Key impacts of the new standard on a fund’s investment valuation
The adoption of the new revenue recognition standard should not have an impact on any entity’s fair value. However, careful consideration needs to be given to the inputs into the valuation to ensure consistency in valuation. Anyone who has ever been involved in the valuation of securities that utilize significant unobservable inputs knows that there are numerous inputs into the valuation models, much of which emanates from the financial data supplied by the underlying investee. In applying valuation approaches that rely on data from market comparables, the valuation method’s basic premise relies on the fact that financial information is consistent over time and comparable across industry participants. Revenue and earnings before interest, tax, depreciation and amortization (EBITDA) multiple approaches are a core component of the market approach to valuation. For example, under the market approach, the private equity industry often utilizes its investee’s financial results as a key input into the valuation. Changes (increases or decreases) in revenues or EBITDA from period to period are considered to be a result of change in the operations of the investee and are considered in evaluating changes in values for the fund’s investment. An investor will need to evaluate whether changes in revenues or EBITDA are driven by the underlying investee’s actual financial performance, the adoption of the new standard or a combination of both factors.
In addition to the market approach, there is also a potential impact to the income approach. Forecasts are often developed based on trends in historical financial performance and market-comparable benchmarks. For instance, for companies that anticipate seeing a significant impact to deferred revenue resulting from the new guidance, the market-comparable company benchmarks need to be evaluated to understand if they are reporting working capital levels based on the new guidance or the prior guidance. Additionally, valuation models must consider how this deferred revenue adjustment should impact forecasted revenues.
Internal control considerations
The development and maintenance of valuation models are a critical component of a fund’s system of internal controls. During this time of transition, a company’s system of internal controls will also need to respond to these accounting changes. It is important that those individuals responsible for determining fair value gain an understanding of, and an appreciation for, the impact of the new standard in order for them to properly perform their control functions.