to three years, contact your KRD advisor for help in getting prepared.
