If you’ve kept tabs on the regulatory space over the past few years, you’ve likely heard about the new revenue recognition standard. In 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) each issued new standards for recognizing revenue on contracts with customers. In the United States, the result is the guidance in ASC 606. What you may not know is that ASC 606 affects how businesses are valued.
At its core, the reason is simple: Because ASC 606 changes the accounting treatment of revenue, it changes the numbers used to value a company. But revenue recognition is complex, and it’s worthwhile to cultivate a deeper understanding of how it affects valuations and why.
What Is Revenue Recognition?
Historically, U.S. generally accepted accounting principles (GAAP) has consisted of broad revenue recognition concepts and numerous rules-based requirements for certain industries and transactions. ASC 606 changes this to a principles-based model. Revenue is earned when control of a good or service is transferred from the provider to the customer and is recognized in an amount the provider expects to receive as consideration for providing the good or service.
ASC 606’s five-step process provides for identifying the contract(s) with a customer, identifying the performance obligations in the contract, determining the transaction price, allocating the transaction price to the performance obligations and finally recognizing revenue as the performance obligations are satisfied.
Under ASC 606, revenue must be recognized over time if any of the following are true:
- Your customer receives and consumes the benefits at the same time.
- Your business creates or enhances an asset that the customer controls (e.g., a work in progress).
- Your business does not create an asset with an alternative use to you, and you have an enforceable right to payment for work completed to date.
Otherwise, you must recognize revenue at a point in time, which is when control transfers to the customer.
Why Are the FASB and IASB Making These Changes?
There are several main reasons for ASC 606. The new standard aims to:
- Remove inconsistencies and weaknesses in revenue requirements.
- Provide a more robust framework for addressing revenue issues.
- Provide more useful information to users of financial statements through improved disclosure requirements.
- Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.
Comparability matters because users of financial statements are typically financial institutions and investors, who have a lot of choice between industries and will choose to invest where it will provide a good return. Everyone is competing for the same dollars, so a consistent revenue recognition standard for all industries creates a more even playing field between industries.
How Does Revenue Recognition Impact Me?
There are quite a few ways the ASC 606 standard affects organizations. Your method of when to recognize revenue may change, which may lead to recognizing it earlier or later than you historically have. The number of performance obligations in the contract may also affect the timing of revenue recognition. Presentations and disclosures will change, and significantly more information will be required to be disclosed in financial statements.
You will definitely need to re-evaluate how your contracts are written, especially concerning termination clauses, change orders and contract duration. Contract terms are even more important now. Previously they were legally important but are now equally important to accounting.
Other impacts include the costs of obtaining a contract (e.g., sales commissions and precontract costs) and fulfilling a contract (e.g., bond premiums and mobilization costs). Both will likely need to be capitalized and amortized over the life of a contract rather than immediately expensed.
Additionally, EBITDA and working capital may be affected because of the changes to revenue and corresponding receivables and underbillings. Cash flow needs may also be impacted (e.g., costs to restructure contracts, new system technology, tax implications, added resources to understand and implement, etc.). And you’ll need to consider principal versus agent status since it will affect gross versus net presentation of revenue. And from an internal controls perspective, a company considering a sale may get better pricing if they have good internal controls.
These are just a few of the impacts revenue recognition could have on your organization. It’s not difficult to see how ASC 606 impacts valuations as well. When we value a business, we use an income approach and a market approach. The income approach to valuations asks what someone would be willing to pay based upon earnings or cash flow. The market approach asks what someone in the market would be willing to pay based upon earnings or cash flow. Without a doubt, revenue recognition affects both approaches.
When Do I Have to Adopt ASC 606?
While calendar-year public companies had to adopt ASC 606 on January 1, 2018, private companies have had an additional year to adopt it, with a deadline of January 1, 2019. Additionally, private companies are not required to apply ASC 606 on interim statements until January 1, 2020. If your company hasn’t adopted ASC 606 yet, the good news is that companies can adopt retrospectively or via a cumulative catch-up adjustment to retained earnings in the year of adoption. The bad news is, it may be challenging to determine the amount of any retrospective or cumulative catch-up adjustments.
What About My Valuation?
Revenue recognition can be complex and difficult to navigate, and understanding how it impacts valuations takes a knowledgeable and experienced professional. The revenue recognition and valuation specialists at Wipfli can help your organization understand the effects of the ASC 606 standard on your specific situation. Contact us to get started or learn more about our business valuation services.