Editor’s Note: On July 17th, 2019 the FASB proposed delaying effective dates for four key accounting standards (accounting for leases, credit losses, hedging and long duration insurance contracts). Check out our blog, FASB Proposes Delay in Major Accounting Standards for more information.

Private equity (PE) firms need to prepare investors for major changes under US Generally Accepted Accounting Principles (GAAP) that will soon hit companies’ financial statements. These changes could alter key financial ratios that PE investors use to evaluate financial performance. Here are the details.

New Guidance for Contract Revenue

Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, goes into effect for public companies in the first quarter of 2018. Private companies don’t have to make the changes until 2019, but early adoption is permitted for all entities. So, it may be hard to tell which companies have implemented the changes, possibly resulting in apples-to-oranges comparisons.

The new revenue recognition standard will change when and how companies record the top line in their income statements. It will also expand the footnote disclosures about the nature, amount, timing and uncertainty of revenue that’s recognized. The standard is expected to have a big impact on such entities as construction contractors, software companies, wireless providers, media companies and asset managers.

Effect on Financial Ratios

When buying or selling companies, revenue is a key value driver. PE firms generally prefer investments with track records of consistent revenue growth and prospects for continued growth in the future. As companies implement the new revenue recognition standard, they may report revenue earlier or later than they would have under the previous rules.

If implementing the new standard causes a company in your portfolio to miss its revenue target, it could alarm investors or cause the acquired company to default on its debt covenants. Conversely, if an acquired company hits its revenue target only because the new standard calls for earlier-than-expected revenue recognition, investors could be misled into believing the company is healthier than it really is.

Changes in the amount of revenue recognized during the accounting period will also trickle down to financial ratios that have revenue in the numerator or denominator, such as:

• Profit margin (net income ÷ revenue),
• Gross margin [(revenue – cost of sales) ÷ revenue],
• Total asset turnover (annual revenue ÷ total assets), and
• Days in accounts receivable (average accounts receivable ÷ annual revenue × 365 days).

More Changes Coming Soon

Unless you’re a CPA or CFO, you probably haven’t given much thought to the new revenue recognition standard or how it will impact an investment’s performance metrics. You also might not be aware of other major accounting rule changes in the pipeline that will impact companies’ financial statements and ratios. Examples include:

• The lease standard (which goes into effect in 2019 for public companies and 2020 for private companies),
• The credit loss standard (which goes into effect in 2020 for public companies and 2021 for private companies), and
• The debt classification standard (which also goes into effect in 2020 for public companies and 2021 for private companies).

Contact Us

In recent years, the Financial Accounting Standards Board has been busy updating the financial reporting guidance under US GAAP. As companies start to implement the changes, their financial statements and key financial ratios could be affected.

Our accounting and assurance professionals are on top of the upcoming implementation dates for the new accounting rules. We can help you understand the changes and which companies have implemented them. We can also help explain to investors how the changes will affect prospective acquisition targets and existing investments in your portfolio.