The prospect of increased revenue or, top line, continues to be one of the primary drivers to mergers and acquisitions (“M&A”) activity domestically, internationally and across-national borders. Whether to expand a company’s offering to its current customer base, acquire a strategically desired offering and its loyal customers or, to venture into new territories, a growing stream of recognized revenue continues to be one of the primary drivers of value.
Before January 1, 2018, despite the industry-specific differences in recognizing the nature, amount, timing and uncertainty of revenue from customers, analysis of financial results relied on the expectation of company-specific (i.e., for example, year-over-year) consistency in the method of revenue recognition; variances noted would thus have to be explained by volume, price or competitive forces. This reliability is now demanding a closer look and potentially expanded analysis because of the changing regulatory landscape.
Standards Revision
In 2014, the US [“FASB” – Financial Accounting Standards Board] and international [“IASB” – International Accounting Standards Board] accounting standards-setting organizations responsible for Generally Accepted Accounting Principles (“US GAAP”) and International Financial Reporting Standards (“IFRS”) successfully agreed to and issued a similar set of revised standards for the recognition of customer revenue.
The result is that nearly all previously existing US GAAP and IFRS guidance directing the recognition of revenue was replaced beginning in 2018 for public filers and will be effective in 2019 for non-public entities. The four-criteria test for revenue recognition under US GAAP, codified and previously resident within ASC 605-10-S99, was replaced by a five-step model in accordance with Topic 606 (ASC 606: Revenue from Contracts with Customers) in the US. For IFRS filers, the effective date was similarly set to apply in 2018 (i.e., “for annual reporting periods beginning on or after January 1, 2018”) without the public-versus-private filer distinction.
Prior to the converged issuance of ASC 606 and IFRS 15, revenue recognition was certainly subject to potentially significant divergence among companies reporting under US GAAP because the standards were industry-specific and internationally, the IASB’s “principles-based” tenet resulted in significant discretionary latitude for the point of revenue recognition under complex customer contracts.
In order to accomplish their core principle, namely to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled, the standard-setters adopted a five-step model, which instructs:
Step 1: Identify the contract with a customer;
Step 2: Identify the performance obligations in the contract;
Step 3: Determine the transaction price;
Step 4: Allocate the transaction price;
Step 5: Recognize revenue when or as the entity satisfies a performance obligation.
While “Step 1” is intuitive and consistent with the predecessor four-step guidance in ASC 605, Steps 2 through 5 compel interpretive judgement, which presents a change from the prior guidance for certain industries. Accordingly, companies will experience an impact affecting the comparability of their pre- and post-effective date financial statements. Further complicating the task for those seeking to “compare apples to apples,” ASC 606 permits companies a number of adoption methods and IAS 15 provides for at least two transition options.
In summary, both standards allow a full retrospective approach that restates all prior periods presented to conform with the new standard; this should be the most helpful to readers of the financial statements. However, there is also an option that permits a company to record/report a cumulative effect of the historical change at their date of adoption, which doesn’t recast the previously reported periods, leaving the reader with a comparability mystery that may only be solved by reference to the notes to the financial statements.
Therefore, acquiring parties in a planned M&A must endeavor to take note of the chosen transition approach to more fully understand the significance of the historically reported financial statement results.
Where the guidance changes matter in M&A
As financial due diligence and investment banking analysts will acknowledge, the historical performance of a subject company is conveyed through a variety of data points and analytics, a significant portion of which, deals with historical revenue. Prospective buyers will digest and seek to normalize these historical results, in an effort to project the post-closing performance of the target and accordingly, justify their proposed purchase price. The exercise to normalize, or eliminate certain non-recurring aspects from the historical data, is intended to increase comparability and this will necessitate an analysis of the new revenue standards’ impact, including the selected method of adoption deployed.
Working Capital & Earnouts
Although the foregoing has emphasized a statement of operations or income statement perspective, deal professionals and advisers are all too familiar with the role that the balance sheet, and more specifically the target working capital of the acquired company, will have on determining the final purchase price. Ensuring that the historical inputs used to derive the “peg,” the elements used to derive the closing estimate and then the true-up of the final closing working capital, are all prepared on a consistent and comparable basis is critical to ensuring a smooth M&A transaction. Challenging as that may have been historically, the addition of a newly implemented revenue recognition standard that can affect both current assets (customer receivables) and current liabilities (deferred revenue liability), has significantly increased the likelihood for a dispute.
In addition to the potential impacting on working capital there is a much more direct impact the new standards may have on purchase price elements that rely in the income statement, such as the earnout.
Earnouts, a technique whereby a significant portion of the purchase price is determined post-closing, are generally based on statement of operations targets that are derived pre-closing and then measured in the post-closing period of the negotiated earnout (i.e., often 12 to 36 months).
Despite the reality that total revenue, over the course of the customer relationship, will be the same regardless of the standard or measurement technique agreed-to, divergence in the revenue recognition method can affect the achievement of earnout targets based on the timing of when such revenue is recognized.
Conclusion
If your client or company is in the throes of implementing ASC 606 or IAS 15 and simultaneously contemplating an M&A, understanding the transition options from the predecessor revenue recognition guidance is tantamount to ensuring a smooth transaction. Remain mindful of the effects the new guidance will have on the comparability of historical income statements, balance sheets and working capital calculations and where applicable, the measurement of earnout targets and future results. In drafting provisions to purchase agreements, be especially cognizant of the traditionally specified basis of accounting clause, “GAAP, consistently applied,” as this may have just taken on unanticipated ambiguity courtesy of the new US GAAP and IFRS revenue recognition standards.
