CEO’s and Boards are usually inclined to think that changes in accounting rules are matters that only their CFO needs to worry about. Not true at all in the case of the new revenue recognition standards recently promulgated under the converged authority of the (U.S.) Financial Accounting Standards Board and the International Accounting Standards Board.
Understanding the business impact of the new rules should be a priority for CEO’s and Boards, especially those that might be interested in raising capital or selling their company within the next five years.
How to Prepare for The New Revenue Recognition Rules
Preparing proactively for the new rules can go a long way to minimize the cost and time of restating prior period results in a few years when the rules come into effect. Taking action now to get your arms around this issue, understand and communicate its impact to stakeholders and develop long-term processes to minimize related cost and disruption should be an immediate priority for many companies.
The new standard is expected to have the most impact on companies in industries like software, health care, telecom, aerospace and defense, life sciences, real estate, asset management, building and construction and contract manufacturing, in which:
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Sellers bill customers and record revenue for services in advance of entirely fulfilling their commitment to provide those services, or
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Sales involve contingencies that will affect how much revenue billed today must be deferred.
Many sales, especially in the high-tech economy, are actually a bundle of different components, e.g. hardware, software and services. Accounting principles say that each component of a sale should be recognized in the period in which it is actually earned.
The new accounting standard basically requires your company to undertake a more rigorous analysis and segregation of revenue components, assigning them to the time periods in which they are earned and contingencies are satisfied. Companies will be required to follow a 5-step model and multiple decision trees to address various contingencies including implied financing components, which in itself is a migraine-worthy task.
The new standard also addresses revenue recognition issues such as discounts, rebates, refunds, credits, incentives, performance bonuses/penalties, royalties, price concessions and rights of return. In some cases the new rules may actually lead to earlier revenue recognition for some entities.
Based on how arduous the process promises to be, there’s a temptation to defer considering the impact of the new standards. On the surface there appears to be plenty of time: the new standard is only required to be adopted by publicly held entities (and certain non-for-profits) for fiscal years beginning after December 15, 2016. Privately held companies must adopt the new standard for fiscal years beginning after December 15, 2017, though they are permitted to adopt one year earlier. But there is a devil in these details.
Under two of the three alternatives permitted for transition to the new rules, companies will basically have to restate revenue for prior periods that were originally reported under the old rules—so that they are comparable with the period that is presented based on the new standard. Generally, privately held companies will have to restate one prior year and SEC registrants will have to restate two prior years.
SEC registrants may even be required to restate four prior years of selected financial data tables, including segment reporting tables. Private companies preparing for a capital transaction could be faced with similar restatement challenges when they present their historical financials for comparison with current financials that are prepared under the new standard.
Whatever the exact specifics of the transition, the key point is this: if the sales/services contracts you perform in the years leading up to your cut over to the new standards are material to your business, you may have to go back and disaggregate the revenue related to these contracts, even if they date back many years.
What are the implications?
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Revenue, costs and EBITDA will change for some companies—and with them their company’s valuation.
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Exit planning strategies may be affected. In some cases the net impact of the new standards on your financial statement results may be positive. Being proactive in restating your financials according to the new standards and quantifying the impact on your business can make a positive impression on a prospective buyer, as well as simplifying and shortening the due diligence process.
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If the new standards affect taxable income, tax planning may need to be adjusted. Debt covenants also may need adjustment.
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If your competitive situation allows it, you may be able to adjust contractual sales terms with your customers to produce more desirable reporting results than current terms and/or to simplify the accounting process.
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Setting up systems now to examine contract elements and capture the required data will save you time and money later on. Putting off these tasks may lead to extensive, expensive research through old records.
CEO’s and boards of private companies that will be particularly impacted by the new accounting rules might consider asking an advisor or board director to help assemble and oversee such a project team.
You’ve spent years building the value of your enterprise. Don’t let compliance with new standards jeopardize your company’s true worth. Don’t procrastinate. Seize the day.
About the Author
Fred brings to Newport extensive background as a CFO and corporate leader. He has a track record of enhancing shareholder value across engineering, manufacturing, distribution, infrastructure projects, project financings, financial services and high-tech firms. Contact or learn more about Fred here.
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