New Revenue Recognition Standard Could Prompt a New Story
Private equity firms may need to change their models and rewrite growth narratives for their portfolio companies in response to ASC 606.
A new accounting standard for how to recognize revenue, ASC 606, could prompt private equity firms to adjust the way they project the growth of portfolio companies and revise the way they market those companies for sale.
The Accounting Standards Codification (ASC) 606 and its global companion, International Financial Reporting Standards (IFRS) 15, went into effect earlier this year for public companies. The deadline to adopt ASC 606 is Dec. 15, 2018, for private companies with annual reporting periods that begin after that date. Although private companies are generally not required to file financial statements, they often prepare reports for their investors, bankers and other related parties.
Surveys have found that many private companies are dragging their feet. A March survey by Deloitte LLP found that 47 percent of private companies had either not yet started to prepare for the standard or were only in the early stages. In an April survey of emerging and midmarket companies by consulting firm MorganFranklin, 63 percent said they had not made significant progress toward implementing the new revenue recognition standard. Only 9 percent said they had completed adoption; 19 percent said they had made significant progress.
But that doesn’t mean the change isn’t on the minds of business leaders, according to Mark Davis, managing partner of Deloitte Private Enterprises. “In the last six months we’ve seen a lot more activity from private companies, including private equity-backed companies, (which are) starting to take this seriously,” he says. “They are realizing that they’re not going to get a free pass and they need to deal with this now.”
Delivery-Based Model
The goal of the standard is to create a comprehensive revenue recognition model across all industries and capital markets. (See sidebar.) To do so, it ties the recognition of revenue more closely to when the value of a product or service is delivered to a customer and title is transferred. For example, if there are several products and services included in one contract, a value will have to be assigned to each and the timing of the revenue recognized accordingly. That can mean big changes for when and how revenue is recognized, depending on the type of company. That in turn could impact the financial numbers in ways that affect debt covenants, mergers and acquisitions, and other exit strategies, including initial public offerings.
Accounting experts stress that all companies need to re-evaluate how they account for revenue and pay closer attention to the provisions of each contract. In some cases, the effects will be minor. Companies in telecommunications, technology (especially software), aerospace, construction and real estate are among the most likely to see significant impacts. Any company that provides services over an extended period of time is likely to see some changes, Davis notes.
The effects aren’t limited to the accounting department. “Companies are really shocked by how far-reaching the standard is,” Davis says. “Normally accounting standards are the problem of the accounting or finance department, but in this case companies have been surprised by the impact the rules have had on many facets of operations throughout their organizations,” including legal, HR, sales and IT. Attorneys may need to revise contracts in light of the new rules, for example, or IT may need to roll out new software. The changes can even impact bonuses and other performance-based compensation. Experts recommend that companies develop training for any employee who is involved in a revenue-producing transaction.
Among the most important impacts for private equity will be on debt covenants, due diligence and exit strategies.
As a company implements the standard, it may have to defer recognizing revenue that it previously recognized up front. That could require a change in debt covenants that are often based on EBITDA. “If you’re dealing with a bank, you may need to go through a loan committee to get covenants changed, and that takes time,” Davis says. For new financing arrangements, companies need to know how the standard will impact their financial metrics before they negotiate a covenant.
“In the last six months we’ve seen a lot more activity from private companies, including private equity-backed companies, (which are) starting to take this seriously.”
MARK DAVIS
Managing Partner, Deloitte Private Enterprises
It’s important that private equity firms know the new standard well enough to evaluate its potential impacts during due diligence, says Stephen Thompson, partner at KPMG. “In evaluating a target, the PE firm needs to understand how the accounting will look next year,” he says. It may mean changing the questions asked during due diligence as well as additional analysis. If the target has not yet implemented the new standard, what will be the added cost to become compliant? “A $2 million cost to implement a new software system (to handle new revenue recognition rules) could be a big deal for a small private company that you’re acquiring,” he says.
On the sell side, firms need to make sure their portfolio companies have implemented the new standard, or be able to provide an explanation of why they have not. This is especially important if the potential buyer is a public company that has already complied with the new standard. “I have seen deals unwind because of that,” Thompson says, although more often it becomes a negotiating point.
Rewriting the Story
When a company implements the new rule, private equity owners may need to rewrite the “growth story” they tell potential buyers. PE firms use financial modeling to identify and project revenue streams, then devise a strategy for improving those numbers with the goal of exiting the investment in a set number of years. These growth projections underpin their story. “Under the new rules, your whole model can be impacted, because the numbers change,” Thompson says. “It will make it harder to tell your story to attract buyers.” He emphasizes, however, that nothing actually changes in the performance of the company. “What’s changed is how we are telling the story and how the financial statements reflect that story,” he says. “The private equity firm has to get out in front of that, try to understand as soon as possible what the impacts are going to be, and start remodeling and shifting how they talk about the company.”
The prime goal of ASC 606 is to produce more useful financial information for investors through more disclosure about the nature, timing and uncertainty of revenue from a company’s contracts.
Thompson gives an example of a company that sells software licenses. Under traditional revenue recognition rules, that company may spread $15 million in revenue over a three-year license period. This recurring revenue is one of the metrics used to evaluate the company’s performance over time, and thus is the basis for the growth story.
Under the new rules, instead of $5 million dollars in annual recurring revenue over three years, the company “may have to recognize $12 million of that on Day One and can spread only $3 million over three years,” according to Thompson. “That just wreaks havoc on their models, even though the long-term profitability is the same. You just have to figure out different ways of explaining the results.”
Public companies have reported that ASC 606 adoption took much longer than initially anticipated, so private companies should start as soon as possible. Private equity owners should evaluate each portfolio company to see how revenue might shift, plan for it, and know how to explain it.
After all, nobody—be it buyer, seller or lender—likes financial surprises.
“I have a client who is 12 months away from what they hope is an IPO,” Thompson says. They had already begun to prepare before realizing the new rules would change their numbers. “So, they now have to go back and figure out how to present (their story) differently.”
The prime goal of ASC 606 is to produce more useful financial information for investors through more disclosure about the nature, timing and uncertainty of revenue from a company’s contracts.
The standard also:
- Provides a more robust framework for addressing revenue issues.
- Improves comparability of revenue recognition across entities, industries, jurisdictions and capital markets.
- Replaces many different, industry-specific U.S. GAAP revenue recognition requirements.
- Removes inconsistencies and weaknesses in existing revenue requirements.
- Simplifies the preparation of financial statements by reducing the number of requirements to which an organization must refer.
ASC 606’s underlying principle is to recognize revenue more accurately by more closely matching recognition to when a customer actually receives the value of a good or service. The new standard instructs companies to follow five steps to do so:
- Identify the contract with a customer.
- Identify the distinct performance obligations (or promises) in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the reporting organization satisfies each performance obligation.
Source: Financial Accounting Standards Board
Tam Harbert is a freelance journalist based in the Washington, D.C., area.
