In 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued new standards for the recognition of revenue in contracts with clients. Globally, according to 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 these new accounting regulations affect the way businesses are valued.
In essence, the reason is simple: as this new accounting standard changes the accounting treatment of revenue, it alters 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 reviews.
What is revenue recognition?
Historically, accounting principles have consisted of broad revenue recognition concepts and various rule-based requirements for certain industries and transactions. The new accounting standard changes this to a model based on principles. Revenue is obtained when control of a good or service is transferred from the provider to the customer and is recognized at an amount that the provider expects to receive as compensation for the provision of the good or service. The five-step process of the new accounting standard provides for identifying contract (s) with a customer, identifying performance obligations in the contract, determining the transaction price, allocating the transaction price to performance obligations, and recognizing revenue as performance obligations are fulfilled. Under ASC the new accounting standard, revenue must be recognized over time, if any of the following are true:
• Your client receives and consumes the benefits at the same time;
• Your company creates or enhances an asset that the customer controls (for example, a work in progress);
• Your company does not create an asset with an alternative use for you and you have an applicable right to payment for work completed to date. Otherwise, you must recognize the revenue at a certain time, i.e. when control is transferred to the customer.
Why are the CPC, FASB, and the IASB making these changes?
There are several main reasons for the new standard and they aim at:
• Remove inconsistencies and weaknesses in revenue requirements;
• Provide a more robust framework to address revenue issues;
• Provide more useful information to users of financial statements through better disclosure requirements;
• Improve the comparability of revenue recognition practices between 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 sectors and will choose to invest where it will provide a good return. Everyone is competing for the same dollars, so a consistent pattern of revenue recognition for all sectors creates a more balanced field of action across sectors.
How does revenue recognition affect me?
There are a few ways in which the standard of the new standard affects organizations. Your method of when to recognize prescription may change, which may lead to recognizing it before or after what you have historically. The number of performance obligations in the contract may also affect the timing of revenue recognition.
Presentations and disclosures will change and, significantly, more information should be disclosed in the financial statements. You'll need to reevaluate how your contracts are written, especially in relation to termination clauses, amendment requests, 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 (for example, sales commissions and pre-contract costs) and fulfilling a contract (for example, bond premiums and mobilization costs). Both will likely need to be capitalized and amortized over the life of a contract, rather than being immediately disbursed.
Additionally, EBITDA and working capital may be affected because of changes in revenue and receivables. Cash flow needs may also be affected (for example, costs to restructure contracts, new system technology, tax implications, additional resources to understand and implement, etc.). And you'll need to consider principal versus agent status, since this will affect your gross versus net revenue presentation. And from the standpoint of internal controls, a company considering a sale can get better prices if it has good internal controls.
These are just a few of the impacts revenue recognition can have on your organization. It's not hard 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 profits 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 as of January 1, 2018.
What happens with my review?
Revenue recognition can be complex and difficult, and understanding how this affects evaluations requires an experienced professional to support analyses and implementations. The revenue recognition and valuation specialists at TATICCA — ALLINIAL GLOBAL can help your organization understand the effects of the new revenue recognition standard on your specific situation. Contact us to learn more or to start your assessment.