The Balance Sheet in a Quality of Earnings Part II: Fixed Assets

Last month we discussed inventory and the balance sheet. This month we turn our focus to fixed assets.

As we all know, fixed assets such as equipment require capital and are typically purchased from a third party.  We typically assess growth and re-occurring capex as part of diligence.  Normally fixed assets require a one-time cash outlay or are financed.  Obviously, this affects earnings.

However, you may not know that sometimes companies utilize internal resources to generate fixed assets that are reported on the balance sheet.

In one instance during diligence and an assessment of fixed asset additions, we determined the Target was utilizing production employees to generate tooling to be used in future production.  As a result, a portion of the labor for these production employees was being capitalized on the balance sheet and not reported on the income statement until the assets were depreciated.  As a result, the cost never hit EBITDA.

We concluded this was a significant Quality of Earnings adjustment.  The Company was required to keep these employees on hand to meet current production levels.  Putting these employees as part-time production employees would substantially affect the business so it was not a viable option.  The resulting adjustment to account for the full labor cost in the income statement significantly reduced EBITDA and the overall valuation.

This is a situation where even when the Target is recognizing the accounting appropriate (i.e. you can capitalize internal labor) understanding the balance sheet and associated trends is critical to determining adjusted EBITDA.

In July we will wrap up this three-part series by taking a deep dive into deferred revenue and how it can affect Quality of Earnings. Stay tuned!

ABOUT THE AUTHOR – CHRIS FAMEREE, MANAGING PARTNER

Chris Fameree is the founding partner of Assure with nearly 15 years of combined public accounting and industry experience. He has led and participated in numerous engagements including SOC 1 & SOC 2 engagements, due diligence engagements, financial statement audits and other advisory projects.

Prior to founding Assure, Chris was a Senior Manager in the Transaction Advisory Services Group and Audit Group of a large regional CPA firm. During this time, Chris participated in numerous business combinations and due diligence assignments. These transactions ranged from $10 million to over $100 million in value. Chris also worked at a national CPA firm, where he served lead roles on engagements from international Fortune 500 companies to closely held private manufacturers.

Chris received his Bachelor of Business Administration in Accounting from the University of Wisconsin. He is licensed as a Certified Public Accountant in North Carolina and Wisconsin.

cfameree@assureprofessional.com