Glossary
Revenue Recognition in Due Diligence
Revenue recognition is the question of when a sale counts as revenue, and in a transaction it decides how much of a target’s reported top line a buyer should actually believe. Invoicing is not earning. At Treewalk we test recognition on every diligence engagement, and it is one of the two or three places where reported earnings most reliably move.
The core test: has the work been done?
Revenue belongs in the period the business earned it, not the period it invoiced or collected. Everything below follows from that single principle.
Two mirror-image items sit either side of it, and they are two halves of the same coin:
Deferred revenue.
Billed or collected, not yet earned. It is a liability, not revenue.
Accrued revenue.
Earned, not yet billed. It is an asset, and it is the one small businesses forget to record.
Where we find the problems
Upfront billing that lands before year end
This is the most common and the most consequential. Where a contract is billed 50 percent on signature and 50 percent on completion, that first invoice goes out before a single day of work has been done. Invoice a large new contract days before the fiscal year closes and the year looks materially better than the work performed justifies. We handle it by building an intake schedule: every contract with a deferred component mapped against when work actually started and finished, so we can quantify the deferred revenue exposure at each month end rather than accepting the invoiced figure. We run the same analysis in reverse for accrued revenue.
Non-operating income sitting in revenue
Sublease income is the classic case. A business subletting part of its premises books that receipt as revenue, and it flows straight through to reported EBITDA. It is not operating income, and it has to come out before earnings or debt service coverage mean anything. We back it out entirely, along with any other rental or non-operational receipts.
Percentage of completion in project businesses
Construction and project-based revenue is where recognition most often fails testing. Work in progress, over- and under-billing, and change orders all have to be tested against actual progress rather than the billing schedule. A meaningful share of the diligence work we do each year is on project-based businesses using percentage-of-completion methods, and it is consistently the sector where presented revenue holds up least well.
Customer deposits treated as the seller’s cash
Where a business holds deposits or prepayments on the balance sheet, that money is not the seller’s to take at close. The obligation it represents transfers to the buyer, so the cash should be left behind with the business. Even a small recurring deposit balance is worth flagging, because the principle matters more than the amount and it belongs in the working capital discussion rather than being discovered afterwards.
What each finding does to the deal
| Finding | Effect |
|---|---|
| Upfront billing inflating a period | Revenue and EBITDA restated to the earned basis |
| Sublease or other non-operating income | Backed out of EBITDA and out of debt service coverage |
| Unrecorded accrued revenue | Can increase earnings, this one occasionally favours the seller |
| Deferred revenue not on the balance sheet | New liability, and a working capital adjustment |
| Customer deposits | Cash left in the business at close rather than taken |
| Percentage of completion misapplied | Revenue reallocated between periods, trend line changes |
Worth noting that not every finding hurts the seller. Unbilled work that was genuinely earned is real revenue that nobody recorded, and we adjust for it in the seller’s favour when the evidence supports it. Diligence done properly moves the number in both directions.
Why buyers should care beyond the multiple
Recognition problems distort more than earnings. They move the trend line, which changes the growth story a buyer is underwriting. They change working capital, because deferred revenue and unbilled work are balance sheet items. And they affect the debt service coverage ratio a lender is using, which can affect financing availability rather than just price.
Frequently asked questions
Is this the same as revenue quality?
Related but not identical. Recognition is about timing and whether an amount belongs in a period at all. Quality of revenue is broader, covering recurrence, customer concentration and whether the revenue is likely to persist after close. A QoE report covers both.
Does this only matter for subscription businesses?
No. Subscription models make deferred revenue obvious, which paradoxically means it is usually handled properly. The larger problems appear in project and service businesses that bill in stages, because the recognition question is easy to overlook when there is no obvious subscription to defer.
What if the seller’s accountant already reviewed it?
An external accountant preparing statements is working to a different standard and objective than a buyer’s diligence. Their work is a useful starting point, not a substitute. On cash-basis targets, the tax preparer may never have considered recognition at all.
Can revenue recognition adjustments increase the price?
Occasionally, yes. Where a business has genuinely earned revenue it never billed, recording it raises earnings. It is less common than the other direction, but it happens and we report it either way.
How do you test it?
By tracing individual contracts to work performed rather than relying on the ledger. Intake schedules for contracts with deferred components, sampling invoices against project dates, and for project businesses reconciling billing to actual progress. See buy-side due diligence for how this fits the wider process.
Where to next
If your business bills in stages, holds customer deposits, or has any income in the top line that is not from operations, revenue recognition is likely to move your reported earnings in diligence. Our transaction advisory services team tests this on every engagement. Related reading: EBITDA normalization adjustments and cash vs accrual accounting. To talk through a specific deal, email Avnit Sekhon at avnit.sekhon@treewalk.com.
