This write-up in inventory value reduces the company’s income and profitability during the period that the acquired inventory is sold. This means that even though the acquired inventory items had the same cost as those sold just before the transaction closed, the profit on post-transaction sales is artificially deflated due to the write-up in inventory value on the acquired company’s opening balance sheet. This is a unique rule in GAAP that generally only comes in to play when an acquisition occurs, which triggers fair value accounting (instead of historical cost accounting) for recording the acquired inventory balance. In an acquisition, however, inventory is written up to “fair value,” which represents the selling price of the inventory less any sales/completion costs (and an appropriate profit on those costs). Inventory typically is carried on a company’s balance sheet at cost. For every dollar that deferred revenue is reduced when it is adjusted to “fair value” on the opening balance sheet of the acquired company, that equals one dollar of revenue and income that will never be reported or realized.ĭeferred revenue is not the only sneaky perpetrator that can hamper post-acquisition earnings inventory also impacts an acquired company’s financials. For companies that receive meaningful prepayments, this can have a material impact on the amount of revenue that is recorded post-acquisition when the deferred revenue is reversed and recognized as revenue. Poof! That revenue basically disappears and never gets recognized. In an acquisition, deferred revenue typically is adjusted down from its originally recorded amount to its “fair value,” which is based on the cost to deliver the related product or service (not the larger amount of cash collected prior to the related revenue being recognized, which may include a significant gross profit component not reflected in the “fair value” of the related liability).īecause of the reduction in the deferred revenue balance to “fair value,” there is a portion of revenue (for which cash has been received) that never gets recorded on the company’s pre- or post-transaction books.
Even if an acquired company operates at the same exact level of activity pre- and post-acquisition, the reported income in those two periods can differ significantly as a result of two lesser-known culprits: deferred revenue and inventory.ĭeferred revenue is an accounting term for cash that is received as a prepayment for a product or service-the related revenue is not actually recognized until the goods are shipped or the services are rendered. Let’s assume that these factors are not an issue for the moment, though. In many cases, when reported income immediately declines after an acquisition, integration costs and customer attrition are the primary causes. While “ The Case of the Missing Post-Acquisition Income” is not likely to go on to be a best-seller for Hasbro, there are some important lessons for investors and users of financial statements to learn from this financial mystery. Who knew that those same sleuthing skills would be necessary in piecing together the mystery of why an acquired company’s post-acquisition income is often lower than its historical levels. White in the billiard room with the lead pipe.”Ĭlue was a great “whodunit” game in which players had to use their sleuthing skills to piece clues together to solve a mystery. “I think it was Colonel Mustard in the kitchen with the candlestick.” How many of you remember trying to deduce the culprit, the murder weapon and the room in which the attack took place?
One of my favorite games as a kid was the murder-mystery classic Clue.
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