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. The following is part one in a two-part article series.

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.

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.

The second article in this series will discuss pre- and post-transaction considerations for your PEG evaluating the impact of revenue recognition.

For more information, please visit sikich.com/insights.

By Cheryl Aschenbrener | cheryl.aschenbrener@sikich.com
National Co-Leader and Partner, Transaction Advisory Services