In 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued new standards for recognizing revenue in customer contracts. Globally under IFRS it is IFRS 15, in the United States ASC 606 and in Brazil it is CPC 47 (issued by the Accounting Pronouncements Committee - CPC). What you may not know is that this new accounting policy affects how businesses are valued.
In essence, the reason is simple: because this new accounting standard changes the accounting treatment of revenue, it changes the numbers used to value a company. But revenue recognition is complex, and it's worth cultivating a deeper understanding of how and why it affects valuations.
What is revenue recognition?
Historically, accounting principles have consisted of broad revenue recognition concepts and various rule-based requirements for particular industries and transactions. The new accounting standard changes this to a principles-based model. Revenue is earned when control of a good or service is transferred from the provider to the customer and is recognized in an amount that the provider expects to receive as consideration for providing the good or service. The new accounting standard's five-step process provides for identifying the contract(s) with a customer, identifying the performance obligations in the contract, determining the transaction price, allocating the transaction price to the performance obligations, and recognizing the revenue as performance obligations are met. Under ASC the new accounting standard, revenue must be recognized over time if any of the following is true:
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Your customer receives and consumes the benefits at the same time;
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Your company creates or enhances an asset that the customer controls (eg, a work in progress);
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Your company does not create an asset with an alternative use for you and you have an applicable entitlement to payment for work completed to date. Otherwise, you must recognize revenue at a certain point in time, that is, when control is transferred to the customer.
Why are the CPC, FASB and IASB making these changes?
There are several main reasons for the new standard and they aim to:
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Remove inconsistencies and weaknesses in revenue requirements;
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Provide a more robust framework for addressing revenue issues;
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Provide more useful information to users of financial statements through improved disclosure requirements;
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Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.
Comparability is important because users of financial statements are typically financial institutions and investors, who have a lot of choice between industries and will choose to invest where they will provide a good return. Everyone is competing for the same dollars, so a consistent pattern of revenue recognition across industries creates a more balanced playing field across industries.
How does revenue recognition affect me?
There are a few ways in which the new standard's standard affects organizations. Your method of when to recognize revenue may change, which could lead to recognizing it earlier or later than you have historically. The number of performance obligations in the contract can also affect the timing of revenue recognition.
Presentations and disclosures will change and significantly more information will need to be disclosed in the financial statements. You will need to re-evaluate how your contracts are written, especially regarding termination clauses, change orders, and contract duration. The terms of the contract become even more important. Previously, they were legally important, but now they are equally important for accounting. Other impacts include the costs of obtaining a contract (eg, sales commissions and pre-contract costs) and fulfilling a contract (eg, bond awards and mobilization costs). Both will likely need to be capitalized and amortized over the life of a contract, rather than being immediately disbursed.
In addition, EBITDA and working capital may be affected because of changes in revenue and receivables. Cash flow needs may also be affected (eg costs to restructure contracts, new system technology, tax implications, additional resources to understand and implement, etc.). And you will need to consider principal versus agent status as this will affect your gross versus net revenue presentation. And from an internal control perspective, a company considering a sale can get better prices if it has good internal controls.
These are just some of the impacts that revenue recognition can have on your organization. It is not difficult to see how the new accounting standard also impacts valuations. When we value a business, we use an income approach and a market approach. The income approach to valuations asks what someone would be willing to pay based on earnings or cash flow. The market approach asks what someone in the market would be willing to pay based on earnings or cash flow. Undoubtedly, revenue recognition affects both approaches.
When do I have to adopt IFRS 15 / CPC 47?
Companies must adopt IFRS 15 / CPC 47 since 1st. January 2018.
What happens to my assessment?
Revenue recognition can be complex and difficult, and understanding how this affects valuations requires an experienced professional to support analysis and implementation. TATICCA – ALLINIAL GLOBAL's revenue recognition and valuation experts can help your organization understand the effects of the new revenue recognition standard on your specific situation. Contact us to learn more or start your assessment.