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Case Study: Construction Acquisitions Gone Awry – a Quality of Earnings Story

By: Damien Strohmier, Senior Manager, CPA, CCIFP

Failed transactions can happen for a variety of reasons.

This article explains one potential reason for a failure, which is the inherent risk in reporting and understanding a construction company’s accounting transactions in accordance with generally accepted accounting principles (GAAP). This example, while construction-centric, will highlight the importance of accurate accounting records in any transaction or industry.

The contractor in question engaged an accounting firm to perform a Quality of Earnings (QoE) engagement to support the adjusted EBITDA. The contractor maintained the books in QuickBooks and engaged an outside accountant for CFO services.

During the meeting with management and the outside accountant, it was evident the contractor had experienced significant growth in the past several years, demonstrating greater than 10% revenue growth over each of the past five years. The contractor also experienced positive growth in margin and EBITDA over the three-year QoE period. Specifically, EBITDA increased from $1.2 to $2.7 million over the three-year period.

Based on discussions with management, the increases in margin and EBITDA were the result of several factors, including reaching an optimum capacity with the labor crews that were in force, and new and expanded customer relationships that provided logistical improvements for crews in both the installation and monitoring of jobs.

The contractor’s jobs were generally short-term in nature, as they dealt primarily with the residential market. Because of the short-term nature of the jobs, a work-in-process schedule was not created for any closing periods. Furthermore, management believed their billing process, which was driven by the actual completion of installations or receipt of materials, would not produce any significant cut-off issues.

This fact pattern had already directed management’s decisions not to investigate any cut-off issues. Management, under the impression that the most recent $2.7 million EBITDA would be representative of the range of future performance, had already engaged an investment banker to assist with the identification of, and marketing to, potential buyers.

The result: an excited owner thinking about multiples of $2.7 million, a management team ready for a closing bonus, and external investment banker actively seeking buyers in the market. What could go wrong?

The simple procedure of evaluating the margin on all jobs performed and in-process over the QoE period at the cut-off dates provided a different picture of the company’s results. Cut-off errors were experienced across the range of residential work and the limited commercial jobs the contractor performed. The residential job errors, while small in nature at the individual job level, did create a significant cut-off error because each tended to incur cost in one period and not bill until the subsequent period. During periods of growth, this adjustment similarly grew because of the amount of outstanding work at the cut-off periods. Overall, this wasn’t a deal breaker, but did represent an adjustment of nearly 10% to EBITDA in the third year of the QoE period.

Unfortunately, there was a deal breaker, and it was the result of an adjustment related to two commercial contracts. These contracts were started near the end of the first year of the QoE period. The majority of the work under the contracts was completed during the second year of the QoE period, but a work-in-process adjustment was not made to recognize earned revenue on the contract that was consistent with the progress on the contracts. This adjustment resulted in the final bills on the commercial contracts that were issued in the third year – which totaled over $1.1 million – being reclassified to the second year of the QoE period. More than 30% of expected EBITDA, which had been based on the third year of the QoE period, was gone with one adjustment.

Anyone familiar with the income approach of valuing a business also knows this $1.1 million is amplified by the multiple seen in similar transactions in that industry, thus greatly impacting the estimated value of the business. On the lender side, the deal structure will have to be changed to meet the new expected debt service coverage, which means the seller is likely to have to take on a seller note for a larger piece of the transaction.

This example highlights the importance of maintaining accounting records in accordance with GAAP. Owners that may be considering an external sale should evaluate their own accounting records to understand potential adjustments that may exist. A thorough evaluation will provide an accurate starting point for marketing the business for sale and will establish a realistic value at which a transaction could be consummated.

Learn more about QoE:

Case Study: Normalization Adjustments and the COVID-19 Pandemic

Understanding the Need for Quality of Earnings Report in a Transaction

If you have any questions, please reach out to your local Blue & Co. advisor.

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