Sudden Impact: New Revenue Recognition Rules Will Immediately Affect Acquirers
Businesses are dealing with the most significant accounting changes in over a decade. With U.S. and international accounting standard setters issuing largely convergent new rules on how to account for revenues and associated direct costs, Revenue from Contracts with Customers (ASC 606 and IFRS 15) requires sweeping changes for many companies globally.
Starting last year for public companies and in 2019 for private companies, the new standard requires an allocation of revenue to each promise of performance made to a customer in a contract. It then requires the deferment of expense recognition to align with the contract’s performance delivery.
These are not entirely new concepts in accounting principles. But as companies move through the compliance process, many are surprised to learn how much they may have underestimated the complexity of this transition. The changes will require many companies to completely rethink the way they do business—and that rethinking needs to happen right away, even for acquirers or lenders.
Say, for example, a public company is interested in buying a private company. For private companies, the revenue recognition deadline isn’t until 2019. But once the business is purchased, all of that changes, since conversion work needs to start the day the deal closes.
This means publicly traded acquirers must make the new revenue recognition standard a central part of their due diligence efforts. They need to plan appropriately and allocate sufficient resources to ensure that conversion to the new standard happens immediately.
What’s more, acquirers and lenders will need to change the way they value a private company, at least for this year. It’s not uncommon for acquirers to use public market valuations when trying to figure out the price for private companies.
In 2018, public companies will be presenting their financial statements based on the new standard, while private companies will report using the old U.S. GAAP standard. This means it will be very difficult, if not impossible, to make an apples-to-apples comparison between the two.
Revenue recognition will impact some industries more than others. Software companies that operate under a license plus long-term customer maintenance fee model will feel the effects strongly as the allocation and timing of revenue between the two components of these arrangements may change drastically. Retail companies offering accumulating loyalty programs may also experience significant change. In the past, loyalty programs were often considered a marketing expense. Going forward, though, they may need to be reported as a deduction against top-line revenue.
Additionally, any company that pays its salespeople a commission will be impacted, since the new guidelines contain strict rules on amortizing expenses. Prior to the new rules, sales commissions were typically expensed in full when paid to the salesperson. But under the new standard, commissions must be spread over the estimated life of the revenue arrangement with the customer, including a consideration for expected customer renewal periods.
As an example, if a SaaS company pays a one-time commission to a salesperson for bringing in a new customer, but the average customer stays with the company five years on average, the sales commission would have to be deferred on the balance sheet and expensed over a five-year expected customer relationship period. The commission payment needs to align with the revenue being generated from that customer over the expected period.
In a more extreme example, let’s say an insurance broker signs up a new client who purchases a life insurance policy for $100 a month for the first year, and automatically renews thereafter without any additional work to be done by the broker. The broker-dealer’s track record is that life insurance policies have a very high renewal rate with average policies renewing for 15 years. The company would typically record the initial policy year’s revenue and pay the sales rep a one-time commission for securing that initial contract. Moving forward, it would record renewal revenue and pay a smaller residual commission in each year the policy is renewed by the customer. The company would record the expense of that commission at the time of each payment to the salesperson.
But under the new revenue recognition guidelines, companies are prevented from doing this. Instead, they are required to accrue revenue for the initial policy commission plus an estimate of all future renewal commissions they expect to receive based on past renewal experience. They must then accrue the expense of that commission payable to the broker over the estimated lifetime of the contract. Thus, the new guidelines will have an impact not just on revenue recognition, but on book profits vs. cash flow. Companies may consider changing their definition of EBITDA.
The transition to ASC 606 and IFRS 15, Revenue from Contracts with Customers, is not a simple switch. Companies must reexamine every one of their contracts and begin recognizing revenue differently than they did before. Some companies will be more affected than others. Those that get it right will thrive in the coming years. Those that don’t will be forced to restate their revenues, which could be chaotic for their business.
Every organization must be prepared to reevaluate each of its contracts as part of the transition to the new revenue recognition standard. Additionally, transaction teams are advised to adjust how they value targets and to make the new standard a central part of the diligence process.