How new IFRS accounting rules can turn a good deal into a bad one
This article was originally published by CVCA in February 2018.
Changes to the reporting standards for revenue from contracts (IFRS 15) took effect on Jan. 1, 2018, and they have the potential to change a good acquisition into a bad one—or vice versa.
Most of the changes come from the International Financial Reporting Standards (IFRS), whereby Canadian publicly traded companies must comply starting Jan. 1, 2018 (see here for RSM’s analysis of what IFRS might mean to you). In addition to changes in the IFRS standards, there are new changes to Generally Accepted Accounting Principles used in the United States (US GAAP).
These changes may affect you when dealing with companies reporting under either of these two accounting frameworks, whether you are on the acquisition side, or preparing a company for sale over the next few years. As such, the changes pose the risk that performance of a company (previously reporting financials under old accounting standards) may appear more or less favorable under the new revenue from contracts standards under IFRS or US GAAP. In addition, the changes could influence key covenants under banking arrangements.
Here are some company characteristics that should raise flags for you and may require additional investigation:
Does the company have multi-year contracts with suppliers or customers?
These contracts can often include rebates, volume discounts, volume incentives, referral bonuses and other incentives, which may be accounted for differently going forward.
Has the company yet to determine what a standard contract should look like (particularly applicable to startups)?
These companies often have customized contracts for each customer which may need to be treated differently and thus each contract is reviewed individually to gauge impact.
Are there long-term contracts for the delivery of multiple goods or performance of multiple services?
Now termed “performance obligations”, the accounting standards have more guidance about whether the goods or services in the contract are distinct and provide clarity on the allocation or timing of recognition of revenue to each component.
These are a few of the many potential problem areas and you may need to focus more effort in diligence to uncover potential surprises—either good or bad—in a target company’s financials. This additional effort, particularly in the context of structuring banking agreements and covenants, should be identified early to ensure a smooth transition post close.
When preparing to sell, it will be important to understand how any of these changes may impact the near-term revenue and profitability of the company.
Transition options under the new standards
There are different options for transition to the new standard, and a change in revenue recognition may result in restatement of prior years’ revenue amounts preserving comparability. However, there is an option not to restate comparative information resulting in amounts that may no longer be comparable between years. Reporting the previous year’s financial results using the previous accounting method, and the current years’ financial statements compliant with the new IFRS standard may distort the true historical earnings trend. Both sets of financials may be accurate representations but under different rules. Your goal should be to establish whether you can make an apples-to-apples comparison between years and between companies, or if you are in fact comparing inconsistent numbers. It is important to note that this change in reported revenue may have an impact on valuation without there being any “real” economic changes in the prospects of the business.
Looking for surprises in financial figures
A surprise that may be uncovered in diligence may be around when the company recognizes revenue, particularly from ongoing contracts.
Consider, for example, an equipment dealership that sells its merchandise “one dollar over our supplier’s cost.” They leave unstated the fact that if they hit a certain volume each year, they get a significant rebate from their supplier, issued annually. The proper account treatment for this type of arrangement would be to accrue the expected rebate—products are sold evenly throughout the year and adjusting as new information may determine other levels of rebates. This is a departure from how existing GAAP standards would have treated this.
Contracts with multiple goods, or performance obligations, may now have a portion of that revenue deferred, or recognized more quickly. It is important to note that how revenue is recognized has no effect on the company’s long-term prospects—but how the revenues get recorded on a yearly basis may change significantly.
The main problem, for due diligence and valuation purposes—as well as deciding whether to proceed with a potential deal—has to do with cash income that occurs in large lump sums and over a period of time may not be representative of how the financial statements will recognize revenue.
Due diligence and valuation processes need to take these standard changes into account, by looking for red flags such as those listed above. For example, anyone involved in deal-making will need to take a closer look at the impact on financial statements they are analyzing. This is particularly the case if there are complex contracts involved in the company’s revenue stream, or if it has financial payment obligations that may come in lump sums.
A qualified professional can work with you to find out if there are any surprises, either good or bad, in a target company’s financials. Based on their experience with other companies, they would have a good idea of potential problem areas and can help you get past this new wrinkle in the due diligence and valuation processes.