Impacts of Revenue Recognition on Private Equity
Accounting Standards Codification Topic 606 (“ASC 606”) is a new revenue recognition standard that affects all companies that enter into contracts with customers. ASC 606 went into effect for public companies for periods beginning on or after January 1, 2018, and for private companies for periods beginning on or after January 1, 2019. The Standard has the potential to have a profound impact on revenue recognition criteria for companies across all industries.
Private equity (“PE”) firms and their portfolio companies will also encounter many challenges as they adopt and incorporate the new standards, as 2019 financial statements will be the first reporting under this new standard for most portfolio companies. Not only will portfolio companies be impacted, but funds themselves may encounter material changes to valuations as a result of ASC 606. Accounting treatment may not directly impact the cash flow from customers, but it may change cash flow as it relates to required distributions, and earn-out and claw back calculations.
As PE funds pursue transactions related to acquiring or selling portfolio companies, the timing of revenue recognition for a portfolio company may be affected based on the new five-step assessment model. The portfolio company’s debt covenant compliance, anticipated earnings before income, taxes, depreciation, and amortization (“EBITDA”), contingent consideration calculations, and the ultimate acquisition decision may change based upon this assessment and the implementation of ASC 606.
PE firms will also need to evaluate how revenue recognition may affect the valuation of the underlying portfolio companies within the fund. Whether a fund utilizes an EBITDA multiple, discounted cash flow model or a comparable company analysis to value its portfolio companies, a change in revenue recognition may affect the fund’s valuation.
The results of items governed by the PE firm’s partnership agreement may also be affected, as the timing of revenue recognition may change the allocation of profits and losses, fees, and potentially carried interest calculations.
Now that you know how the standard may affect your company, how can your PE firm assess the impact of compliance with ASC 606?
- Fund managers should remain alert to changes in a portfolio company’s EBITDA as a result of 606 implementation, especially if a transaction is imminent,
- A firm’s management fees allocation terms should be reviewed. ASC 606 will limit recognition of variable consideration so that revenue is recognized only when it is probable that it will not change substantially when any related uncertainty is resolved. A fund’s portfolio companies’ contingent considerations should be re-assessed to determine if the respective targets were affected by changes in timing of revenue recognition.
If you have questions about ASC 606 or how it may affect your private equity firm, reach out to your Cherry Bekaert professional. We are here to help guide you forward with your specific needs in mind.