Phil Hersey, Heiko Ziehms and Anna Hartley of Berkeley Research Group explain how the new revenue recognition rules will affect M&A disputes
Revenue recognition has been the battleground for some of the largest and most complex M&A-related disputes.
While International Financial Reporting Standard 15: Revenue from Contracts with Customers (IFRS 15), a new accounting standard for recording revenue, could have a significant impact on M&A transactions, there is no indication that revenue recognition will be less relevant to disputes in the future.
This is due to the judgment required under IFRS 15 on the part of the preparer of financial information, and its link to the valuation of the target company and the completion mechanism. With this in mind, the nature of revenue recognition disputes itself may evolve.
IFRS 15, applicable to accounting periods beginning on or after 1 January 2018, has been developed in parallel with equivalent changes to US Generally Accepted Accounting Principles (GAAP).
The purpose of the new standard is to remove inconsistencies in current revenue recognition practice, provide a more robust framework for addressing revenue issues and improve comparability of revenue reporting across sectors and jurisdictions.
In the short and medium term, the transition between the old and new rules will create challenges in an M&A context in several ways.
Under the new rules, revenue recognition may be accelerated or delayed, affecting reported profitability, working capital, net debt or other deal metrics, potentially impacting the closing balance sheet or earnings adjustment mechanism.
The new rules also mean that forecasts stated using the new rules may differ materially from those provided during due diligence, or those forming the basis for the transaction price.
Changes in earnings could impact profits available for distribution or could result in non-compliance with loan covenants, triggering indemnity clauses, when the new rules come into force.
IFRS 15 will also mean that earn-outs clauses negotiated using accounts prepared under the old rules, could result in materially different compensation when the agreed earn-out methodology is applied using accounts prepared under the new rules.
In the long term, there is no reason to expect that revenue recognition will be less relevant to M&A-related disputes, as revenue recognition plays a prominent role in these disputes for two reasons.
Firstly, revenue recognition is an important link between a target company’s accounting information and its valuation. Additional sales increase the reported earnings in any given period. This increase in earnings may result in an increase in the transaction value, magnified by the transaction multiple. EBIT or EBITDA-based valuations often provide a significant incentive to maximise reported earnings even for sellers who have no intention to deceive investors.
The second reason is derived from the fact that revenue recognition is a significant judgment area in accounting. The seller’s judgment and estimates are typically applied to historical financials that are often the basis for the buyer’s valuations. At the time of the deal, the buyer has less information than the seller concerning the target company. If the buyer considers that the seller’s judgment was biased or estimates turn out to be incorrect in hindsight, the buyer may feel they overpaid.
The new standard continues to have important areas of judgment (albeit different from those in existing standards). For example, IFRS 15 requires that for long-term contracts where revenue may be recognised over time, the percentage of the performance obligations satisfied is subject to estimates, including appraisals of results achieved, surveys of work completed, time elapsed, milestones reached, units produced, costs incurred, and labour hours expended. Appraisals, surveys of work completed and estimation of total hours or costs of a project will involve technical knowledge and judgment.
Additionally, under IFRS 15, estimates are required for contracts with variable consideration or where some goods are expected to be returned by customers. These and other estimates of probabilities or amounts can be biased or, in hindsight, turn out to be incorrect.
IFRS 15 will not only lead to different accounting treatments once the transition to the new standard has occurred, but also to uncertainty during the transition itself.
Beyond affecting reported earnings, IFRS 15 may require wider changes to customer contracts or loan agreements; legal matters that may not receive sufficient attention during busy negotiations.
The motivation behind the changes is improved comparability in financial reporting between companies and across industry sectors. This is a worthy objective, however, in the short and medium term, the changes introduce additional complexity into the financial and accounting aspects of M&A transactions.
In the long term, revenue recognition issues will continue to play a prominent role in M&A-related disputes.
Phil Hersey is director of Berkeley Research Group and a forensic accountant with over 15 years’ experience. Heiko Ziehms is managing director of Berkeley Research Group. Anna Hartley is a senior associate at Berkeley Research Group.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.