January 20, 2021

ASC 606 and Business Valuation

By Ashley DeCress, CPA, CVA, Manager, Advisory Services

ASC 606 and Business Valuation Valuation

There are countless reasons to have a business valuation completed for your company—strategic planning, gift/estate tax reporting, divorce, shareholder or partnership disputes, to name a few, and the list goes on.

For an appropriate business valuation to be performed, it is important to understand the revenue recognition standards and the effect they may have on your company’s accounting practices.

New Revenue Recognition Guidance

In May 2014, the Financial Accounting Standards Board (FASB) issued ASC 606, which provides a model for recognizing revenue from contracts with customers. The objective of ASC 606 is to improve the comparability of revenue recognition practices across industries. The model has a five-step process for recognition:

  • Identify the contract with the customer.
  • Identify the performance obligations in the contract.
  • Determine the transaction price.
  • Allocate the transaction price to the performance obligations.
  • Recognize revenue when (or as) the entity satisfies the performance obligation.

For privately held companies, this guidance is effective for annual reporting periods beginning after December 15, 2021. Public companies, which have already been required to implement ASC 606, established a blueprint for complying with the new standard. However, there are new and updated interpretations of ASC 606 based on company application experiences and communications between FASB and the SEC.

Impact on Business Valuation

In general, a change in accounting practices will not make a company more or less valuable. However, as a company transitions to the new revenue recognition standard, there may be shifts or delays in the recognition of revenue based on the requirements of ASC 606. Significant timing changes may distort a business valuation if the metrics used do not take these shifts into consideration.

Both the income- and market-based approaches utilized in business valuations are predicated on what a hypothetical buyer is willing to pay based on a company’s expected earnings and cash flows. During the year of adoption, a company’s revenues (and resultant earnings) may look very different from historical results based solely on the new accounting practice (and not a change in the company’s performance). This variability is further compounded by behaviors in the marketplace in the form of ever-changing market multiples. For example, there may be challenges associated with calculating applicable valuation multiples based on the timing of those comparables’ adoption of the new standard.

Additionally, net working capital and EBITDA (earnings before interest, taxes, depreciation and amortization) may fluctuate as a result of the changes to revenue and corresponding changes to accounts receivable, as well as the way the company records costs (under the matching principle).

It is also worth noting that the five-step process above uses the word “contracts,” which can include written, verbal or even implied agreements. A company may find it necessary to re-evaluate how contracts are written or communicated with customers, which could impact cash flow by adding various costs (e.g., contract restructuring, resources to understand and implement the new guidance, tax implications, etc.).

A company’s understanding and implementation of ASC 606 will help ensure the execution of an accurate business valuation. It is important for both management and the valuation analyst to be aware of revenue timing changes and their impact of the valuation process.