My first year as an audit partner, I had to sign off on a journal entry that cost my client $4 million.

He ran an insurance agency and was in the process of selling to a huge agency at 10x GAAP Net Income. 🤯

Here's the full story, why the client became an incredible referral source, and what buyers can take away from it all.

Background

It was an audit partners dream to start out - summer work, multiple years audits at once, and price elasticity because the buyer needed audits to finalize the sales price.

But it soon turned into a nightmare of nightmares. The client didn't keep a GL - no QuickBooks, no Sage, nothing. And to get to GAAP basis financials we had to work to recreate accounts receivable, payables, and other accruals. All while tip-toeing independence to not audit our own work. 👉 👈

But we did it - and we got back within a few percentage points of what his "gut" feel was on net income: $2.5 million.

The Entry Heard Round the World

We felt good about the draft financials - they'd been shared with everyone and we had just one last thing to do before I could sign the report: update subsequent disbursements to report date.

Looking at subsequent disbursements (payments made after the balance sheet date) is one way auditors use to find unrecorded payables. Usually it's a nothing test to check the box.

But we weren't so lucky this time.

It was 6 months after the balance sheet date and he had just paid $400,000 in prior year earned insurance commissions to agents that we hadn't previously accrued. One of the worst feelings in the world explaining the entry to him - we'd credit payables and debit (increase) commission expense.

$400,000 x 10 multiple = $4,000,000 in sales price 💨 evaporated.

He called me direct after seeing the effect and asked me "do we really have to book this? There's no other way?" My managing partner (who was tax lead on the account) similarly popped into the office and made sure we didn't have a way to pass.

There was no other way - we booked the entry.

Friends for Life

But after the shock wore off (and he got his $20 million payout), something surprisingly happened.

He shared how he admired us sticking to our guns on a hard decision. And went on to refer multiple audits to his circle of business buddies 🤝 who were wanting to sell in a few years. Sharing with them how he should have started the process well before the sale was in the works.

It was one of those moments in my audit career that really made me question whether I was cut out for it - but that's a whole other story.

What You Should Do About It

If you're going to sell your business in the next few years, the best thing you can do is start tightening up financials by paying for a review and then phasing into an audit (depending on the size of exit). Get a realistic picture of what you're working with.

But the real alpha here is to think about it from the buyers side.

The buyers in my story would have caught it on the working capital true up - and sued me and my firm. But how many small - medium size deals don't have these true-ups? How many buyers don't even know the right question to ask to protect themselves on the downside?

That payment left a $400,000 dent in cash 6 months after the year end - would a buyer know to look for that? Or how to even start?

Before buying a business, especially in the small - medium space, the best thing you can do is get a Quality of Earnings (QOE) report. These are ideally accompanied by audited financials, but QOEs can be just as effective without a formal audit.

QOEs look for odd items, events that shouldn't be multiplied by the multiple, owner add-backs, tax issues, proofs of cash. All things that can help get a better picture of what the business is producing on a consistent and realistic basis.

This is why I am excited to be a (very minor) investor in Bedrock QOE.

Will, the CEO at Bedrock, has a background in Big 4 and National Firms running QOEs and is now bringing that expertise to the small - medium size market with high touch service.

If you're on the search for a business to buy, make sure you feel good about the numbers before signing.

Big adjustments will either hurt the seller or buyer - make sure you're on the right side.

🫡