Under U.S. Generally Accepted Accounting Principles (GAAP), two new accounting rules on revenue recognition and leases will soon go into effect. In turn, the new rules could affect parts of the business valuation process.
Overview of changes
First, it’s important to understand the changes the standards will bring to companies that follow GAAP.
Revenue recognition. ASU No. 2014-09, Revenue from Contracts with Customers, primarily affects the timing of revenue recognition. It replaces about 80 industry-specific revenue recognition rules with a basic principle: Companies should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the payment that it expects to be entitled to in exchange for the goods or services.
Public companies must implement the new revenue recognition standard in 2018. It will have a major impact on entities that enter into long-term contracts with customers, such as software, wireless and media companies and asset managers.
Leases. Under the current accounting rules, companies report many obligations for leasing real estate, vehicles and equipment as operating leases on their income statement under rent expense. Starting in 2019, ASU No. 2016-02, Leases, is expected to add more than $1.2 trillion in off-balance-sheet leases to public companies’ balance sheets.
For all leases with terms of more than 12 months, the revised standard requires right-to-use assets and lease obligations to be added to the balance sheet. A lease obligation must be discounted to its present value by the rate implicit in the lease or the lessee’s incremental borrowing rate.
Early adoption of the updated standards is permitted under GAAP. Plus, private companies receive a one-year delay for implementing the changes. As companies adopt the changes using different timelines, it may be difficult to compare early-adopters vs. on-time adopters, public vs. private companies, and the subject company before vs. after implementation. Beyond that time frame, the changes could result in apples-to-oranges comparisons between companies that follow GAAP and those that report results using another basis of accounting (such as tax-basis financials).
Valuation experts benchmark financial performance to get a handle on a company’s risk profile and capital structure. This analysis may be used to adjust pricing multiples or to estimate future cash flow and discount rates.
When analyzing the subject company’s financial results, business valuation experts consider whether the company and the companies that it’s benchmarked against have implemented the new standards. In some cases, an expert may need to adjust the financial statements to achieve meaningful comparisons.
Likewise, when using comparable pricing data under the market approach, business valuation experts must consider whether the subject company and the comparable companies have implemented the changes.
For example, when valuing a software company as of December 31, 2018, it might not be accurate to apply 1) a price-to-revenue multiple based on transactions involving comparable public software companies that have implemented the new revenue recognition standard to 2) a private software company that hasn’t implemented the new standard.
Experts also need to consider whether the company has implemented the accounting rule changes when applying the income approach. For example, changes to the lease accounting rules could make lessees appear significantly more leveraged than they were under the old rules. If an expert uses the industry average capital structure to quantify the weighted average cost of capital for a small business, it’s important to consider the extent to which these companies have implemented the new lease standard.
Major changes are coming to U.S. GAAP. Before relying on financial statements to value a business, experienced experts evaluate the company’s underlying accounting methods and consider the extent to which they will affect the value of the business.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.