Our 2023 Exit Smart Report indicates that 43% of SME business owners and key decision makers are preparing their business for an exit even within five years. What many of these business owners are unprepared for is the surgical reconstruction that occurs to their books upon sale or a listing. Over many years, Nicholas Benbow, Director, Audit and Assurance at William Buck has seen this process unfold. Here, Nicholas explores five of the most common accounting adjustments that enterprises face when transitioning their books to be exit-ready.
Inventories
Many SME business owners look for ways to minimise their inventory – the less on the books, the more in taxable deductions they stand to claim. In a business sale, this reverses dramatically, and suddenly an incentive arises to find use and commercial value for those previously neglected stock keeping units (SKUs) gathering dust in a corner of the warehouse. The more the inventory, the more the overall value the business has to the potential purchaser, particularly as often a premium is paid where actual working capital exceeds that budgeted by the purchaser in their initial due diligence phase.
Notwithstanding this, the seller needs to be aware of accounting rules when valuing inventory. These rules include appropriately attributing on-costs to purchased raw materials and components, valuing those materials and components at an appropriate average weighted cost and ensuring that the cost value of the SKU in its finished (or raw) form does not exceed net realisable value. Finally, don’t forget to consider the terms of trade for any stock on water, as this will impact the overall value of the inventory (and potentially an offsetting stock on water liability accrual).
Employee accruals and provisions
Under a tax regime, such accruals or provisions are typically not deductible, so why bother accruing them? Well, upon an exit event, a problem arises in accounting for expenditure for which the service has already taken place. This is true not only for annual or long service leave provisions, but any cut-off adjustments that arise when a payroll period spans the end of a reporting period. And don’t forget all the complexity that comes with accounting for these adjustments, including adjustments for projected increases to salaries, forecast attrition, discount rates and on-costs like superannuation, work cover and payroll tax.
Deferring that revenue
Yes, that revenue has been invoiced, but has it been earned? Enterprises will sometimes create payment arrangements that permit early invoicing. These arrangements also bring forward revenue recognition. These arrangements have been traditionally used to bring forward revenues in-advance of the delivery of services. Think up-front licence fees, deposits, platform establishment fees, prepaid after sales care, etc. Unfortunately, the accounting standards look through to the substance of the delivery of the service and the benefit received by the customer. This can be complex and often beyond the means of most off-shelf accounting systems. A spreadsheet solution is often needed to compare the delivery of services, juxtaposed against the progress of milestone billings with the difference carried to the balance sheet as unearned revenue.
Deferred tax adjustments
The final adjustment, which should only occur once all pre-tax numbers are set (usually those above) is for deferred tax. This is one of the more complex matters involved in the process. The general purpose of deferred tax accounting is to remove the volatility that occurs in a tax charge that arises from timing differences: that is expenses or revenues that are not deductible or assessable in the current accounting period but will eventually become deductible or assessable in future accounting periods. Be wary however for whether any of the tax assets can be carried forward and utilised in the event of an exit transaction, and therefore whether they have any value on the balance sheet.
Group consolidation
Once the base numbers are done, the purchaser usually expects a fulsome understanding of the entire enterprise, notwithstanding how many separate legal entities it has. This consolidation process is rarely straightforward – many businesses are structured in such a way that their trade is separated from their intellectual property for asset protection purposes, and when multiple business join the fray, such separate entities can multiply. Then there’s accounting for the goodwill for any prior acquisitions. In such circumstances, it is handy to know what practical expedients exist in the accounting standards that can navigate around such complexities on the first time that full accounting standards are adopted for a financial report. As a rule of thumb, the less complex, the better. This includes writing off previously unexplainable or un-recalculable goodwill.
Being exit ready involves addressing matters that are encountered in a vendor due diligence process, like ensuring visible financial performance metrics and working capital targets and managing tax risks. The application of full accounting standards to the financial reports that underpin these matters can serve as a deep dive to ensure that all bases are covered by the vending party ahead of proceeding down the exit event.
At William Buck, we would be pleased to explore how the application of full accounting standards to your financial reports will work for your business as it prepares for exit. Please contact your local William Buck audit and assurance advisor.
