New Revenue Recognition Rules and Their Impact on Private Company Investment Advisors

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. 

Jeff: The standard is already effective for public companies. Non-public companies, such as private equity and hedge funds, must begin to apply the rules for fiscal years beginning after Dec. 15, 2018. In addition, the standard is effective for both Investment Advisor (IA) and General Partner (GP) entities, i.e., for the calendar year 2019.

Stuart: Companies have been taking a very close look at this, and while public companies have already adopted this standard, we encourage our PE, HF, GP, and IA (collectively Asset Management (AM)) clients to take the necessary steps to ensure they are addressing the various aspects of this standard. Since public companies have already adopted the standard, this can be used as a resource for those AM companies in the process of determining the necessary disclosures and impacts on any adjustments. 

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.

Jeff: There are several fees between the investment advisor and the fund, some of which are paid over the life of the fund. Management fees, are usually calculated based upon assets under management and recorded by the IA during the period in which they are earned. The IA typically also charges a fee based upon the performance of the fund over the life of the fund.  There are several ways IAs use to calculate this performance fee or carried interest. 

Jeff: The initial discussion was whether carried interest for both GP and IA financial statements fell within the scope of this standard. Ultimately, it was determined to be within the scope, the most significant change relating to whether GP and IA entities can recognize carried interest prior to it being probable that a significant reversal in the cumulative amount of revenue recognized will not occur. The guidance indicates that recognition of carried interest would not take place until reversal of such amount is certain to not occur.

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.

Stuart: TPAs appear very aware of the new standard and are monitoring it closely. We have had some discussions with them, specifically on what needs to be disclosed on the financials. We recommend collaborating with your TPA to figure out the impact of the new rules both on the fund and advisor. 

Chris: They are aware of the standard at a high level. On the management side, the granularity gets complex. In PE, you could have a company with multiple investments in private companies that is currently using different revenue models for different types of investments. If there is a change in how the revenue is recognized, it could change the valuations of some of the underlying companies they are invested in.

Stuart: The new standard allows for more judgment for some contracts and performance obligations, whether they are met or not. Over the long run, if used appropriately, the new disclosures will improve reporting of revenue. The core principle prescribed by the standard is that it recognizes revenue to depict transfer of promised goods and services to an amount that reflects the consideration to which the company expects to be entitled. The new standard forces you to take a step back and ask whether you are achieving the standard’s core principle. If not, it’s an indication you need to re-evaluate how you are applying the detailed guidance.