The best time to start looking at the new revenue standard from the Financial Accounting Standards Board and International Accounting Standards Board was “last year,” experts say.
Hyperbole aside, while the initial deadline for adoption isn’t for another two years, GPs shouldn’t delay looking into what it means for them and their portfolio.
GPs will have to examine how the standard affects each portfolio company, decide on any new systems and practices that are required, and devise a communication strategy for reporting any valuation changes.
The FASB and IASB issued the joint standard for how revenue should be identified, recognized, and disclosed, regardless of industry or geography, in 2014. The deadline for implementation was recently pushed to 2018 for public companies, and 2019 for private, but even with that leeway, adopting it may be more expensive and complicated than firms expect.
“Some PE firms may be discounting the level of effort to adopt the standard because they believe their industry isn’t as impacted as others,” says Stephen Thompson, a partner at KPMG. Experts argue the changes will have major consequences for GPs of all sizes and strategies, consequences that take real time and effort to address.
Eventually, however, the standard may simplify a process that’s currently directed by a grab-bag of industry-specific guidance. But in the near-term, adopting the standard may change when revenue gets recorded, which can alter valuations during due diligence, quarterly reporting and exits. It could even impact how some GPs report their own performance.
One of the principles of the new model is the idea of “constraint.” This means that if there is any variability in revenue, such as rebates, refunds and price concessions, the company only records the revenue that is “not probable” to be reversed in the future.
“In plain English, if you think the amount will be returned back to the customer later, that has to be considered in how, and when, one recognizes revenue,” says John Pappas, an FASB spokesman.
In some cases, this may mean companies recognize revenue earlier. For example, if a company waited until the end of a contract to report revenue, they may now have to recognize a portion of it over the life of the contract, using estimates.
There is no bias in the new model towards accelerating or slowing down revenue recognition; instead, on day one, a company will make its best estimate of the total consideration under the contract, and then recognize that as revenue as the company performs over the life of the contract.
“This is all about greater rigor in how revenue is recognized and calculated. Now companies will report the significant judgements made in recording revenue, with disclosures about remaining performance obligations required to secure that revenue,” says Pappas. “It’s about transparency.”
The new standard requires separating revenue in several more categories instead of broad types such as “sales revenue.”
“With more categories, people better understand where the revenue is coming from,” says Pappas.
Clarity and consequences
Of course, changing when and how revenue is recognized can increase clarity and transparency, and, in theory, shouldn’t have any net effect on revenue. But the transition may involve huge consequences for every phase of a GP’s deal cycle.
“The new revenue standard requires the use of more estimates, which may lead to greater volatility in the numbers, unrelated to any performance factor,” says Eric Knachel, a senior consultation partner at Deloitte.
As an example, Knachel cites the situation where a company sells a product to be incorporated into another company’s product, so royalties would be owed for a fixed period of time. “Under current GAAP, these would be considered contingent and wouldn’t be recognized until it happened, but now, you’d devise an estimate from the start of the agreement.” And needless to say, those estimates may vary, and the revenue numbers right along with them.
“GPs are constantly focused on trends driving valuation and whether they be EBITDA, net income, or some other metric, most will speak to the revenue line when they talk about the fair value and growth prospects of the company,” says Christopher Rhodes, a partner at PwC. “By changing the revenue pattern, you’re changing one of the fundamental drivers of an investment’s perceived value.” And a change in value can complicate the valuation story a GP tells LPs, any potential buyer, or the public markets before an IPO.
Most experts suggest that over time, the estimates will achieve a level of consistency, or at the very least, widespread adoption will create a uniform playing field. But over the next few years, the adoption presents several scenarios that could muddy the waters.
Due diligence could be affected by the flexibility the standard offers.
“For the next 12 to 24 months, some companies may have adopted the new standard, some may not have,” says Knachel. Even if they do adopt the standard, there are two kinds: “full retrospective,” where they would restate all prior years, and “modified retrospective,” where they would record an adjustment between the two standards for the period of adoption.
“The bottom line is that it will make comparison more difficult and introduce more subjectivity in the buying situation because not every company will have the same metric.”
“In certain cases, companies might face ‘orphaned’ revenue,” says Rhodes. This is when the standard requires some revenue be recorded upfront, say in 2015. Then when implementation takes place in 2018, the opening equity is 2016, and because under old GAAP rules, the 2015 revenue wasn’t recorded at all, that revenue disappears.
“It’s not a prevalent issue, but it’s a possibility as the adoption phase gets underway,” Rhodes adds. At the very least, several experts agree that as companies move to the new standard, some might find their “steady growth story” translated into a more erratic one, as revenue is recognized at different times.
That new timing may also alter compensation arrangements at portfolio companies. “So many compensation packages are linked to revenue, so you do need to examine what the impact will be and decide how to respond,” says Knachel. “Does the company need to amend how revenue targets are calculated? Do you keep two sets of books? These are sensitive issues.”
GPs at some private equity firms may find their own compensation arrangements in need of amendment.
There is currently an SEC rule that a firm can record revenues in the same period as the fund value appreciates. However, several experts understand the SEC will remove that guidance. As a result, private equity firms will need to label this appreciation under “variable” consideration, which may force many GPs to delay when they record it as revenue.
“Going forward, it’s highly likely there will be a significant decrease in the amount of revenue they can recognize based on the appreciation of the fund,” says Knachel. And that means LPs need to be informed that the new standard may not reflect actual performance.
Furthermore, the firm may need to compensate management as the fund appreciates, which is a cost, before that appreciation shows up as revenue on the balance sheet. “That’s a mismatch that’ll have to be addressed.”
The clock is ticking
So the stakes are high and the implications are complex. The official deadline for public companies is January 1, 2018, while private companies have an additional year to adopt. But every expert and industry participant we spoke with for this story recommended looking into the new standard’s impact immediately.
“Even if the company isn’t public, some of its debt may be, and failing to adopt could delay or hinder an IPO if that’s on the table,” says Thompson. Most warn that adoption requires time to understand all the implications of the new standard.
“We’ve seen the implementation take more time and effort than expected,” says Knachel. “But when you think of the methods of adoption, the full or the modified, both include a look back that includes periods going on right now.”
There are three main steps to addressing the new standard. First: truly understanding what it means for current accounting practices, which involves digging deep into a company’s books. “I have a mix of private equity and large public company clients and what seemed like a minor change at a high level, once they got into the actual contracts, became more complicated,” says Rhodes.
Second, plotting what new systems and processes have to be in place. “For companies facing major changes, it will be IT or new bolt-on revenue automation tools and that can take six to nine months to introduce, if you fast-track it,” says Thompson.
Finally, there’s communication, as any revenue changes or other effects of adopting the new standard need to be shared with LPs and other audiences. “It can be difficult to explain to, for example, analysts on [Wall] Street, these technical facets without sounding like you’re making excuses,” says Rhodes. Sharing the potential changes from the standard before they show up on the balance sheet mean no one will panic when revenues suddenly look different.
For those that still doubt the advantages of starting this early, most portfolio companies operate with a lean staff, and they might not appreciate a side project that quickly turns into a fire drill. Timing, as those looking at the new standard have discovered, is no small thing.
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