The accrual principle in M&A valuations

Why ignoring it in a sale process usually ends in price adjustments and broken expectations

I get very nervous when, out of the blue in December, a business owner tells me something like:

“We’ve reached about €2 million in EBITDA through November, but we have a couple of big contracts coming in now and we’ll close the year at €3 million of EBITDA.”

When I start pulling on that thread, the same story usually emerges. These are contracts signed in December, invoiced and in many cases already collected, but where the actual work will be carried out over the following months or even over the next few years.

From that point on, a series of explanations tend to appear — with variations, but repeated quite frequently.

The most common explanations

“I have to do it this way for the tax authorities. If I invoice now, I pay VAT now and the income goes into this financial year. If the Tax Agency wants it this way, what am I supposed to do — risk a fine?”

Behind this statement there is usually a confusion between taxation and economic reality. Tax rules determine when a tax must be declared, but they do not define when the value of a service is generated or how the company’s income statement will be analysed in a sale process.

“I recognise revenue when I collect the cash. The client has already paid for the service, they’re not going to ask for the money back, and it doesn’t make sense to move it to another year.”

This reasoning is based on cash logic and the certainty of collection, but the accrual principle is not based on whether the money might be returned. It is based on when the service is actually delivered and when the associated costs are incurred.

“It’s only a three-month service. Spreading the revenue over three months just makes life more complicated.”

Here, the desire to simplify day-to-day operations often prevails, even though those three months represent economic activity distributed over time, with revenues and costs that are not concentrated at a single point.

“We’ve always done it this way. The auditor has never said anything and it’s very common practice in the sector. Everyone does it this way.”

This argument relies on habit and on the absence of objections from the auditor. But the fact that a criterion has not been questioned so far does not mean it will be accepted without adjustments in a sale process, where the analysis is usually deeper and focused differently.

What the accrual principle really means

The accrual principle has nothing to do with when an invoice is issued or when payment is received. It has to do with identifying when value is generated for the client and in which period the costs necessary to provide the service are incurred.

A business school that sells a master’s programme in September, delivered from that month until June of the following year, may collect the full amount upfront. But value is generated month by month, as classes are delivered, professors, platforms, content and resources are used, and the corresponding costs are incurred. In practice, this means spreading the student’s invoice over the ten months in which the programme is actually delivered. In the current financial year, revenue from September to December is recognised, and the remainder, from January to June, is recognised in the following year.

A software company that sells an annual licence may collect payment on day one, but the right to use the product, support and updates are provided over twelve months. In practice, this means spreading the licence fee over the twelve-month contract term. In the current year, revenue corresponding to the months already elapsed is recognised, and the remainder is recognised month by month in the following year until the service year is completed.

Applying accrual accounting means allocating revenues and costs to the period in which the real economic activity takes place, regardless of when cash is received or paid.

Accrual does not always work against the seller

It is worth remembering something that is often overlooked. Adjusting the numbers to an accrual basis does not necessarily imply an automatic penalty for the current year.

It is true that part of the revenue may have to be deferred to the following year, but it is also common for a significant portion of the current year’s revenue to come from contracts signed and collected in the previous year that are being executed now.

In fast-growing companies, the effect is usually more visible in the current year, because there is a higher proportion of future work already collected. In companies with moderate or stable growth, the impact may be small or even close to zero.

When the adjustment appears late

Going to market saying that the company generates €10 million in revenue and €3 million in EBITDA may lead to receiving, for example, a €30 million offer for the company. If, during due diligence, accrual criteria are properly applied and the real numbers turn out to be €9 million in revenue and €2.3 million in EBITDA, it is very likely that the price will change.

In that scenario, two things can happen. With the adjusted numbers, the company may no longer meet the buyer’s investment criteria and the deal may lose its appeal. Or the sellers — who built their expectations around a higher price — may not be willing to accept the new implied valuation and decide not to proceed with the sale.

Both situations occur much more frequently when the adjustment appears late (during due diligence) and unexpectedly.

Better to address it from the beginning

This is not about being conservative too early. It is about going to market with numbers aligned with the criteria the buyer will require anyway, avoiding later adjustments that generate frustration, delays and, in some cases, deals that never close.

For me, this is one of the uncomfortable parts of working as an M&A advisor. In many cases, I am the one proposing the adjustment before going to market, which often creates tension with the business owner and the feeling that I am not on their side.

“You’re adjusting our revenue and EBITDA… are you on our side or are you the buyer’s advisor?”

The reality is simpler. I am on the side of getting the deal done — and for that to happen, the numbers need to be the ones the market will accept. Leaving the adjustment for later almost always ends in frustration, renegotiations, and puts the process at risk

By Joshua Novick, partner at Bondo Advisors