If you’re a private equity-backed CFO, you don’t need us to tell you how challenging and precarious a position that can be. You know the stats — or you’re at least familiar with the anecdotes that color them: post-deal, private equity (PE) investors retain the existing CFO only 25% of the time.
Ask sponsors what’s behind the 75% turnover rate and they’ll provide a long list of legitimate reasons, such as the inherited CFO was more controller than strategic partner or he or she lacked PE experience or the ability to meet complex reporting requirements. Suffice it to say that at some point sponsors simply lost confidence in the CFO.
For PE-backed CFOs, ASC 606 threatens to be this year’s tripwire that may precipitate their exits.
The new standard will significantly change when, and to what extent, companies recognize revenue. And, make no mistake, we’re talking about all companies: the standard just became effective for private entities as of January 1, 2019.
Here’s the good news: Clever private company CFOs can learn from the mistakes, pitfalls, and land mines that tripped up their public company peers last year.
Here’s the bad news: There were a lot of those mistakes, pitfalls, and land mines. And, a mistake here is no small thing: accurate revenue reporting is not only critical to company success, but it informs a sponsor’s strategic roadmap for its investment and for the most appropriate value-creation initiatives to execute.
What’s a PE-backed CFO to do? Be prepared, for one. Mistakes will not only complicate compliance but will shake sponsor confidence. Two, be proactive with your sponsor. Communicate the process, people, and planning logistics in-place to address the new standard. In addition, offer guidance on where and why revenue recognition will differ from historical norms.
Here are the four most common ASC 606 trips and traps:
1. Who, Me?
Yes, you. The 606 urban myth is that it only impacts manufacturers and service providers.
Myth, indeed – as many parts of what’s become known as the software-as-a-service sector will be significantly impacted, as well. While true cloud-subscription services may get a reprieve from a fundamental overhaul to revenue recognition, companies in the business of on-premises and hybrid subscription models won’t. Here, the business model is customer-installed software, combined with recurring license fees. In such instances, how and when revenue is recognized for those licenses will change dramatically.
So, software may be among the most notably impacted industries. But, it’s far from the only one. Because the standard will impact any organization entering into any kind of contract that governs the provision of goods or the transfer of services, the effects of 606 will be far-reaching.
2. Automation Isn’t Automatic
In many ways, automation seems the panacea to a pitfall-plagued revenue-reporting process. Technology promises to help group and aggregate data from disparate sources and systems. Automation can recalculate revenue for contract changes, particularly now that such changes will trigger contract amendments (as opposed to the creation of distinct contracts). And, technology can help track, report, and forecast events that trigger different revenue recognition protocols.
This is all great, and it’s all needed. Whether built, bought, lent or leased, sophisticated systems will help companies solve for 606 complexities.
But when companies are convinced such a system will solve for all the complexities, they’re bound to trip up. CFOs must recognize technology as a valuable tool, not as the ultimate answer. And where new systems and processes are warranted, CFOs must also account for the support and training such tools will require, as well as the integration and implementation issues that will inevitably occur.
3. Half Art, Half Science, All Math
The new standard’s disclosure requirements increase the amount of information private companies must provide about each portion of revenue. At the same time, the requirements also increase the amount of judgment that must be applied. As a result, the answers aren’t cut and dried.
ASC 606 forces interpretation around corporate contractual performance obligations as well as the provision of unique goods and services (particularly when they are provided in an ongoing manner). In addition, step four of the new revenue model requires entities to allocate the transaction price to the performance obligation, which in turn requires the pre-determined standalone selling price of each item.
But, how do you separate goods and services sold together as packaged deals? How do you accurately calculate standalone sales when by their very nature the services sold do not stand alone?
It requires sophisticated judgment (half art, half science) to not only price that item, but to create a formula for pricing protocols going forward. All of which requires more expertise and experienced practitioners than a typical revenue reporting exercise.
Wise is the CFO who invests – in-house or otherwise – in a team with the acumen to create compliant, but favorable, recognition protocols
4. The Revenue Rollercoaster
Sophisticated CFOs understand that, in practice, they’ll experience revenue acceleration for some revenue streams and deferral for others. They’ll also have to switch from a “point in time” recognition approach to an “over time” model and calculate for contract assets.
What will this mean? Private companies may be riding a revenue recognition rollercoaster for some time, experiencing some expected and some unanticipated swings in revenue compared with historical trends. And, that’s OK.
What’s not OK is a sponsor ill-prepared to see those swings. Here, the CFO’s job is less about management of revenue recognition and more about management of sponsor expectations.
Understanding the net impact on all private companies, no matter what sector or service; recognizing the limits of automation and its added complexities; applying sophisticated judgment and embracing those who are best suited to render such judgment; and riding the revenue rollercoaster, with intent and communication — those are the things sponsor-applauded, PE-backed CFOs do. Those are the CFOs who can avoid the many 606 trips and traps and can, instead, troubleshoot their way to PE partner confidence.
Alex Bogopolsky is a Director at Accordion, the private equity financial consulting and technology firm focused on the office of the CFO.