This month we are wrapping up our three-part series examining Quality of Earnings. We have already explored how inventory and fixed assets can impact EBITDA. Our final perspective focuses on deferred revenue.
In its simplest definition, under US GAAP, revenue is to be recognized when realized/realizable or earned. We have encountered countless scenarios where understanding the trend in deferred revenue affects normalized adjusted EBITDA. As a result, we always strip changes in deferred revenue (and any associated capitalized costs out of EBITDA usually as a second level of adjusted EBITDA).
The reason we do this, even if a Target is accounting for items appropriately, is if significant deferred revenue exists, earnings can be misleading.
For example, the Target may have signed up a large one-time contract at the end of last year performing the services over 12 months. However, cash is received from the customer upfront and revenue deferred. The agreement is not renewing. If only the historical income statement is reviewed it may appear that we are paying on the appropriate EBITDA number. However, a detailed analysis of the deferred revenue account demonstrates that this contract is “falling off” and normalized EBITDA is much lower.
Hopefully, the examples we’ve covered over the last few months provide some insight into the importance of the balance sheet when assessing EBITDA. As always, feel free to reach out with questions. [email protected]
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.
[email protected]