Originally published in American City Business Journals
By Joanne Baginski
The rules for revenue recognition and lease accounting are about to change. For many businesses, the standards that inform crucial metrics that private equity professionals use to judge the performance and valuation of portfolio companies may be affected.
The new rules may change such things as top-line revenue and EBITDA (earnings before interest, taxes, depreciation and amortization). There can also be significant implications to budgets, valuations, debt covenants, bonus plans and acquisition earn-out calculations. Private-equity investors will want to ensure their portfolio companies manage this game-changing accounting transition with care.
ASC 606, Revenue from Contracts with Customers, is effective on January 1, 2018, for calendar year-end public businesses and a year later for privately held firms. Bloomberg BNA called ASC 606, “the most historic accounting changes to hit U.S. capital markets in decades.”
Revenue recognition changes
The changes may be more than many businesses can handle without outside help. ASC 606 replaces countless industry-specific norms of accounting for revenue with a principles-based common standard. Central to the new rule is a five-step process for customer-contract revenue recognition that focuses on transfer of control instead of the transfer of risk and rewards. Those five steps are:
- Identifying contracts
- Identifying performance obligations
- Determining the transaction price
- Allocating the transaction price to performance obligations
- Recognizing the revenue
Enhanced disclosures must detail the amount, timing and uncertainty of revenue from contracts.
Putting those rules into practice will be tough for many businesses, especially since accounting teams at most middle-market companies are lean and those professionals already have a full work load. Fortune 500 firms may have enough accountants to pore over every customer contract to review whether the new rule changes revenue recognition, but most middle-market firms don’t have sufficient accounting manpower, not to mention the resources also needed from such disparate teams as information technology to marketing and taxes. Businesses will have to explain any significant changes in their disclosures, using plain language so that investors can understand the nature and reason for any meaningful changes.
Certain business sectors may be particularly affected, including software companies, specialty manufacturers, health care companies and franchise firms. Two simple illustrations:
A software company may have previously accounted for a $1 million contract (split between a $250,000 software sale and a $750,000 five-year support contract) as five equal annual revenue installments of $200,000. Under the new rules, software revenue may be recorded immediately while revenue from the support contract will be recorded in five installments. That new accounting will produce year one revenue of $400,000, followed by $150,000 for each of the remaining four years of the contract.
A company selling a simple five-year franchise contract for $1 million would previously have recognized all of that revenue in year one. Now, it will usually record $200,000 in revenue annually for each of the five years of the contract.
Private equity investors should ensure management at portfolio companies ask the right questions:
- What are the changes to the company’s revenue-recognition policies due to the new standard, and what are the potential financial and tax impacts of those changes?
- Are there particular revenue issues for the company’s specific industry?
- What education will employees need? How will the firm educate investors/analysts/creditors so they understand any changes to financial results?
- Does the firm have a plan, including a timetable and an understanding of the resources needed as well as the cost of the transition?
- Will the new standards potentially impact business practices, such as IT and other systems, risk monitoring and controls, contract and loan agreements, budgeting and forecasting, key performance indicators and compensation plans, as well as joint ventures and alliances?
Lease accounting changes
In addition to the new revenue rules, there are significant changes to lease accounting on the horizon. ASC 842, Leases, will have ramifications for the balance sheets of businesses. Most notably, operating leases previously reported as rent expense on an income statement and disclosed in notes to financial statements will appear on balance sheets, significantly increasing liabilities (lease liability) and assets (right-of-use asset) for most businesses. In addition, the liability will have a short-term and long-term portion, while the asset will be all classified as long term. ASC 842 may change debt-to-equity ratios, EBITDA, and other metrics that borrowers use to gauge company creditworthiness and investors use to value the business.
Businesses need to be proactive
Put together, the revenue and lease-rule changes will require many businesses to be proactive with creditors, banks and bond holders or risk breaching debt and loan covenants. In addition, the rules can have domino effects impacting such things as employee compensation and bonuses. Smart businesses will get ahead of those changes by studying not just how the rules will impact revenue, earnings and balance sheets, but also how such things as compensation for key executives and income tax liabilities could change, too. For private-equity investors, such things as deal earn-outs could also change, so it makes sense to renegotiate terms before problems arise.
With so many middle-market businesses in need of extensive help, there has been a significant spike in demand for outside consultants. Businesses that need help should seek it out now before it is too late.
Joanne Baginski has almost 25 years of public and private accounting experience and leads the transaction advisory services area at EKS&H. She has been involved in more than 200 transactions, working on both the buy and sell sides of deals, and her expertise also includes business finance, financial planning and analysis, and capital financing.