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Thursday, October 18, 2018
Revenue recognition standard could affect bank loans to small businesses
The new revenue recognition standard doesn’t only affect publicly traded corporations and large privately held companies. It could have an impact on small businesses, particularly if they hope to obtain bank loans next year.
Some small businesses may find that because of the standard that takes effect for private companies next year, they will need to recognize revenue later than before. That means they could need larger loans than previously planned or they could fall short on loan repayments. While some financial institutions might be willing to amend the terms of a loan to increase lending limits or adjust payments, others might not be as flexible. For many small businesses, falling short on cash because of inadequate loans could have major consequences for growth, including the ability to pay their suppliers, as well as offer performance-based incentives such as bonuses and hire new employees.
“Private companies are starting to realize is it’s not business as usual,” said Mark Davis, national managing partner of Deloitte Private Enterprises. “When you’re dealing with a bank or a lender, whether it’s a commercial bank or a private lender, they’re in the business of looking to invest their dollars through a loan. They generally have confidence in what they’re receiving, and they build that level of integrity and confidence by their interactions with the company. The standard is very complicated, and one of the things that we recommend to our clients that either have a loan or plan to get a loan is that the banks are going to be looking for a level of confidence and comfort in what they’re getting from the company. They want to see that things are under control. They want to see that they have this standard understood, and they can explain to the bank or the lender what the impacts would be, whether that be on the current loan that they have or on a potential loan that they would look to get.”
Davis believes banks are going to want to know how their small business clients are implementing the revenue recognition standard.
“I think the bank will certainly have an interest in understanding how a company is dealing with it, whether they have it under control, whether they’ve evaluated it, whether they’ve hired somebody to do it for them,” he said. “If you’re looking to obtain a loan, I think that would be part of the conversation. They’re relying on what you give them from the financial statements. Many loans have financial covenants. That’s where the nuances of the standard can have an impact. The issue of covenants and whether you’re in compliance with them currently and will remain in compliance with them after the new standard is a big issue if you have a loan today. If you’re looking to enter into a new loan with somebody, it’s the same thing — how will those covenants be impacted by the new standard?”
Many banks will soon be dealing with another new accounting standard on current expected credit losses, also known as the CECL standard, but the revenue recognition standard is more likely to have an impact on small businesses that rely on bank loans. While small businesses like a mom-and-pop corner grocery probably won’t have to worry much about accounting standards, startup businesses in the technology industry could be facing some concerns.
“I think the standard affects companies more in certain industries than others, and certain businesses than others, like technology or media companies or companies that have long-term contracts or long-term construction contracts,” said Davis. “They’ll be affected whether they’re public or private. We’ve seen in the retail consumer business space much less of an impact in that space, but it really depends on the industry. Each industry has different issues that are affected by the standard. It really has less to do with public vs. private, big vs. small, and I think that’s why private companies have tended to wait to deal with it, because they’re of the view that it probably applies to public companies and may not affect them, when it reality it has nothing to do with public or private. It has more to do with the type of company.”
Startup companies that hope to go public eventually will need to be sure they can secure funding and their revenue recognition accounting is in order.
“If you look at a technology company that hypothetically is an emerging company looking to go public in a couple of years, and they do, say, software as service, hypothetically it could have an impact,” said Davis. “Let’s say they were recording revenue ratably over a period of time, over the life of the contract. Now they might have a different outcome. Let’s say someone had a $10 million two-year contract with a customer, and they were recording that revenue ratably over a two-year period. In each year they would have $5 million of revenue reflected in their financial statements. Let’s say they had covenants that were tied to that. Let’s say they had a revenue covenant in their debt agreement, and let’s say they had an EBITDA [earnings before interest, taxes, depreciation and amortization] covenant, both tied to that expectation of revenue being earned evenly. Now all of a sudden for whatever reason, let’s say a majority of that number doesn’t get recorded until that contract ends, so they may not achieve the revenue target and they may not achieve the EBITDA target, and they would have to go back to the bank in early ’19 to say, ‘We may not make our covenant.’ I would say a significant percentage of the time, a bank would say, ‘Yeah, we expected that. Let’s take a look at it and we’ll adjust the covenant and it won’t be a problem.’”
Deloitte advises clients to be aware of the potential things that could go wrong with loans and debt covenants for small businesses.
“I tell clients that banks go through changes. They go through oversight changes, they go through leadership changes, they go in and out of different industries at different times, and they also look at a company when they get a chance to look,” said Davis. “Let’s say your business isn’t doing as well today as it was when you first got the loan. Or they say, ‘We’re not interested in that space any longer. We’re going to go in a different direction.’ All of a sudden, getting that covenant waived could get more complicated, and you might not get that covenant waived. We’ve been alerting our clients to that issue and why it’s become so important, regardless of whether it’s public or private.”
The new standard could also have an impact on whether companies can provide bonuses to employees and hire new workers.
“Cash is driven by the payment schedule in the contract, so you could potentially be getting the cash all throughout the contract, but with revenue recognition you don’t get to record it in the same manner,” said Davis. “If you go back to the example I gave you, maybe now half of the revenue would have to be deferred and recorded when the contract ends. So you’ve got the cash. It’s not a cash flow problem. It’s not a cash issue. It’s a financial statement, and it’s a reflection of the strength of the business from an income statement standpoint. So could it affect bonuses? Yes.”
The revenue recognition standard is a complex one for many small businesses to handle, and many of them will be turning to their accountants for help. “Another thing we’ve told people as to why this standard is more complicated than others is it’s a very far-reaching standard,” said Davis. “It goes outside of finance. It could touch human resources. It could touch your sales force. If your sales force is used to getting bonuses based on revenue earnings, and if now they have to wait two years to get their commission, a salesperson could be upset about that. There are so many facets that get impacted because lots of these things are tied to the financial statements: revenue or EBITDA. Bonuses could change. It’s really the timing of these things, the timing of when a bonus would occur. It could change. It’s not that the person will never get it. It’s that they may not get it the way they’ve been used to getting it. That gets people upset. Generally they don’t necessarily understand.”