New Revenue Recognition Rules and Their Impact on Private Company Investment Advisors
On May 28, 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09). The new standard changed the accounting for revenue recognition and for related contract assets and liabilities. Since the release of ASU 2014-09, FASB has issued several amendments to the new standard, and a significant amount of implementation guidance has been provided for all companies.
But how will Topic 606 affect private company investment advisors? To find out, we assembled a roundtable of our private equity (PE) and hedge fund (HF) professionals and asked them to weigh in. The panel included Chris Aroh, Partner and leader of our Financial Sponsors practice; and Jeff Moskowitz, Partner, and Stuart Smith, Director, both of our Financial Services practice.
Stuart: There is a widespread misconception that the rules were changed to address problems that arose as part of the 2008 economic downturn. That’s not the case. The FASB has been working on changing revenue recognition for a decade. Eventually, it became one of many convergence projects for the FASB and IASB.
Standard setters have been trying to reduce diversity in practice within accounting for revenue recognition, so companies with similar circumstances apply accounting rules in the same way. There was general guidance for revenue recognition, and there was specific guidance for several industries. The new standards are designed to reduce diversity in practice and improve the consistency and value of information that are provided in financial statements.
Chris: The most important thing to understand is that the underlying support used by financial statement preparers in making revenue recognition decisions is changing. It will affect fee recognition, valuations, and performance fees, and it will require more support from IT and third-party administrators (TPAs). More disclosure will also be required.
Stuart: Performance-based incentive fees for both GP and IA financial statements will be significantly affected, since these fees are considered variable consideration at the contract’s inception, pursuant to ASU 2014-09. GP and IA entities may not be able to conclude that it is probable that a significant reversal in the cumulative amount of revenue recognized would not occur. Therefore, revenue from performance-based incentive fees cannot be recognized.
Chris: The new rules will impact both the portfolio and management levels. This is because the new standard affects early versus later recognition of revenue. The new standard requires combining distinct promises in contracts into distinct and separately identifiable performance obligations. That could change the timing of the revenue for one or more of the agreements, because you could be combining one promise and agreement with another promise and agreement that were previously recognized separately.
Stuart: The standard also changes how the progress of delivering the promise in the agreement is measured, which could cause the revenue to be recognized earlier or later.
Jeff: Possibly, one of the issues will likely be around valuation. Specifically, with private equity investments, there may be impacts to revenue and resulting EBITDA figures of the underlying portfolio company, which can impact certain benchmarks used in valuation techniques and ultimately can change a company’s valuation.
Chris: Revenue recognition is going to have more impact on certain industries versus others, particularly ones that have a lot of deferred revenue. If there are long-term term contracts, those typically include percentage of completion or service arrangements for revenue. If you are doing a deal in tech, for example, you need to be asking questions about the valuation. For example, “The projections I’m looking at for deferred revenue…is it based on the old revenue standard or ASU 2014-19?” If it’s on the old standard, it’s possible you could acquire the company and later receive GAAP statements that differ from the original revenue projections.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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