by Frances Franco and Ed Schenkein
Effective for fiscal years starting December 15, 2018 private companies are required to adopt a new standard on revenue recognition, “Revenue from Contracts with Customers” ASC Topic 606 (“Topic 606”).
“The core principle of the guidance is that an entity should 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 in exchange for those goods or services”1. Since revenue is one of the most important measures relied on by investors, this new standard will likely impact investors and the valuation analyst’s assessment of a company’s performance in addition to the underlying data supporting the company’s valuation.
The objective of the new revenue standard is to make revenue reporting from contracts with customers consistent across different industries. The previous revenue recognition requirement was not always comparable due to guidance that varied for transactions in industries such as software and real estate. The new guidance improves comparability of revenue recognition practices across industries and capital markets.
Most companies are currently transitioning to the new standard which may affect the company’s timing of revenue recognition. As a result, there may be significant shifts in the timing of revenue recognition for contracts, which may distort a business valuation if the metrics used does not take these changes into consideration.
The new guidance requires reporting entities to recognize revenue when each performance obligation per the contract is satisfied. Therefore, an entity must now determine whether the components of goods or services represent a performance obligation and recognize revenue as each performance obligation is satisfied.
A change in accounting standard does not impact the value of an entity (i.e. an entity does not become more or less valuable due to a change in accounting standard). However, the valuation professional needs to be aware of how the revenue recognition swings resulting from the change in this accounting standard impacts the valuation metrics. As an example, if the valuation analyst’s metrics contain historical amounts which do not recognize revenue in accordance with Topic 606, yet current year amounts reflect the application of ASC 606, the revenue growth can be significantly distorted.
Additionally, when comparing the revenue performance per the subject entity to the industry, the valuation analyst’s assessment of the entity’s performance compared to the industry may be distorted if the amounts per the industry reflect the application of Topic 606, yet the entity’s accounting does not yet reflect a change per ASC 606.
Furthermore, it is important to ensure that the metrics used by the valuation analyst considers the consistency of the application of Topic 606 as revenue is not only a growth indicator, but also impacts the analysis of certain direct costs, margins, and revenue multiples.
It is important to note, for the purposes of the metrics and adequately assessing the entity’s performance, that the timing of direct costs also changed under the new standard. As an example, Topic 606 requires an entity to accrue the costs to transfer immaterial goods or services to the customer in cases where those costs are incurred after the satisfaction of the performance obligation (after the recognition of revenue). Under previous accounting standards, “the costs to fulfill the remaining performance obligations considered inconsequential or perfunctory”, would have been recognized when the revenue from the contract was recognized[1]. As a result, there may be swings in the recognition of direct costs in addition to revenue as a result of implementing Topic 606.
Therefore, the revenue and cost swings resulting from the implementation of Topic 606 could result in misleading earnings before interest, taxes, depreciation and amortization (“EBITDA”). EBITDA is a key metric amount in a business valuation. As a result, if a valuation metrics is not adjusted to take the revenue and cost timing swings into consideration, the result could be a business valuation that is inadvertently misleading.
In summary, to ensure a valuation is not inadvertently misleading, the valuation professional needs to be aware of the new Topic 606. The guidance will likely impact investor’s and the valuation analyst’s assessment of a company’s performance in addition to the underlying data supporting the analyst’s valuation metrics. The full version of the FASB Topic 606 can be accessed by clicking on the link below.
[1] Source: FASB Accounting Standards Update “Revenue from Contracts with Customers” (Topic 606) FASB Topic 606
[1] Financial Accounting Standards Board, ASC Topic 606