When would you recast inventory in the EBITDA ?
July 21, 2021
by an intermediary from ESSEC Business School in Ocala, FL, FL, USA
With the Tax Cuts & Jobs Act some small businesses have switched from the usual "accrual" way of accounting for inventory (expensed when sold) to treating Inventory as non-incidental Materials and Supplies and expensing it when it is purchased.
In doing so the Cost Of Goods sold is arbitrarily increased and profits are lowered resulting in a tax saving.
To determine the EBITDA, the CPA of one such business argues that the inventory actually on hand at the end of the tax year should be deducted from the COGS each year after the switch to Expensing Inventory, to reflect the true earning potential of the business, as if the switch had never happened. In addition to the inventory on hand but not in the books, he makes the case that the inventory paid for (and expensed) in one tax year but received in the next should also be added back.
It would seem to me that, other than the floating inventory expensed and not received, only the increase in inventory each year should be added back, and not the total value of the inventory on hand a the end of the year.
The SBA lenders on the other end say No Inventory Add-Backs- No Exception!
Has any one else been confronted with this issue and how was the inventory added back in the EBITDA or SDE to reflect a fair valuation for both the Seller and the Buyer?
from Washington University in St. Louis in Denver, CO, USA
Here I read it as the seller making the argument that while they took an expense consistent with the new tax policy and reduced their tax bill perhaps moreso than they would have under the accrual method (resulting in cash savings to the seller pre-transaction but not to the buyer), they should also be rewarded as if they had not, which is double dipping.
If I were the buyer I would stand pretty firmly on this as a negotiating point, I would ask in the spirit of partnership why it's fair for the seller to have this both ways. That said, if you decide to proceed anyway, be very clear with how the APA/SPA is written with respect to pre-close tax liability and responsibilities (is it an escrow holdback account, is it each party pays pro rata directly to IRS, etc.). It's probably worth doing a quick analysis around how any of these positions would impact your year 1 tax bill as the owner so you are not surprised with a big cash tax outflow after you have paid a full price on an adjusted earnings number for the business.
I would not expect banks to accept any simple point-in-time inventory adjustment like this, rather as others have pointed out, recasting the financials so that the methodology is consistent from the time of the policy change is the only way to get it right.
from University of Pennsylvania in Seattle, WA, USA