As a private equity fund, you evaluate several metrics to measure the value of a potential and an existing portfolio company, but revenue is one of the most critical. So when the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued new revenue recognition standards (ASC 606) with an implementation deadline of 2019 for private companies, you likely took notice.
When assessing how the standards would impact their potential (target) and existing valuations of portfolio companies, many funds focused on the key financial metrics such as EBITDA. But you should know the standards have a broader reach and a much bigger impact and may reshape how you evaluate your private equity investments moving forward.
Here are the most significant ways the revenue recognition standards could affect you and what you should do at each step of the transaction process to help ensure compliance.
Pre-Transaction Due Diligence
First, it’s important to make sure your investment still looks solid through the lens of ASC 606. Has your target started the process of preparing for and adopting the revenue recognition standards? Before proceeding with a transaction, you need to make sure the company’s cash flow and EBITDA projections, costs and resources are being evaluated not only for existing GAAP, but also in accordance with the new standards.
And don’t overlook the impact these changes may have on your target’s existing business model, since they could spur shifts in pricing and market strategies. Take time to carefully consider whether your target needs to make changes to its core systems, and if it does, evaluate how those changes will affect capital expenditures.
You also need to consider what the new standard could mean for earnouts and working capital adjustments you’ve established with the target company. If you anticipate that the target will be raising future financing, consider how ASC 606 changes could affect financing ratios and potential debt covenants (more on this below).
Once you’ve brought your target company into your investment portfolio, you may need to review and renegotiate debt covenants to avoid any violations that may result from the new accounting standards. Carefully analyze earnout and working capital calculations after the transaction to spot any discrepancies.
As you might have guessed by now, complying with ASC 606 is no small feat; the standard is complicated and has different implications for companies in different industries. To help your portfolio companies adopt the standard, you may need to bring in outside specialists to assist with various core business functions such as legal, tax, human resources, marketing, credit and underwriting. Some key activities that fall under this umbrella are:
- Existing Legal Agreements and Contracts: As part of the ASC 606 adoption process, you need to review and potentially update existing contract templates. This exercise can be a positive by-product of adopting the new standards, but the process requires ample time and specialized expertise — and you can’t tackle it with a one-size-fits-all approach.
- Taxes: It’s critical to develop a keen understanding of how the standards affect your portfolio companies from a tax perspective. Changes to revenue recognition accounting could impact tax accounting method changes, book-to-tax basis differences, deferred taxes, sales taxes, state apportionment factors and transfer pricing methodologies.
- Compensation: Don’t forget about the people factor — you may need to adjust existing compensation plans to align with the new revenue recognition model in a way that still motivates and rewards employees for meeting certain goals.
Future Portfolio Company Valuations
Remember that complying with ASC 606 is not a once-and-done type of exercise; ongoing portfolio-company fair value measurement will be needed. This new standard will likely have a considerable impact on many inputs into the valuation model. Realize that when you are comparing numbers with the past, you may be looking at the old model. Don’t compare apples to oranges when making decisions. Finally, take time to educate yourself so you can continue to produce the most accurate forecasts, projections and valuations.
There is no question that these new standards will have a massive impact on accounting processes in companies across industries. And though the FASB intended for the standard to simplify how companies approach recognizing revenue, ASC 606 is complex, and it can be difficult to know how to put the standards into practice.
But that’s where Wipfli can help. We have the knowledge and know-how to help private equity funds gain a better understanding of the new revenue recognition standards and the compliance requirements involved. If you have questions about the standards or want to learn more about how we can help, contact me at email@example.com or 215.989.3627.