It’s not quite a “nothingburger” – certainly not for those implementing the accounting and for the CFOs and auditors affected by it – but as private companies implement ASC 606, the new accounting standard for revenue recognition that went into effect in January, those of us who spend a lot of time performing valuation on private equity portfolio companies are not seeing a major impact. We are actually spending more time sweating new lease standards that will impact private companies beginning December 15.
The new revenue standards, which were already required for publicly-traded companies last year, start with the premise that companies should recognize revenue when goods or services are delivered to the customer. They also mandate much more disclosure from companies on why they made the choices they made for revenue recognition.
Five steps to recognize revenue
The standard calls for a five-step process. (Read VRC’s more detailed description of the new standards in our previous article “Preparing for FASB changes to revenue recognition and lease accounting”):
- Identify a contract
- Enumerate the performance obligations, also known as deliverables
- Determine the transaction price
- Allocate the purchase price among the performance obligations
- Recognize the revenue as goods or services provided
In evaluating the new standards, market participants recognized early on that some industries were likely to be affected much more than others. For a consumer goods manufacturer that produces and sells physical products, most practitioners agreed that the changes would be straightforward and de minimis.
However, for other kinds of companies with more complex contracts that may be long-duration and often include large upfront licensing fees and provisions for the ongoing delivery of support services, there was concern that the new standard would be more challenging to implement; would lead to challenges from auditors; and could distort revenue figures (for better or worse), especially in the initial implementation year.
The two factors that made for a smooth roll-out
The roll-out appears to be going smoothly and in large part has not changed how we value private companies. We attribute that to two factors.
First of all, private companies have had a long time to prepare for the new standard. ASC 606 was finalized more than three years ago. Moreover, as it went into effect last year for listed companies, privately-held entities were able to monitor and, where appropriate, emulate their approaches. Many of the private companies we review began implementing the new standards ahead of this year such that any distortion of revenue has already transpired and they have already normalized.
The second reason we have not seen the significant impact that some in the market feared has to do with a fundamental shift in the business models of many of the companies that were viewed as most likely to be affected. Historically, many software companies employed a model with an upfront license fee, followed by ongoing fees for maintenance and support. However, today most software companies have switched to software-as-a-service (SaaS) models.
Under a SaaS approach, the receipt of cash, performance obligation and the recognition of revenue are more aligned than they were under a license-maintenance model, where cash was received up front, the performance obligation was largely up front (but not entirely) and revenue was recognized over the license term unless it was an evergreen contract, in which case, revenues were also recognized up front. As such, the impact of ASC 606 is less significant on a company income statement today than it would have been in the past.
Lease accounting up next
More-so than the new revenue recognition standard, valuation professionals are looking at the impact of ASC 842 – new leasing accounting standards that also kick in for private companies at the end of this year. While again these standards will have the biggest impact on a subset of companies – in this case retailers, restaurant operators and others with significant leasing activity – they may have a relatively bigger impact on valuations than the new revenue recognition standard, as they call for companies to value and capitalize all leases and to reflect them on their balance sheets.
Much of the implementation is fairly mechanical, but the standards will require lessors to calculate and apply their incremental borrowing rate in valuing leases. That could prove a challenge for private companies that have not tapped the bond or bank loan market. In those cases, they may need to perform an analysis based on comparable companies that do have debt and then make adjustments based on the underlying asset they are leasing, the lease terms and their own circumstances.
PJ Patel is senior managing director and co-CEO of Valuation Research Corp.