Back in May of 2014, FASB issued one of the most considerably penetrating compliance changes in over a decade (Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09)). Between May 2014 and today, amendments and implementation guidance for both companies and practitioners have been released with Topic 606 effective for private companies beginning on or after January 1, 2019, trailing public companies by a year.
Before your eyes glaze over from the technical talk, you may be wondering why an accounting standard update from almost six years ago is relevant to your private equity firm. As it turns out, private equity groups are significantly impacted by the implementation of Topic 606. The underlying value of portfolio companies can be greatly affected by the adoption of this standard. To stay on top of your game, PEGs should be well versed on the standard and how it will impact portfolio companies, recent acquisitions, acquisition targets and even exit strategies.
Let’s break it down.
Topic 606: A Catalyst for Change
The evolution of Topic 606 stemmed from a convergence project between the FASB and the International Accounting Standards Board (IASB) to bridge the gap between the jurisdictional differences guiding revenue recognition between the two standard-setting bodies. The overarching goal of Topic 606 was to foster a more comprehensive, industry-agnostic revenue recognition model. Several other goals include:
- Provide a more robust framework for addressing revenue matters
- Improve comparability of revenue recognition across entities, companies, standard-setting bodies and industries
- Provide more useful information to users of financial statements through enhanced disclosure requirements
The five-step model resulting from Topic 606 seeks to attach the recognition of revenue more closely to when customers obtain control of a good or service in an amount equal to which the seller expects to be entitled to in exchange for those goods or services based on the contract(s) in place (in theory, this could help you out).
How, you may ask?
Private Equity Considerations
With EBITDA being one of the primary benchmarks PEGs use to evaluate current portfolio companies and acquisition targets, Topic 606 has the potential to significantly impact how PEGs evaluate their investments.
Thus, each portfolio company should review the five-step model under Topic 606 and conclude how to recognize revenue in accordance with the new guidance—or just ask us for help translating the standard, it can get confusing.
Based on the contracts in place, companies that have historically recognized revenue over time may now recognize at a point-in-time and vice versa. Changes in the timing of revenue recognition will not only impact fluctuations in reported EBITDA, but also may impact debt compliance, earnings-per-share, profitability, taxes, key performance indicators and other financial metrics of particular interest to PEGs.
Since portfolio companies will likely apply the five-step model independent from one another, it is important for private equity firms to evaluate each portfolio company’s assumptions and approach to implementation in order to properly understand the impact Topic 606 will have on the underlying valuation of each company, and, ultimately, the valuation of the fund itself.
Has the target investment started to evaluate the impacts of Topic 606? Reviewed contracts? Identified various revenue streams to bifurcate performance obligations? Put together an implementation timeline? Consider answers to these questions when drafting LOIs and subsequent purchase agreements in evaluating and establishing working capital adjustments, earn-outs or claw-backs.
If the target investment seeks to raise debt financing, PEGs should also assess how Topic 606 might impact potential debt covenants post-implementation. If target investments have already implemented Topic 606, PEGs should be particularly interested in the presentation and comparability of historical financial data provided in evaluating a potential transaction.
Implementation methods are discussed below. These methods could have a significant impact on the comparability of financial results if the target chooses to implement under the modified-retrospective approach, especially in a trailing-twelve-month period overlapping the implementation date.
Similarly, you really need to understand the impact of this standard on the valuations for existing portfolio companies when considering exit strategies.
Existing portfolio companies and recent acquisition targets should seek to understand the performance ramifications under Topic 606. Complying with Topic 606 is no small task and implementation requires an ongoing, in-depth understanding of the nuances of a company’s various revenue streams and how those measure up when evaluated using the new five-step model (say that five times fast).
PEGs should evaluate recent acquisition agreements that contain contingent consideration arrangements, such as working capital adjustments, earn-outs or claw-backs, to determine how these contingent consideration arrangements could change with the adoption of Topic 606 and how those changes will ultimately be handled between buyer and seller.
We won’t lie to you: PEGs and portfolio companies need to work closely with their CPAs to understand how Topic 606 will impact them from a tax perspective. From book-to-tax differences, state taxes, apportionment and transfer pricing, among others, it is important to not dismiss Topic 606 as only having a financial statement affect. Because revenue, EBITDA and other metrics may be affected, PEGs may need to evaluate existing and future employment and compensation plans to align with the new guidance.
The FASB has allowed for two types of adoption methods under Topic 606: full or modified-retrospective. Here’s how they’re different.
Full-retrospective requires that entities apply the standard retrospectively to all reporting periods presented in the financial statements.
Under the modified-retrospective, entities are required to apply the standard in the year of initial application while recognizing a cumulative effect adjustment to beginning retained earnings. Thus, no restatement of prior periods is necessary; however, the entity is still required to quantify the effect of the transition.
The guidance included in Topic 606 is significant and presents many unique challenges for PEGs to evaluate. Topic 606 will have both positive and negative impacts on PEGs, their portfolio companies, purchase agreements, contingent consideration and the environments in which the groups and portfolio companies operate. The implementation of the standard will involve input from many individuals, advisors and departments.
Closing thoughts: try to be proactive in understanding the changes brought forth to your PE firm and the implementation approach for portfolio companies. But if you find yourself confused or overwhelmed, talk to our transaction advisory and revenue recognition experts.