New Accounting Standards Codification (“ASC”) 606 and 842 apply to revenue from contracts with customers and accounting for lease arrangements. Private equity and venture capital funds do not generally have either revenue or leases running through their fund financials. Therefore, there is a presumption that these standards will have little to no impact on funds or their financial reporting. This presumption, however, is inaccurate. The following scenarios will illustrate why:
A fund manager is prospecting an enticing investment opportunity. In due diligence, they find that the company’s revenues have dipped compared to their industry competitors. Their balance sheet presents new massive lease liabilities that their competitors don’t. Based on these seemingly negative financial indicators, they pass on the investment. They do not realize that the company has adopted ASC 606 and 842, whereas their competitors have not (yet).
The early adoption has skewed their perception of the financial metrics. It effectively has caused them to miss out on a profitable investment opportunity. Inverse to the preceding hypothetical scenario and an arguably worse scenario: they have made a bad investment because the portfolio company’s financials present positive financial metrics based on the impact of adopting new accounting standards.
A fund manager uses the market approach in estimating the fair value of their private portfolio investments. In marking to market their portfolio, they leverage comparable public company revenue and EBITDA multiples. They apply them to the corresponding financial metrics of their investment holdings for financial reporting to investors. What they don’t realize is that the comparable public companies have adopted ASC 606 as of FY2018.
In contrast, their private portfolio companies have delayed adoption. As a result, the multiples are skewed upward (or downward) and effectively overstating (or understating) the reported value. At best, this causes some frustrating pushback by their auditors. At worse, this causes reporting asset overstatements to their investors, only to let them down when the investments are realized at lower values.
Knowing the startup accounting changes
These scenarios represent some of the risks that fund managers face if they don’t have an awareness and solid understanding of new accounting standards and the impact of adoption. Fund managers need to be aware of and understand recent accounting updates for two reasons:
- So investment due diligence results in appropriate portfolio company investing decisions
- So fund financial reporting, including mark to market inputs, are fairly stated for the investors of the respective fund
Here are some of the basics that fund managers should be aware of regarding ASC 606, Accounting for Revenue from Contracts with Customers:
- Effective for calendar year-end reporting periods as of December 31, 2018, for most public entities and as of December 31, 2020, for most private entities (early adoption permitted)
- Emphasis on recognizing revenue based on the amount the company expects in exchange for those goods and services
- Recognition is principles-based and can involve judgment, assumptions, and estimates that may result in a change in the amount or timing of the revenue recognition
- Requires certain “costs to obtain a contract” including sales commissions to be capitalized on the balance sheet and amortized over the life of the customer relationship
And here are some of the basics that fund managers should be aware of regarding ASC 842, Accounting for Leases:
- Effective for calendar year-end reporting periods as of December 31, 2019, for most public entities and as of December 31, 2022, for most private entities (early adoption permitted)
- Emphasis on a core principle that a lessee recognizes a right-of-use asset and a corresponding lease liability on its balance sheet for most leases, including operating leases
- Establishes new criteria for what constitutes a lease and requires companies to evaluate all contracts for lease arrangements
- Requires companies to establish a discount rate to record the present value of the lease liability and recognize an interest expense on the P&L in addition to the right of use amortization over the lease life
The adoption of or delay in adopting accounting updates should not have an inherent impact on a company’s fair value. Ultimately, a fund manager will need to determine whether changes in revenues and balance sheet fluctuations are the result of a portfolio company’s actual financial performance, the adoption of a new accounting standard, or a combination of the two. Contact us with any questions.