New IFRS 15 Revenue Recognition Rule Sows Short-Term Risk in M&A Deals
Dealmakers with foresight will avoid surprises as international accounting rules shift.
Phil Hersey and Heiko Ziehms
Making a corporate transaction happen is challenging enough, involving many players and a tangle of financial, legal and regulatory considerations. Now dealmakers can add accounting rules to that mix, because of a new rule that changes how companies recognize revenue.
Investors and deal teams will want to have a clear understanding of the rule’s potential effects, and keep a close eye on the impact it may have on valuation metrics so they can avoid mispricing assets, double-paying earn-outs and inviting legal action.
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The new rule seeks to align US and European standards for the ways publicly traded companies report their revenue. It emanates from the International Accounting Standards Board and the Financial Accounting Standards Board, the two most important organizations promulgating accounting standards. When the two groups announced the change in 2014, they said it would remedy a flaw that had allowed accounting differences to produce different revenue figures for similar transactions.
Unpacking the IFRS 15 Revenue Recognition Rule
At the most basic level, the new standard requires a company to recognize revenue from contracts when the company provides the service or delivers the good associated with that agreement. Aimed at aligning accounting methods internationally and across industries, the change is more in line with the way US companies have historically accounted for revenue, and a significant departure for companies reporting under International Financial Reporting Standards. Revenue recognition is the link between a target company’s accounting information and its valuation; recognizing profitable sales increases reported earnings, which are often the basis of valuation. This figure is both central to many M&A transactions and an area of significant subjectivity, which means it can lead to disagreements.
The rule change is pervasive, affecting any business generating revenue and reporting under international accounting standards, but it will have the greatest impact on companies in industries such as manufacturing, telecommunications and energy, and more generally companies that rely on long-term contracts.
What the IFRS Changes to Revenue Recognition Mean in Action
While anyone who works in accounting or mergers and acquisitions may be aware of this change, many business leaders and dealmakers haven’t fully appreciated the new standard’s complexities or grasped the potential effect it may have on transactions. Acquirers and investors, amid a confusing implementation of the new revenue-recognition method, may be surprised by how many aspects of deal mechanics this could affect.
For markets to work efficiently, participants need transparent data that they can compare among companies and jurisdictions. Companies need to be able to supply consistent, reliable information to allow capital markets to value assets appropriately. The rule change makes that more difficult, at least temporarily. And what’s called for is caution when assessing companies’ financial performance through the transition. Looking across a number of years will now mean comparing data derived from two separate accounting methods.
While its sweeping implications shouldn’t be overlooked, the rule will have the greatest impact on particular aspects of corporate transactions, from the perspectives of valuation, legal, accounting and banking. Here are the areas where executives and dealmakers should maintain the sharpest watch:
Fair Value: Changing Your Measuring Stick Doesn’t Change What You Measure—Except When It Does
The potential effect the revenue rule change can seem to have on a company’s value can be dramatic. For example, for Rolls-Royce Holdings Plc, an operating profit of £471 million for the first half of 2017 under the old accounting standard transformed into an operating loss of £103 million under the new standard. This meant its ratio of enterprise value to earnings before interest, taxes, depreciation and amortization, a widely used valuation multiple, went from just over 10 to almost 40. Similar changes across companies have effectively reset levels for key metrics across entire industries. While what’s being measured hasn’t changed—leaving second-order effects aside—the market must get used to a new measuring stick.
The New Revenue Accounting Standard’s Legal Risks: When MAC Is Material and Adverse, But without a Change
Many professionals involved in deals took note of the recent decision by Vice Chancellor Travis Laster of Delaware Chancery Court approving the dissolution of a deal between German healthcare company Fresenius Kabi and US drugmaker Akorn. It was the first decision of its kind, prompting one observer to note that the split had breached the “MAC wall.”
Material adverse change clauses in purchase agreements provide for a buyer to walk away from a transaction if something goes very wrong in the target business before the deal can close.
As noted in the court’s opinion, Akorn’s problems were clear: a giant, company-specific decline in revenue and “systemic” quality-control failures. If a company in a similar dispute were affected by a change in not just its circumstances but also accounting standards, it would potentially multiply the number of factors that could be brought to any dispute concerning whether an adverse change was material.
To be sure, the new accounting standard will not create material adverse change on its face. But what it could certainly complicate is the already subjective determination of what change is material. Against the backdrop of two parties arguing over whether a deterioration in a company’s reported earnings is material, the additional uncertainty of whether the change could be due to new revenue recognition rules adds further complexity.
Variable Consideration Accounting: Measure Twice, Because You Want to Pay Only Once
The new rules on revenue recognition could also create unpleasant surprises for buyers who haven’t been meticulous about noting what components of revenue and profit form the basis of an earnout.
An earnout often serves to bridge significant gaps in price expectations between buyers and sellers. It also can move part of the risk of achieving the projections for the target business from the buyer to the seller by distributing part of the payment over a period after the deal closes and tying those payments to performance benchmarks.
A buyer could end up paying for the same revenue twice if that revenue was used to negotiate the purchase price under the old accounting rule, then is used again, to satisfy the earnout terms, because the rule changes took effect post-closing.
Acquisition Costs May Contain More Moving Parts than Ever
Business doesn’t stop when companies agree to M&A transactions. And the agreements that are negotiated to account for regular variations in working capital become extra fraught when they must bridge different accounting standards. Every movement in net debt and working capital should be adjusted to ensure the final purchase price corresponds to the value transferred to the buyer at closing. But a change in revenue recognition related to accounting rules could affect levels of both net debt (for example, deferred revenue) and working capital (for example, trade receivables) at closing.
While there would be no change in the true value of any part of the transaction, the way revenue is recorded—and the resulting shifts in other key metrics—may give the impression that value has changed or may be measured against reference values prepared under the former standard. If a buyer were surprised by the new standard, that surprise could give rise to a disagreement over purchase price adjustments, creating an expensive and unnecessary drain on management’s time and a company’s resources in post-deal disagreements. The good news is such disagreements can often be prevented with a comparatively small extra effort—sometimes as little as a few extra words included in the sale and purchase agreement.