Last year, after six long years of work, the Federal Accounting Standards Board (FASB) and its global counterpart the International Accounting Standards Board (IASB) agreed to a new, converged revenue recognition standard.
The new five-step standard will replace hundreds of industry-specific revenue recognition requirements under US GAAP, and enhance the limited guidance found in international financial reporting standards (IFRS). For private fund GPs, the shift promises an easier way to compare and contrast the top-line growth at companies worldwide.
FASB voted to delay the timeline for adopting the new standard by one year this past July. Now, for public companies following US GAAP, the new rules take effect for annual reporting periods beginning after December 15, 2017. Private companies following US GAAP will have until 2018 to adopt, but have the option of adopting early alongside their public counterparts. Meanwhile, companies using IFRS must apply the new revenue standard for reporting periods beginning on or after January 1, 2017, but can begin doing so early, regardless of their public/private status.
The implementation delay was welcomed by the industry, after stakeholders argued that the original timetable did not allow enough time to revamp their practices. But GPs are being urged by accounting advisors not to wait to address the standard’s impacts, but rather to recognize the deferral as a sign of how significant an undertaking its adoption will be.
“The ‘rev rec’ standard is clearly on the agenda with the private equity finance folks, but what I’m seeing is that there are a number of things that are higher priority,” Scott Gehsmann, deal partner in the compliance practice at PwC, tells pfm. He cites issues like the consolidation standard and deal costs allocations taking precedence.
As of now, the standard may be low on the priority list, but its changes will impact high-priority firm functions. Carried interest accounting may be subject to a total overhaul, and changes to key financial metrics and ratios at portfolio companies, including EBITDA, could affect due diligence, investment and exit strategies.
“If they haven’t commenced the dialogue, they need to start,” Gehsmann warns.
At the management company
Today, most GPs record carried interest as it’s achieved – either when a portfolio company is exited, or when a fair value estimate indicates they’ve achieved the performance fee on paper.
The new rules, however, say that any carry subject to a clawback is not firm revenue until it is certain the cash will stay firmly in the GP’s pocket. In other words, carry isn’t carry until it becomes impossible for a single bad investment to result in revenue being clawed back.
For Matt Maulbeck, professional practice partner at EisnerAmper, the standard’s effect on carry reporting will be “the most impactful thing” for private equity managers.
“The new standard will require them to defer the recognition of performance fees until collection is certain, which may take several years,” he tells pfm.
The manager may still be paying certain employees as usual, based on the underlying economic performance of its funds, so this change in reporting might yield a discontinuity between when employees receive carry versus when its accounted for in the books. In the past GPs might have been able to match those revenues and expenses, Maulbeck notes.
Moreover, the way carry is recorded in a firm’s financial statement may no longer sync with what LPs are told. Most managers will be able to clarify any discrepancy with confused LPs with a few phone calls – but publicly-listed firms like KKR and The Blackstone Group may need to explain the situation to outside analysts. This may even lead analysts to begin considering non-GAAP financial metrics, in order to better track these firms’ earnings, says David Larsen, managing director at Duff & Phelps.
“Any analyst following that stock would have to look at non-GAAP measures as opposed to GAAP measures, because a big chunk of the revenue would be missing quarter to quarter,” says Larsen.
The new standards do not allow for a seamless transition for publicly-listed private equity management companies, but Larsen reckons FASB and IASB were aware of that fact when they created the standard, and CFOs from this narrow group of the market will be able to adjust.
“It just means GAAP may no longer become the primary basis to evaluate performance of those management companies, and highlights that a universal accounting standard doesn’t necessarily work for everybody,” he says.
At the portfolio company
Although the deferral may make it seem as though compliance with the new standards is a long way off, the fact that IFRS will allow early adoption may become an issue sooner than expected. Various countries are adopting IFRS as an entire body of work at different points in time, and if a private equity firm is buying a company in the US and comparing it to public market comps reporting under IFRS, it will add an extra layer of work.
“If they have adopted IFRS, you’re comparing apples to oranges as far as multiples go. That’s where you have a due diligence problem,” says Larsen.
GPs should make sure that their deal valuation models take into account the impact of the new standard. For example, if revenues were being deferred under current GAAP, but are recognizable earlier under the new standard, the previously deferred revenue could be “lost” upon transition to the new standard for financial reporting purposes, noted Gehsmann in a recent industry article on the subject.
And when managing investments, debt covenants should be considered, because the amount, timing and pattern of revenue recognition and EBITDA could change under the new standard, Gehsmann added. If a revenue transaction with a customer includes a significant financing component, because of differences in timing between payment and performance under the contract, more or less revenue could be recognized than under current rules.
Portfolio company exits planned before the rule becomes effective will be confronted with disclosure challenges around the projected impact of the new standard on the company, the article noted, further complicating matters.
Despite these concerns, the new standard will have a positive impact on due diligence and valuations as well, allowing managers to have more information right at their fingertips when assessing a company with audited financial statements, says Maulbeck.
“The standard will require more disclosure around revenue recognition. Specifically, it requires more disaggregation of what companies need to report, especially around the nature of their revenue, the uncertainties around cash flows in their revenue and what judgements are made in terms of the revenue they’re booking,” he says.
Mark your calendars
CFOs should be planning how to handle these impacts now, and communicate the significance to the whole firm, especially because accounting personnel are not the only ones who will be impacted. Lack of preparation and knowledge from the deal team could lead to lost revenue and lost time.
“The challenge we see is that the people in private equity firms doing the deals are typically not accountants. Getting an accounting focus involved on the front end during deal making is going to be important around this standard. We see that as a looming surprise for some of them when the impacts of the standard start to bite,” notes Gehsmann.
Within a portfolio company itself, it’s going to take some time to adapt from an operational standpoint –shifting internal accounting systems and potentially changing contracts and paying for the associated costs, notes Larsen.
Although he admits, it’s human nature to “wait to deal with it until it’s right in front of you,” Maulbeck notes that firms receiving substantial upfront fees and incurring upfront costs have more data to track, and will have to consider whether current processes and systems are sufficient for meeting the requirements of the new standard.
GPs would be wise to start thinking about these concerns before the end of this calendar year, Gehsmann says. “This topic just can’t fall off the list.”