While adoption of the new principle-based revenue standards (ASC 606 and IFRS 15, Revenue from Contracts with Customers) is old news for public companies who were required to conform with the standard starting January 2018, many private companies have not yet considered the impact the new standard will have on their revenue recognition nor created a plan on how to achieve compliance with the new standard.  The standard becomes effective for private companies in the next year and the software industry will be significantly impacted by the new standard. Given the prevalence of private companies in the software industry, along with healthy M&A activity, potential sellers and buyers in the industry should expect due diligence to include tailored procedures to assess the impact that the new standard will have on their historical and future income statements. While the new standard does not impact cash flows (which is what most Private Equity firms are most focused on), changes in the timing of revenue recognition and increased earnings volatility may impact valuation models and how much money lenders are willing to lend based on those models.

Changes in the standard related to software revenue recognition

Previous US GAAP revenue recognition guidance included robust and restrictive software-specific revenue recognition standards. The previous rule-based standard required establishing fair value for separable components of sold software and service contracts. Inability to determine the fair value of a component of the software suite, bundled services and support, or future updates that further improved or expanded the software functionally, could lead to delayed recognition of revenue from the entire contract. This often resulted in large deferred software revenue balances and smoothed revenue recognition out over many future months (or years). The new ASC 606 revenue standard is principle-based, permitting greater flexibility and interpretation in software revenue recognition, likely leading to more upfront revenue recognition.

From a quality-of-earnings perspective, this change is likely to make revenue and earnings more volatile and consequently make valuation modeling more challenging. Small private software companies’ compliance with the requirement to obtain vendor-specific objective evidence (VSOE) under the old revenue standard was spotty with many companies preparing financial statements on a cash basis, anyway. However, the new standard will add another layer of complexity because many of these companies will be in various stages of adoption and compliance with the new standard in the coming years.  And, variation between companies’ interpretation and compliance with the new standard will make comparisons between similar companies more challenging.

Impact on quality-of-earnings assessment, buyers, and potential sellers 

Financial due diligence has always required a team that can quickly gain a deep understanding of a company’s accounting policies and processes in order to assess its conformity with US GAAP and the quality of its earnings. However, the new standard further emphasizes the need for the diligence team’s knowledge of current accounting standards and its ability to apply that knowledge to assess a company’s earnings quality. How a company responds to the new accounting standard indicates the extent of management’s commitment to achieving high earning quality (there will more on this point in a future blog post).

From the buyer’s perspective, it will be important to understand where along the adoption continuum a target company is and consider how the historical and future quality of earnings will be affected. Changes to revenue recognition timing could require some changes to a buyer’s valuation model and a more robust analysis of “comparable” companies (accounting for differences in adoption compliance).

For potential sellers, the new standard presents the opportunity to highlight management’s competency and adaptability to a changing regulatory environment.  Management’s proactive response to new accounting standards demonstrate a focus on earnings quality and on maintaining high usability of their financial statements.