by Jacqueline Pruscha, Audit Manager at Sensiba San Filippo
There has been a lot of chatter regarding changes in revenue recognition criteria lately, but the effects it will have on the evaluation of companies planning an exit is just beginning to emerge. While the dust is still settling, it’s becoming increasingly clear that these changes will affect not only the way a potential acquirer analyzes a target’s financial statements, but also on the way a deal is structured.
A change in revenue recognition means a change in the due diligence process, specifically accounting diligence, modeling, quality of earnings and cost of integration.
Understanding these changes is critical for companies looking to successfully navigate the landscape of M&A in the future.
What are the changes?
The new revenue recognition standard aims to take the current rules that vary by industry, and replace them with a principles-based approach across all industries. Specifically, the new standard will follow a five step model for revenue recognition:
- Identify the contract (the deal that has been reached)
- Identify the performance obligations (what’s expected and who’s doing what)
- Determine the transaction price (what will be owed)
- Allocate the transaction price (split it up if there are various performance obligations)
- Recognize revenue when performance obligations are met (good(s) or service(s) have been provided)
The new standard is the latest change aiming to create a cohesive model that can be consistently applied across all industries, while also aligning U.S. standards with international guidance. Another theme running through the changes is to de-emphasize specific technical rules and transition to a model that emphasizes management judgment and expanding disclosure.
In certain industries, such as Software as a Service (SaaS) and hardware companies, the new standard is a minor tweak. For other sectors, notably enterprise software, the changes will be very significant. In the past, enterprise software companies were often focused on Vendor Specific Objective Evidence (VSOE), which will now be very much de-emphasized.
Effects on valuation.
The changes will not significantly impact how much revenue is recognized, but will more likely affect the timing of the revenue recognition. In some instances, revenue will be recognized earlier than in the past, and sometimes later, which will inevitably impact the valuation of the company. However, important considerations such as the quality and mix of your customer base, customer cash collections, and the likelihood of your customers buying your service again remain as important as ever.
Additionally, certain contract acquisition costs, such as commissions, may be added to the balance sheet, thus impacting the timing of expense recognition. Companies should review working capital needs and assumptions and revise them to fit the new cost patterns as these are likely to be assessed in the due diligence process as well.
Timing of new standard and comparability.
The new standard goes into effect for public companies on January 1, 2018, and January 1, 2019 for private companies, while both have the option of early adoption. Because public companies have an earlier adoption date than private companies, there’s going to be a period of time when both reporting methods will be used.
Because of this, it is important for companies to understand how they are being benchmarked and compared to other companies. The new standard will affect revenue multiples, margin analysis and overall cost of integration of the target company. A company not ready for implementation, or unaware of the changes on their business, will not have the analysis ready to cast their revenue under the new guidance — which can delay the deal or negatively impact the merger price.
Regardless of timing or method of adoption of the new revenue standard, an acquirer will normalize a target’s financial statements in order to create an accurate comparison between financial periods. This will help appropriately predict future forecasts, making it important for companies to understand how revenue will be determined under the new standard.
What to consider.
Acquirers are going to have significant questions and concerns when assessing the value of a company, especially for those lacking a comprehensive plan for implementing the new revenue recognition standards. It’s important to address those concerns proactively and with accurate information. They will ask about the plan for implementation, and what are the system-wide needs and costs associated with implementing the new standard? What effects this will have on the future revenue model of the company and management’s ability to forecast?
A good CPA and M&A exert can help assess how the new standard will affect the company, help determine the best practice for implementation, as well as assess the needs of the organization in order to implement this standard to get you the accurate relevant financial information you need to answer those questions.
Jacqueline Pruscha is an Audit Manager at Sensiba San Filippo, specializing in accounting and financial reporting for technology, medical device and venture-backed companies. You can reach Jacqueline at firstname.lastname@example.org.