The transition from current GAAP rules-based revenue recognition practices to the new principles-based model means added considerations — and potentially surprising impacts — on a business’s quality of earnings. Whether you're acquiring or selling a portfolio company or planning a future exit, one thing is certain: The new model for recognizing revenue will soon create shades of gray during due diligence.
Understanding what the new standard means with respect to a company's quality of earnings and your valuation models isn't going to be business as usual.
What do I need to consider?The new revenue recognition standard could impact EBITDA and other performance metrics that are inputs to private equity (PE) groups' current valuation models, creating an interesting situation. The changes will have resulted from a change in an accounting standard; however, the cash flows and operations of the business will not have changed. Since the business model isn’t changing, in theory, the value shouldn't change. But, if PE groups don't update their valuation models, the models could indicate changes in value. As a result, you need to ask, "What adjustments should I be making to my valuation models to incorporate the effects of the new standard?"
While the standard goes into effect in 2018 for public business entities and 2019 for all other organizations, companies can early-adopt in 2017. This means, as a buyer, you could be looking both at target companies that have adopted the new standards and those that haven’t even thought about them at the same point in time. That's why it's important to understand where in the process a company is.
When performing due diligence, PE groups should begin to consider the following:
Prior to implementationUnderstand how the business's revenue and EBITDA will change under the new rules. Will this impact the value of the target? Should it? Additionally, a company’s readiness to test, implement, and operate under the new standard may have significant implications for its appeal as a target. It will be important to understand the prospect’s progress towards implementation during due diligence and the costs associated with implementation if the target isn’t far along in that process.
Closer to implementationUnderstand how forecasts are being built — whether under the old rules or the new rules — to determine what adjustments to the valuation model are necessary and in what periods the adjustments should be applied.
After implementationBe aware of historical numbers used in analyses and how those will need to be recalibrated to be consistent with revenue under the new rules. For some companies, the bottom line won't change much. Others may see a major shift, for better or worse, and in unexpected ways.
Additionally, the new standard is principles-based rather than rules-based. This means there are plenty of judgment calls and estimates on the part of management. As a result, it's key for sellers to provide and for buyers to consider the rationale and assumptions behind decisions and projections and understand how those assumptions impact the bottom line.
We’ve seen many examples of unexpected changes through our work with clients who have begun planning for adoption. The following is a sampling of some of the changes we've observed.
What could change?
- Capitalize or expense sales commissions? Current state: Companies can make a policy election to capitalize sales commissions and recognize them as expense over the long-term contract period or to expense them as incurred.
- Vendor Specific Objective Evidence (VSOE) for software companies Current state: When a software license has been bundled with other services, such as maintenance and support, VSOE has been difficult for many software companies to establish, track, and prove. Companies that couldn’t consistently do so were required to recognize revenue over the full contract term, rather than recognizing license revenue when the software was delivered.
- Manufacturing custom parts Current state: Manufacturers that produce custom parts for a client recognize revenue for those parts when the title transfers, which is usually when the parts ship.
Under the new standard: Sales commissions related to long-term contracts meeting certain criteria will be required to be capitalized. Capitalizing commissions on these contracts will likely result in a more favorable bottom line for many businesses that were previously expensing them when incurred.
Under the new standard: VSOE is no longer a requirement. In instances where the license is a separate performance obligation from the other promises in the contract, companies could recognize the license revenue upon delivery of the software by using an estimate of that software's standalone value. This could result in some software providers significantly accelerating the timing of their revenue recognition.
Under the new standard: If certain criteria are met, for example, if the part has no alternative use to the company producing it, and the company has the right to payment for work completed to date in the event of contract termination, revenue would be recognized sooner — as the parts are produced rather than when shipped. We don’t see this in all contracts for manufacturers, but contracts with these terms are common.
In all three examples, revenue was advanced or expense deferred. While some companies will experience little change, we've seen numerous examples like the three above, across a wide range of industries. In the year of adoption, it will be critical to adjust PE valuation models to take into account the effects of the known changes and of the adoption if you want to avoid unexpected results from your models.
Final thoughtsAlso, keep in mind that a portfolio company's readiness to test, implement, and operate under the new standard, including having an inventory of customer contracts and terms, can impact how prospective buyers view, and value, the business.
Portfolio companies should assess the impact now. Start reviewing contracts to understand the accounting changes the business will need to make to comply with the standard. Don't wait until the required implementation date. And, be prepared to discuss your progress during due diligence. Understanding what the new standard means with respect to a company's quality of earnings and your valuation models isn't going to be business as usual.