FASB’s new revenue recognition standard is expected to have wide ranging effects on M&A transactions. The new revenue recognition standard under GAAP (Accounting Standards Update 2014-09; Topic 606) will be applicable to public companies for annual reporting periods beginning after December 15, 2017. Thus the impact of the new standard should begin to be assessed for public company transactions that are negotiated in the fall of 2017. For private companies, the new standard will be effective a year later, for annual reporting periods beginning after December 15, 2018. This post provides a summary of the new accounting standard, describes several ways the new standard will impact M&A transactions, and offers sample representations for use in M&A transactions before and after the adoption of the new standard.
To understand the effect on M&A transactions it is helpful to consider some background with respect to the new standard.
The new standard sets forth a five-step process to recognize revenue arising from contracts with customers:
- Identify the contract(s)
- Identify the performance obligations
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the entity satisfies a performance obligation
The new standard permits two methods of transition. For purposes of comparing the two transition methods, consider a calendar year-end public company that must begin recording revenue using the new standard on January 1, 2018:
- Retrospectively to each prior period presented, subject to the election of certain practical expedients (“full retrospective method”). In its 2018 annual report, the company would revise its 2016 and 2017 financial statements to reflect recognition of revenue from customer contracts according to the new standard and record the cumulative effect of the change recognized in opening retained earnings as of January 1, 2016.
- Retrospectively with the cumulative effect of initially applying the new revenue standard recognized at the date of adoption (“modified retrospective method”). In its 2018 annual report, the company would not revise its 2016 or 2017 financial statements, but it would record the cumulative effect of the change recognized in opening retained earnings as of January 1, 2018.
While required footnote disclosures for the two transition methods are similar, there are subtle differences regarding disclosure about the effects of adopting the new standard:
- Full Retrospective Method: Required disclosures are to include the effect of the change on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), any other affected financial statement line item, and any affected per-share amounts. The foregoing disclosures are required for each reporting period that has been retrospectively adjusted but not for the current reporting period in which the new standard is adopted.
- Modified Retrospective Method: Required disclosures are to include the amount by which each financial statement line item is affected in the current reporting period by the application of the new standard as compared with the guidance that was in effect before the change and an explanation of the reasons for any significant changes.
We do not mean to suggest that the new standard will result in material differences in financial results for all companies. Many public companies have disclosed they do not believe the new standard will have a material impact, and a significant number are still in the process of evaluating the standard. Even if the impact on revenue or the bottom line is not material, extensive new disclosures must still be prepared. Whatever the resulting impact may be, the new standard represents a significant shift in methodology that should be considered in evaluating a proposed target.
Business Valuations and Valuation Metrics
A new accounting standard should not affect the valuation of an enterprise except in unusual situations. However, to the extent the new standard accelerates or delays revenues, it will impact EBITDA multiples and like metrics used to price transactions. Where revenue is accelerated, logically one would expect EBITDA multiples to decrease. While the valuation remains constant, a decreased EBITDA multiple could have a negative psychological impact on sellers who naturally seek to equal or improve on the multiples associated with the most recently reported transactions.
If revenue is shifted to later years under the new standard, it has the opposite effect – to increase EBITDA multiples. The wary buyer may think she is overpaying for the business.
What are the unusual situations where the new revenue recognition standard might actually affect the value of business? It is difficult to be specific, but it would probably be those situations where the new standard and related disclosures provide additional transparency into the economics of the business that provide new insights into valuations.
Changes in valuation multiples may not happen immediately. Transactions priced off of trailing twelve months results may reflect some mixture of a change in multiple for a period of time, especially in the earlier months.
The inability to make direct apples to apples comparisons with transactions before and after the adoption of the new standard is expected to persist from some time, especially in industries where comparable transactions do not occur regularly.
Forecasts and Projections
Confidential information memorandums associated with auctions often include forecasts or projections of future results. Caution is urged on the publication of forecasts where the impact of the new revenue recognition standard has not been evaluated. Alternatively, disclosure is urged if the forecasts do not consider the impact of the new standard.
Working Capital Adjustments
A change in revenue recognition patterns will affect the calculation of a target’s working capital. The change will be most difficult to deal with when the working capital target is determined before adoption of the new standard with a true up occurring after the new standard has been adopted. Solutions will include calculating working capital using existing standards for the true up (or using the new standard for the determination of the target) but the level of effort will need to be assessed as it will vary amongst companies and the alternative calculations may not be feasible for some.
Working capital targets are often calculated using an average of working capital for the twelve preceding months. Thus for transactions documented after the new standard becomes effective, a method may need to be developed to account for differing accounting principles during the look back period.
Much like working capital, the transition to the new standard may greatly impact the documentation and calculation of earn out payments in purchase agreements entered into before the new standard is effective. The obvious solutions present significant drawbacks. Parties could agree that earn out thresholds will be determined and measured using the new standard, but without visibility into the future impact of the new standard it will be difficult to determine applicable thresholds for earn out payments. Parties could alternatively require that earn out thresholds and company performance will be determined under the current standard for the duration of the earn out period, but requiring the target to keep two sets of books in order to calculate earn out payments using the current standard far into the future may be exceptionally burdensome. Transaction parties that are determined to use financial statement metrics for an earn out should search for bench marks that are not affected or least affected by the new standard, such as net cash provided from operating activities as set forth in the statement of cash flows. It is possible non-financial statement based milestones may become more prevalent for a period of time.
The new standard will affect more than top line revenue, and deal teams will need to assess the total impact of the transition. The new standard can affect how costs associated with revenue are recognized, and shifts the analysis from a matching principle to a balance sheet inquiry. Accruals for income tax are important as well. It is possible that adopting the new standard to recognize revenue for financial statement purposes means the target is no longer using a method permitted by the IRS for tax purposes. If not, the target may need to comply with IRS procedures to employ a new method of revenue recognition for tax purposes. Other areas need to be considered as well, such as the impact of the new standard on incentive compensation based on financial statement metrics and sales commissions.
SEC Registration Statements
Public companies that need to file a registration statement on Form S-3 to sell securities to finance an acquisition must also consider impacts resulting from the interaction of the new standard with the S-3 rules. Public companies that adopt the new revenue recognition standard using the full retrospective method may encounter difficulties if a Form S-3 is filed after the first quarter of 2018. Item 11(b)(ii) of Form S-3 requires restated financial statements to be filed if there has been a change in accounting principles that requires a material retroactive restatement of financial statements. This would require filing of restated financial statements for 2015, 2016 and 2017 significantly in advance of the 2018 Form 10-K (likely filed in the first quarter of 2019), and restated 2015 financial statements would not otherwise be required. This can be avoided if the Form S-3 is filed during the first quarter of 2018 because during this time period no public filings have yet been made that reflect a material retroactive restatement of financial statements.
SEC Form S-4 is often used to register securities issued in M&A transactions such as stock-for-stock mergers. Items 10, 12 and 15 of Form S-4 include similar requirements to Form S-3.
When acquisitions are financed with debt that includes financial covenants, the impact of the new revenue recognition standard will have to be considered when negotiating the financial covenants. Lenders may also be interested in the same due diligence maters as acquirors.
Representations and Warranties before Adoption of the New Standard
It is likely that transition to the new standard will result in new representations being included in acquisition agreements. For public companies, any such specific representations may begin to appear later in 2017 and the first quarter of 2018, before a company actually issues any financial statements reflecting the new revenue recognition standard. Many acquirors will simply want contractual protections to the effect that the target is prepared to adopt the new standard and its prior disclosures on this matter have been accurate. The representations for public companies could take the following form, although perhaps with more qualifiers if the issuance of financial statements is not imminent and work to adopt the standard is ongoing:
The Company has developed disclosure controls and procedures required by Rule 13a-15 or 15d-15 under the Exchange Act which the Company anticipates will be effective to ensure that information required to be disclosed by the Company pursuant to Topic 606 [FN 1] and Subtopic 340-40 [FN 2] of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”) is recorded and reported on a timely basis to the individuals responsible for the preparation of the Company’s filings with the SEC and other public disclosure documents. The Company has developed internal controls over financial reporting (as defined in Rule 13a-15 or 15d-15, as applicable, under the Exchange Act) which the Company anticipates are sufficiently designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the Revenue Recognition Standard. The Company’s disclosure of the impact of the adoption of the Revenue Recognition Standard set forth in [describe SEC filing] is true and correct in all material respects and is in accordance with Staff Accounting Bulletin No. 74 promulgated by the SEC.
FN 1: Topic 606 is the heart of the new standard.
FN 2: Subtopic 340-40 is a corollary to the new standard and is captioned “Other Assets and Deferred Costs—Contracts with Customers.”
Representations and Warranties after Adoption of the New Standard
Once financial statements have been issued which reflect the adoption of the new standard, the representations could take the following form if an issuer has used the modified retrospective method to adopt the new standard, but as usual subject to negotiation:
The Financial Statements [describe financial statements] have been prepared reflecting the adoption of Topic 606 and Subtopic 340-40 of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”). The Company elected to utilize the modified retrospective method of transition beginning [January 1, 2018]. Footnote [insert reference] to the Financial Statements accurately states in all material respects (i) the amount by which each Financial Statement line item is affected [describe reporting period] by the application of the Revenue Recognition Standard as compared to GAAP that was in effect before the change and (ii) the reasons for each significant change identified. [FN 3] Footnote [insert reference] to the Financial Statements accurately states in all material respects the judgments, and changes in judgments, made in applying the Revenue Recognition Standard that significantly affect the determination of the amount and timing of revenue from contracts with customers. [FN 4]
The Company has implemented disclosure controls and procedures required by Rule 13a-15 or 15d-15 under the Exchange Act which are effective to ensure that information required to be disclosed by the Company pursuant to the Revenue Recognition Standard is recorded and reported on a timely basis to the individuals responsible for the preparation of the Company’s filings with the SEC and other public disclosure documents. The Company has implemented internal controls over financial reporting (as defined in Rule 13a-15 or 15d-15, as applicable, under the Exchange Act) which are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the Revenue Recognition Standard.
FN 3: See ASC 606-10-65-1i.
FN 4: See ASC 606-10-50-1.
For issuers that have used the full retrospective method of accounting, the first paragraph of the foregoing representations could be replaced with the following paragraph, subject to negotiation (with changes from the modified retrospective method representation noted as well):
The Financial Statements [describe financial statements] have been prepared reflecting the adoption of Topic 606 and Subtopic 340-40 of the FASB Accounting Standards Codification (the “Revenue Recognition Standard”). The Company elected to utilize the modified full retrospective method of transition beginning [January 1, 2018]. Footnote [insert reference] to the Financial Statements accurately states in all material respects (i) the amount by which each Financial Statement line item is affected [describe reporting period] by the application of the Revenue Recognition Standard as compared to GAAP that was in effect before the change and (ii) the reasons for each significant change identified the effect of the change on income from continuing operations, net income [or describe other appropriate captions of changes in the applicable net assets or performance indicator], any other affected financial statement line item other than the effect on financial statement totals and subtotals, and any affected per-share amounts for [list prior periods that have been retrospectively adjusted]. [FN 5] Footnote [insert reference] to the Financial Statements accurately states in all material respects the judgments, and changes in judgments, made in applying the Revenue Recognition Standard that significantly affect the determination of the amount and timing of revenue from contracts with customers.
FN 5: See ASC 606-10-65-1e.