February 22, 2017
By now, almost all Finance executives understand they’re facing a deadline on the new revenue recognition standard. Arguably the most significant accounting change in years, the standard takes effect for most companies in 2018. For companies choosing the full retrospective option for adopting the new standard, the transition period has already begun.
What they and many private equity dealmakers may not realize is the significant effects that these changes will have on determining valuation models, due diligence, management compensation, debt covenants, tax planning and exit strategies. Now is the time to give careful consideration to the rules, which may be adopted and applied retroactively to some prior years’ financial results.
This change is no surprise. In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued the new standard to eliminate industry-specific guidance and increase financial statement comparability, creating a consistent principles-based framework to recognize revenue in the same way across all industries and markets. That sounds like a simple enough idea, but it may prove to be difficult given the shift away from prescriptive guidance that historically existed.
Challenges continue to arise with interpreting the new principles-based guidance and the downstream implications to processes, controls and systems. The new standard has the potential to impact the results of key financial metrics and ratios – including EBITDA – that may change valuations and business decisions.
A few of the considerations companies should review as they prepare for this change:
- Valuation Models and Due Diligence – Performance metrics could change in ways that aren’t driven by operations or cash flows. For starters, the pattern of revenue recognition may change under the new guidance, even when the underlying operations and contracting has not changed. In addition, Private Equity funds that adjust GAAP results to determine run rates for purposes of valuation will need to fully assess the impact of such changes. For example, upon adopting the new standard, there could be a loss in the ability to recognize previously deferred revenue, or a requirement to capitalize and amortize costs already incurred in a prior period. Additionally, the ability of target companies to comply with the new rules and implement any required changes to processes and systems will need to be evaluated during due diligence.
- Management Compensation – Of course, performance bonuses and other compensation based on revenue, EBITDA, or other income metrics will be impacted by the new model, so companies need to look at whether incentive plans should be changed.
- Debt Covenants – The new rules could change the timing, amount and pattern of revenue recognition in ways that alter EBITDA. While covenants will often allow adjustments for changes in GAAP, including “frozen GAAP” provisions, this may require companies to keep two sets of books which may be unwieldy.
- Tax Payments – In jurisdictions where the tax treatment is influenced by financial reporting, the new rules may affect the timing of tax payments by portfolio companies if, for example, revenue is recognized in different periods than under the current GAAP standard. It may also affect how revenue has been categorized for tax purposes, which could have a resulting change on other items, such as transfer pricing arrangements.
- Opportunities – Current US GAAP sometimes constrains how entities do business, but the new standard aims to be less prescriptive, which in turn could lead to changes in business models, pricing and go-to-market strategies.
- Investor Relations – Because adoption of the new standard will affect revenue, the timing of the change may affect EBITDA trends. Funds hoping to take companies public need to look at the best way to communicate the altered revenue figures with potential investors and analysts, particularly given short-term challenges related to the consistency and comparability of historical v future results during the period of adoption.
- Exit Strategies – Private Equity portfolio companies should examine the time and effort required to adopt the new rules, and they shouldn’t underestimate the broader operational and downstream impacts of this accounting change. The new rules are effective in 2018 for public companies and 2019 for private companies. In addition, under full retrospective adoption of the new rules, exits through an IPO in 2018 could require presenting three years (2017, 2016 & 2015) of financial statements in compliance with the new standard. Public companies must disclose the impact on revenue if they plan an exit before the effective date.
Of course, there’s good news here – future consistency in the way revenue is recognized globally and across industries should lead to greater transparency and more informed business decisions. While the deadline is fast approaching, there is still plenty of time to work with your team to ensure you’re truly ready to comply and benefit.