Revenue Recognition and Private Equity: Are You Paying Attention? Part II
In our previous article, we broke down 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)) and its significant impact on private equity groups. Between May 2014 and today, amendments and implementation guidance for both companies and practitioners have been released; meaning, PEGs should prepare to be well versed on the standard and how it will impact portfolio companies, recent acquisitions, acquisition targets, and even exit strategies.
The following is part two in a two-part article series.
Are you currently evaluating potential investments? Make sure to understand the changes to the target’s business through the purview of Topic 606.
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.
The 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 the 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.
By Cheryl Aschenbrener, National Co-Leader and Partner, Transaction Advisory Services. Learn more on the Sikich website.
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.