How might the target’s revenue model change under the new standard?
As the dealmakers are modeling a target firm’s future revenue, they need to consider the target’s current revenue model as well as what that model will look like in the future. Dealmakers must ask themselves, “What assumptions are we building into the deal model related to revenue recognition, and do we understand how the target’s financial model is going to change under the new standard?”
For example, if a major value driver of the deal is a stable, recurring revenue stream generated by the target, the potential acquirer will need to determine whether that revenue stream will remain stable and recurring under the new revenue recognition standard, or whether it will become more “lumpy.” Dealmakers should also consider the method of transition (full retrospective or modified retrospective) the target has selected or plans to select. The transition method will impact the level of comparability between prior period and future results
Why is the target’s readiness for transition important?
- For public acquirers seeking to buy a company just before the new standard implementation date, dealmakers need to consider how prepared the target is for the transition. If the target is private, it has had a longer preparation “runway” than the public acquirer has had, and it may not have set up needed systems and processes. In such cases, the acquiring company may purchase the target only to discover that it’s unable to close its books under the new standard.
- There’s a cost element to consider as well. As the acquiring company is building its deal model and looking at expense lines, a key question is whether the target has budgeted adequately for the capital expenditures and operational expenses needed to implement systems and processes related to preparation for and adoption of the new standard. Dealmakers must build this consideration into their cash-flow assumptions to avoid overpaying for the target.
- Post-merger integration (PMI) complexity can be another concern. If the target has not prepared for the new standard, getting it ready to switch to the standard during the PMI period may call for significant effort on the acquirer’s part—during a time when resources may already be stretched thin.
What questions should dealmakers ask to determine the target’s readiness?
- Has the target completed an initial assessment of the new standard’s impact on its business model, operations and financial statements?
- Has the target budgeted adequate capital expenditures and operating expenses for adopting the standard?
- What actions has the target taken so far to prepare for the new standard? Has it begun making needed system and process changes? Will it be ready to “go live” by the implementation date? Or will the acquirer have to help the company make the switch during the PMI phase? If so, how easily and inexpensively can its current systems be integrated with the acquirer’s systems? What resources will we need, and how available will they be?
- Has the target chosen a method for adopting the new standard, and is it the same as ours? Which method is it: (1) full retrospective (restating all prior periods presented) or (2) modified retrospective (recognize the cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings in the initial period of application.
For targets that have adopted the new standard, how do they approach due diligence?
If the target has already adopted the new standard, acquirers will need to take another look at their due diligence checklist and areas of focus relating to revenue recognition. The application of the new standard requires companies to exercise significant judgment in many areas such as identifying which promised goods and services in an arrangement are distinct and thus accounted for as separate performance obligations impacting the timing and method of revenue recognition. Companies may also make certain policy elections under the new standard that could create diversity in practice between the target company and acquirer. For example, a target may elect to expense the incremental costs to obtain a contract (such as sales commissions) as incurred when the expected amortization period is one year or less.
Acquirers should also consider the impact of the new revenue standard when filing financial statements of acquired businesses pursuant to the requirements of Rule 3-05 of Regulation S-X.