Revenue recognition dominated the private company accounting landscape in 2019 and companies and their accounting departments continue to feel the changes well into 2020.
Implementation of the revenue recognition standard should be wrapping up. The Financial Accounting Standards Board (FASB) accounting standards update 2014-09, Revenue from Contracts with Customers (Topic 606) required calendar-year private companies to adopt the new principles based revenue recognition standard changes for Dec. 31, 2019 calendar year end financial statements.
A close look at the updates indicates the standard will be felt far beyond the controller’s office. It may even bring pause to those thinking about buying or selling a business.
Topic 606 was created for a host of reasons, but the FASB primarily designed the update to create consistency in the way we think about revenue across entities, industries, jurisdictions and capital markets. In making the changes, the FASB also enhanced disclosures about revenue disclosures to provide some additional transparency for financial statement users.
The changes in Topic 606 introduce more judgment and discretion relative to previous revenue recognition guidance, which numbers among the reasons companies and their accountants spent so much time implementing the revenue recognition updates.
Changes associated with Topic 606 affect the timing and recognition of some expenses as well. When adopted, Topic 606 may have required companies to retroactively defer revenues or expenses or accelerate revenue recognition. On the other hand, companies may have found the timing of the revenue recognition did not change at all under the new standard.
How Revenue Recognition Changes Affect M&A
The buying and selling of a business often involves considering historical revenue or income trends. The analysis of these trends may be more difficult. Certain industries — most notably media, life sciences, franchisors, software, and aerospace and defense — were impacted to such an extent by Topic 606 that many companies had to materially alter the amount and timing of their revenue or expense recognition. As a result, comparing a company’s revenues and earnings in 2019 to prior years may be challenging. Furthermore, the comparability across companies in the same industry is now potentially more difficult due to the introduction of more judgment in the revenue recognition process.
In addition, when conducting a quality of earnings analysis for a business, the increased use of judgment in decisions around when and how much revenue to recognize may result in differences of opinion about the correct amount of revenue. The increased judgment may require sellers to more clearly document and explain their judgments and the factors that led to the decisions they made. It may also require buyers to invest more time in understanding the basis and reasonableness of the historical accounting and the likely accounting subsequent to closing on the deal. This analysis may be particularly relevant in properly negotiating and structuring contingent payments, such as earn outs.
Both buyers and sellers should fully understand the income tax implications of the new revenue recognition rules, too. This is especially true in the lower middle market, where income tax consequences often play an outsized role in strategic decision making. In certain situations, companies that recognize revenue earlier under Topic 606 will also be required to pay tax earlier, even if cash has not yet been received. The change to the income tax treatment came about because of a change in the tax reform law commonly known as the Tax Cuts and Jobs Act.
Revenue recognition changes driven by accounting standards generally will not affect the cash flows of an entity. They may however, affect metrics commonly used as substitutes for cash flows, such as EBITDA. In transitioning to the revenue recognition standard, some entities may have had to recognize revenue or expenses twice (in the year before implementation and the year[s] after) or not at all (with the revenue booked directly to retained earnings). Sellers that experienced this particular Topic 606 effect should disclose it to potential buyers in the event their EBITDA in 2019 is materially impacted by changes to recognition of the revenue or expense.
How to Navigate Revenue Recognition in Deal-Making
Understanding the impact on the timing and presentation of revenues and expenses will be important when negotiating key contract terms, such as earn outs. Buyers and sellers of businesses should confirm they, along with their advisors, have answers to the following questions:
- How are the changes under Topic 606 generally affecting the industry in which the business is operating?
- Have changes under Topic 606 been fully implemented? How were they applied and what reports and other information reflect the changes?
- If adopted, was the population of impacted contracts correctly identified and the associated adjustment accurately quantified?
- Have adjustments recognized under Topic 606 been taken into account when quantifying the enterprise value (if using an income valuation approach such as a multiple of EBITDA or revenue) of the business?
The answers to the questions above will ensure stakeholders know how the new revenue recognition rules are affecting their deal. On the buy-side, it will clarify the impact of the standard on investments (or potential investments) and may inform the evaluation of a target. For sellers, the answers to the above questions will provide insight into the associated valuation implications of adopting the revenue recognition standard.
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Published on March 03, 2020