This Accounting Change Might Give you Pause About Buying or Selling a Business

2019 brought with it one big change for those in the accounting and finance space that privately held companies have been working diligently to implement. Beginning on January 1, 2019 (January 1, 2018 for public companies), calendar year-end private companies were required to adopt a new, principles based revenue recognition standard, FASB ASU 2014-09, Revenue from Contracts with Customers (Topic 606).

The cynic might be prone to complain this change to accounting rules is simply the “full employment act for accountants,” but a closer look at the change should, at a minimum, bring pause to those thinking about buying or selling a business.

The Context

Topic 606 was created for a host of reasons; primarily to create consistency in the way revenue is thought about across entities, industries, jurisdictions and capital markets. It also designed to include revenue disclosure.

In creating a new principles based framework, Topic 606 introduces more judgment and discretion relative to previous revenue recognition guidance.

How Revenue Recognition Changes Affect M&A

Changes associated with Topic 606 also impact the timing and recognition of some expenses. When adopted, an entity may retroactively defer revenues or expenses, they could also accelerate revenue recognition, or not have any impact at all.

Certain industries (most notably licensors such as media, life sciences, franchisors, software, and aerospace and defense) were impacted to such an extent that many companies are materially altering the amount and timing of their revenue or expense recognition. As a result, comparing a company’s revenues and earnings in 2019 versus prior years may be challenging. Furthermore, the comparability across companies in the same industry is now potentially more difficult due to the introduction of more judgement in the revenue recognition process.

Last, and certainly not least, the income tax implications of the new revenue recognition rules should be fully understood. This is especially true in the lower middle market, where income tax consequences often play an outsized role in strategic decision making. In certain situations, companies that recognize revenue earlier under Topic 606 will also be required to pay tax earlier, even if cash has not yet been received. This change came about as a result of a change in the 2017 tax reform law commonly known as the Tax Cuts and Jobs Act.  

At the end of the day, revenue recognition changes driven by accounting standards generally will not impact the cash flows of an entity.  They may however, affect metrics commonly used as substitutes for cash flows, such as EBITDA. In transition, some entities may even recognize revenue or expense twice (in the year before implementation and the year[s] after) or not at all (with the revenue booked directly to retained earnings).

How to Navigate Revenue Recognition in Deal-Making

Understanding the impact on the timing and presentation of revenues and expenses will be important when evaluating a target and negotiating key contract terms, such as earn outs. Buyers and sellers of businesses should confirm they, along with their advisors, have answers to the following questions:

• How are the changes under Topic 606 generally impacting the industry in which the business is operating?
• Have changes under Topic 606 been implemented? How were they applied and what reports and other information reflect the changes?
• If adopted, was the population of impacted contracts correctly identified and the associated adjustment accurately quantified?
• Have adjustments recognized under Topic 606 been taken into account when quantifying the enterprise value (if using an income valuation approach such as a multiple of EBITDA or revenue) of the business?

John Shoemaker is a Senior Manager in the Kansas City office of CBIZ and MHM, a Top Ten national accounting provider. He specializes in transaction advisory.