Revenue recognition standards and lease accounting changes are upon us. Bloomberg is calling them “the most historic accounting changes to hit U.S. capital markets in decades.” Are you ready?
For several years now we have sought to focus your attention on two particularly important accounting standard changes that will soon take effect: changes in lease accounting standards (effective December 15, 2019, for nonpublic companies) and the revenue recognition update (effective December 15, 2018, for nonpublic companies). For many businesses, these changes could impact how private equity professionals view and judge the performance and valuation of their companies. The new rules could change such things as top-line revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization). There could also be significant implications for budgets, debt covenants, bonus plans, and more.
If you haven’t already begun working with your BGW team members to manage this transition, we urge you once more to begin the process. The upcoming changes are more than most businesses can handle themselves.
Revenue recognition changes
ASC 606 replaces industry-specific norms of accounting for revenue with a principles-based common standard. How much things will change depends on your industry. Companies that currently follow specific industry-based GAAP, such as software, real estate, asset management and wireless carrier companies, will feel the biggest changes. But virtually all companies will be affected by the expanded disclosure requirements.
A five-step process for customer-contract revenue recognition that focuses on the transfer of control (instead of the transfer of risk and rewards), and is central to the new revenue recognition update:
- Identify the contracts. Answer the question, “Do I have a new agreement?” OR “Is this a modification of an existing agreement?”
- Identify performance obligations. “What do I deliver/do?”
- Determine the transaction price. “What do I expect to be paid? Do I owe anything?”
- Allocate the transaction price to performance obligations. “Do I need to split up the payment(s)?”
- Recognize the revenue. “Have I earned the payment?
Enhanced disclosures must detail the amount, timing, and uncertainty of revenue from contracts.
Lease accounting changes
ASC 842, Leases, will affect the balance sheets of businesses. Most notably, operating leases previously reported as rent expense on income statements and disclosed in notes to financial statements will appear on balance sheets. That will significantly increase liabilities (lease liability) and assets (right-of-use asset) for most businesses. Further, the liability will have a short-term and long-term portion, while the asset will be all classified as long-term. ASC 842 may also change debt-to-equity ratios, EBITDA, and other metrics that borrowers use to determine company creditworthiness and metrics investors use to value the business.
Significant Impact on Small Business
You know the drill: Big companies have enough in-house accountants to handle the increased workload that new mandates bring. Small and middle-market firms do not. Our biggest concern for our clients is that putting these new rules into practice is going to be incredibly burdensome. In addition to increased manpower needed to pore over existing contracts and lease agreements, resources for IT will have to be increased. Businesses will also have to explain any significant changes in their disclosures and do so in a way that allows investors to easily understand the nature and reason for any changes. There is major work ahead. For those in the business of software, specialty manufacturing contractors, and healthcare, and those operating franchises, we see a particularly difficult transition.
A few questions to ponder:
- What changes are needed to our company’s revenue-recognition and lease policies due to the new standards, and what are the potential financial and tax impacts of those changes?
- What education will my employees need? How can we educate investors/analysts/creditors so they understand any changes to financial results?
- Does my firm have a plan, a timetable, and an understanding of the financial we’ll need to make this transition?
- Will the new standards potentially impact business practices, such as IT and other systems, risk monitoring and controls, contract and loan agreements, budgeting and forecasting, key performance indicators and compensation plans, as well as joint ventures and alliances?
Businesses need to be proactive
Revenue and lease-rule changes will require many businesses to be proactive with creditors, banks, and bondholders, or risk breaching debt and loan covenants. In addition, you must realize that the changes can impact other areas of your business -- even employee compensation and bonuses. Smart businesses will get ahead of these changes sooner than later.
It will require extensive help, and we urge you not to wait. Please reach out to us.