The new revenue recognition standard: How will it affect Tech sector M&A deals?

January 2017

Overview

To extract maximum value from their deals, companies will have to begin preparing for the transition now.
 

Impact on Tech companies’ M&A activities

Many dealmakers may assume that the new revenue recognition standard warrants little attention. They view it merely as an accounting change that doesn’t affect cash flows (which is what they typically focus on in a deal scenario). However, as we’ll see below, dealmakers that go into the transition unprepared may make costly mistakes.

The Technology sector is on pace for a second year of record-breaking M&A activity, underscoring an even greater need for early preparation

Technology deal momentum has continued to build throughout 2016 with a large concentration of multi-billion dollar transactions and conditions primed for a continued elevated level of activity to come. For example, Technology deal values in the third quarter of 2016 grew to 102.5B, showing a notable increase from both Q2 2016 (24%) and Q3 2015 (89%).1 While the majority of tech acquisitions are driven by Technology industry buyers, there is increasing activity from non-Technology companies, meaning that preparation isn’t just for Tech companies.

1. Source: PwC: US Technology Deals Insights Q3 2016, October 2016.


The critical questions Tech M&A dealmakers need to consider

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

View more

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.

View more

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.

View more

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.

View more


 

The lesson for dealmakers? It’s even more important to understand how executives at the target have made those judgments and estimates and whether they approach such decisions in the same way the dealmakers do. Failure to detect a mismatch in approaches could lead to unpleasant surprises after the ink on the M&A deal has dried.


How will the new standard affect functions in our company?

Switching to the new revenue recognition standard will require companies to make changes in the way functions assess targets that link most directly to deals, such as the corporate development and post-merger integration, and finance-related functions. Additionally, dealmakers will need to consider the fact that the new standard has broad-reaching implications for the organization as a whole—exerting impacts on systems, taxes, data, products and sales and marketing activities and resulting in incremental costs to implement and ensure compliance with the new revenue standard.

The impact on finance related functions:

  • Predicting when an M&A deal will become accretive could prove difficult for financial planners: Under the new standard, revenue may be recognized earlier than it is under the current standard. But forecasting the effects of possible changes in revenue recognition timing may be more challenging for some companies.
  • Some ratable models will be hard to preserve, and deferrals for accounting purposes that don’t reflect the economics of the transaction will generally disappear.
  • Today, deferred revenue on a target’s books that is deferred primarily owing to “accounting reasons” often disappears in purchase accounting and is not recognized by the target or the acquirer. Such deferred-revenue “haircuts” (as they are known) will probably become smaller under the new standard, because there will often be less revenue deferred on the target’s books in the first place.

 

The impact on other functions: New standard’s implications for acquirers’ functions

  • Marketing and sales
  • Legal and compliance
  • Tax
  • Investor relations
  • IT systems

Marketing and sales

  • The standard provides more flexibility on pricing and go-to-market strategies because VSOE of fair value is not required to separately account for a software-related element. Company may be willing to reexamine areas where go-to-market strategy or pricing and discounting practices were constrained by current accounting rules.
  • Companies may decide to include in revenue deals items that would have resulted in deferrals under current GAAP (e.g., software roadmap).
  • Companies may want to reexamine how product and service bundles are structured today; may restrict bundling because of associated accounting implications.
  • Incremental contract acquisition costs, including commissions, will be capitalized. Company thus needs to track complexity and impact of EBITDA metrics and/or revenue recognized on compensation and bonus plans.

Legal and compliance

  • Companies may need to renegotiate certain contracts to preserve historic revenue recognition patterns, because certain terms that cause revenue deferral today won’t lead to deferral under new standard.
  • If flexibility in contracting practices increases significantly, back-office legal and compliance costs could increase post-acquisition.
  • Complexity of deal-review activities (e.g., variable consideration and time value of money) could increase.
  • Sales-approval policies will need review and possible revision so a Company’s sales force knows the new rules and how they’re applied at the company.

Tax

  • Pro-forma reporting could become uncertain and more complex, and current/non-current deferred classifications may change.
  • Need to track new book/tax differences and adjust to existing deferred tax balances.
  • Financial accounting will change for cash, consumption, and state taxes.
  • Need to weigh considerations related to compliance, domestic book/tax differences, foreign inclusions, valuation allowance assessment positions, and intra-period allocations.

Investor relations

  • The standard will bring more complex and possibly costly disclosure requirements.
  • Investors will need to know choice of adoption method and impact of adoption on revenue. The SEC staff recently indicated publicly that they expect more robust SAB 74 disclosures regarding the impact of the new standard in 2016 year-end filings.

IT systems

  • Systems must accommodate new standard’s reporting and data management requirements, such as dual GAAP processing/reporting, statutory requirements in countries following local GAAP, and capture/analysis of data not previously tracked.
  • Need to handle impacts of decisions regarding bundling/unbundling, allocation (e.g., discounts and variable consideration), and commissions capitalization and amortization.
  • Processes and controls must support automation of judgments and estimates and revisions to them.

Layering on major acquisitions in the same timeframe as adoption of the new standard will introduce additional levels of change. Ensuring consistency and alignment across the buying organization and acquired entity will call for strong project governance, which may constitute an important workstream during the PMI process.


Key takeaways

Preparation for transition impact on deal process should happen now

The effort it takes to transition to the new standard should not be underestimated. A typical transition timeline takes months (or even years) and is often delayed by competing priorities within an organization. Dealmakers can start by asking themselves some tough questions—not only about potential targets on their M&A radar screen but also about their own readiness to switch to the new standard, given its impacts on a wide array of business functions.

Acknowledgement that transition increases the complexity of M&A deals

Companies will have to align stakeholders throughout the organization behind the new standard and communicate the approaches to implementing it.

Contact us

Chris Smith
Capital Markets and Accounting Advisory Services (CMAAS) Leader
Tel: +1 (408) 817 5784
Email

Chris Rhodes
Partner
Email

Todson Page
US Technology Deals Leader
Tel: +1 (408) 817 1223
Email

Follow us