Revenue booked before the work was done

The situation

A sponsor completed the acquisition of an industrial installation contractor, financial statements represented in the purchase agreement as prepared in accordance with the company’s stated accounting policies. Closing net working capital and EBITDA both cleared the 30-day true-up objection window without dispute — nothing in the closing statement itself looked unusual, because the problem was not in the balance sheet arithmetic, it was in how revenue had been recognized on the income statement feeding it.

The problem

Ninety-seven days after closing, well past the objection window, the buyer’s newly installed controller identified three progress-billing installation contracts — valued at $210,000, $165,000 and $95,000 — that had been recognized as 100% complete on the closing balance sheet despite still being mid-install on the closing date. The target’s prior practice, it turned out, was to recognize revenue at the point of invoicing rather than at completion or customer acceptance.

The numbers

Physical completion records — site logs and subcontractor sign-offs, not accounting entries — put the three contracts at 55%, 40% and 70% actually complete on the closing date. The overstatement totalled ($210,000 × 45%) + ($165,000 × 60%) + ($95,000 × 30%) = $222,000 of revenue booked before the underlying work existed. Against a represented EBITDA of $980,000, the corrected figure was $758,000 — a 22.7% swing from the number the deal had been priced against.

The rule that decided it

Because the overstatement surfaced on day 97 — well after the 30-day closing-statement objection window described in Treadstone Law’s account of how a true-up actually runs — the buyer could not use that mechanism at all; the window that resolved the receivable and inventory disputes in the two related files was simply closed by the time this one was found. The available remedy instead was an indemnity claim for breach of the financial-statements representation, drawn against the $540,000 escrow holdback held back at closing precisely because “most of those statements cannot be verified until after closing, and some not for a year or more”. The claim was then tested against the deal’s $54,000 basket (1% of the $5,400,000 price) and $810,000 cap (15% of price). The basket in this agreement was a tipping basket — once cleared, the whole loss is recoverable, not just the excess over the threshold — which is a drafting choice, not a default: Treadstone Law’s explainer records only the general rule that a loss which “doesn’t clear the negotiated threshold…generally doesn’t count toward a claim at all,” and does not distinguish tipping baskets from deductibles. Had this been drafted as a deductible instead, the recovery would have been $168,000, not $222,000. At $222,000 the claim cleared the basket comfortably and sat well under the cap — recoverable in full.

The outcome

The buyer filed a written indemnity claim within the survival period for financial-statement representations, and the $222,000 was paid entirely from the escrow holdback without drawing on any further recourse against the seller directly. The survival period is itself a negotiated term, not a statutory one — “There is no statutory period. The holdback should be matched to how long the underlying indemnity survives, and that is negotiated” — and Ontario’s general civil limitation periods “can also apply…and may interact with — but don’t necessarily extend — a shorter contractual deadline.” A buyer on day 97 is inside a contractual clock, not a statutory one. The claim resolved in under two months once the completion records were shared, because the underlying facts — percentage complete on the closing date — were not seriously disputed once documented. See the two related closing-statement disputes on the same class of deal: a receivable collectibility dispute caught inside the true-up window, and how a quality-of-earnings review is meant to catch exactly this kind of issue before closing.

What it would have cost otherwise

Had this surfaced on day 25 instead of day 97, the buyer could have used the same true-up mechanism that resolved the receivable and inventory files — likely faster and without needing to establish a representation breach at all, since a true-up correction does not have to clear a basket the way an indemnity claim does. Missing the window did not cost the buyer the recovery itself, because the escrow and the indemnity structure were built to cover exactly this kind of post-window discovery — but it did cost two additional months of process to get there, and it is the reason the deal carried a $540,000 escrow in the first place rather than relying solely on the 30-day mechanism.

The tell

There is a reason this pattern is easy to normalise inside a business: for tax it is close to correct. ITA section 12(1)(b), marginal note Amounts receivable, includes an amount receivable for services rendered “notwithstanding that the amount or any part thereof is not due until a subsequent year,” deemed receivable on the day the account was rendered, and section 20(1)(m), Reserve in respect of certain goods and services, offers a reserve for services “reasonably anticipated will have to be rendered after the end of the year.” None of that governs a purchase agreement’s financial-statement representation, which is contract and accounting standards, not tax — but a controller who has only ever had to satisfy the Act can carry the habit into a set of statements a buyer then prices off. So revenue recognized at the point of invoicing rather than at completion or customer acceptance, on any business doing progress-billed contract work, is a policy question a quality-of-earnings review should test directly — ask specifically how percentage-complete is determined and whether it is backed by physical sign-off records, not just whether the revenue figure ties to invoices issued. A closing statement that clears its true-up window clean is evidence the arithmetic was consistent, not evidence the underlying accounting policy was correct.

Takeaways

• • A closing statement clearing its true-up window without dispute confirms internal consistency, not that the underlying revenue-recognition policy was sound.
• • An issue discovered after the objection window closes has to run through an indemnity claim against the escrow, tested against the basket and cap — a materially different process than a true-up correction.
• • Progress-billing revenue recognition is a specific quality-of-earnings diligence question: ask how percentage-complete is determined and whether physical sign-off records back it.
• • An escrow holdback exists precisely to cover exactly this kind of post-window discovery — know its size and survival period before assuming the true-up window is the only protection a deal has.

Sources

• • Treadstone Law — Post-Closing Integration and Disputes — the closing-statement objection window and expert referral — the mechanism that had already closed by day 97.
• • Treadstone Law — Escrow & Holdbacks in a Sale — why a holdback exists (“most of those statements cannot be verified until after closing, and some not for a year or more”) and, on duration, “There is no statutory period.” It gives no typical percentage, so this file’s 10% holdback is illustrative.
• • Treadstone Law — Time Limits on Indemnity Claims in an Ontario Business Sale Agreement — general Ontario limitation periods “may interact with — but don’t necessarily extend — a shorter contractual deadline.” It deliberately states no month figures, so the survival period here is the agreement’s, not a standard.
• • Treadstone Law — Indemnity Baskets and Caps in an Ontario Business Sale, Explained — a loss that “doesn’t clear the negotiated threshold…generally doesn’t count toward a claim at all.” It does not distinguish a tipping basket from a deductible, and gives no typical percentages — both are supplied by this file and labelled as drafting choices.
• • Income Tax Act, s.12(1)(a) and (b) — marginal notes Services, etc., to be rendered and Amounts receivable — the tax rule that pulls an invoiced amount into income on the day the account is rendered. Cited to explain why the target’s habit felt defensible internally; it does not govern the financial-statement representation.
• • Income Tax Act, s.20(1)(m) — marginal note Reserve in respect of certain goods and services — the offsetting reserve for services “reasonably anticipated will have to be rendered after the end of the year.” Again tax only: no statute tells a private company how to recognise revenue on a closing balance sheet.