Accounting and Valuation Conference Tackles Critical Issues for Credit Funds

By: Paul Balynsky | John Czapla | Ryan MacLean

Ahead of an uncertain 2018, senior professionals provided their insights and concerns regarding trends in accounting, valuation, taxes and other industry practices. Following is a summary of these topics.  


The recent GOP tax bill, which drops corporate rates from 35 percent to 21 percent and limits interest deductions to a maximum of 30 percent of EBITDA among other changes, had not passed at the time of this conversation. Participants were, however, able to comment on many other topics including revenue recognition, callable debt amortization and management estimates.

Revenue Recognition Standard, ASC 606

New guidance for revenue recognition under ASC 606 has been a significant topic of interest in broad accounting circles. ASC 606 calls for a principles-based approach—as contrasted with the current rules-based approach, which carves out numerous revenue recognition treatments for different industries—with a single standard that details a five-step process for evaluating when and how to recognize and allocate revenue. These five steps include:

  1. Identify the contract with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations of the contract
  5. Recognize revenue when (or as) the entity satisfies a performance obligation

While ASC 606 took effect for many entities on January 1, 2018, an informal poll of credit market participants in the audience suggested that the buy side is just beginning to focus on the issue. “It’s probably fine that some have yet to look into it,” said one conference participant, explaining that for many credit funds, especially those that use fair-value accounting, the majority of their revenue streams—including interest/dividend income, original issue discounts, and realized gains/losses—will not fall within the scope of the guidance.

However, he said, business development companies and other credit funds should be aware that ASC 606 does affect certain ancillary revenue sources, including upfront structuring fees and other service fees such funds sometimes collect. In these cases, funds will need to apply the five-step revenue recognition approach specified by the standard.

Callable Debt Amortization

One accounting change that many market participants would do well to focus on in the new year is the amortization of premiums for purchased callable debt instruments. The new FASB guidance (Update No. 2017-08)—which takes effect for fiscal years beginning after December 15, 2018, for public entities and fiscal years beginning after December 15, 2019, for others—requires investors who are holding callable debt instruments at a premium to amortize the premium through the next call date. At that point, if the debt is not called, they must recalculate a new effective yield analysis and amortize the premium over the balance until maturity.

It was noted, however, that the IRS is not in sync with FASB on the treatment of callable debt. So, for tax purposes, premiums should still be calculated through maturity.

Management Estimates

Practitioners are also monitoring proposed new guidelines from the Public Company Accounting Oversight Board (PCAOB) on how to evaluate management estimates and proprietary valuation models. The PCAOB released a proposal for comment in June 2017, and many practitioners were alarmed by what they considered to be the cynical tone of the release, which repeatedly used the phrase “management bias” suggesting to some that the PCAOB believes that companies are chronically aggressive in their estimates. VRC notes there were additional concerns that the PCAOB might be contemplating getting directly involved in evaluating the internal models companies use for valuation.


Participants also commented on the evolving practices used by buy side investors in private debt instruments. In some cases, buy side firms are now applying the rigorous and well-documented valuation processes they developed for their publicly traded vehicles to their private funds. Their primary focuses include valuation personal, third-party valuation firms, valuation ranges, and constant adjustments to EBITDA which are summarized below.

Separate Valuation Teams

There was agreement among those present that, within a firm, it is best to have a separate team focused on valuation. These teams can have many advantages over traditional teams in their depth of experience, independence and transparent documentation of processes. That is not to say the portfolio management team, or the deal team should not stay involved. They know positions front and back and can provide valuable information for valuation teams as well as push-back in a situation where valuations don’t quite line up. Such conversations serve as a foundation for third-party valuation firms to implement their expertise and independence within a specific industry or asset class, especially when communicating with auditors.

Ex-post analysis and narrow valuation ranges: Investors should make sure that they capture the sale prices of private assets and perform a rigorous, retrospective analysis of how the actual sale prices compare to the previous marks. One area that many firms don’t pay adequate attention to—but that the SEC is acutely focused on—is the size of the valuation range for individual positions. While it is not uncommon for owners of private securities to calculate a range of values, one participant stated, “[the SEC] always asks, ‘Can you drive a truck through it?’”

Debt Modification

Changes to existing debt agreements appear to be on the rise, and the question of whether the changes are treated as a modification or extinguishment brings up important accounting and tax issues. The first factor accounting practitioners evaluate is whether the lender stays the same or changes. In the latter case, a change is treated as an extinguishment. If the lender remains the same, audit practitioners will evaluate whether the change is substantial enough to qualify as extinguishment by looking at the present value of cash flows—if they change by more than 10 percent, the change is an extinguishment.

Similarly, tax practitioners must determine, through a six-step test of facts and circumstances, whether a modification is significant and should be treated as a taxable transaction where gains or losses must be recognized. These six steps are as follows:

  1. General test – facts and circumstances
  2. Change in yield
  3. Change in timing of payments
  4. Change in obligor or security
  5. Changes in the nature of a debt instrument; or
  6. Changes to accounting or financial covenants

It is not uncommon for holders of an obligation to reach divergent conclusions on whether a modification is significant: “I’ve had situations where one client argues that it’s nontaxable and another client says it is taxable,” said one panelist. “Long story short, there is a grey area and room for interpretation.”


There was agreement among those present that, within a firm, it is best to have a separate team focused on valuation. These teams can have many advantages over traditional teams in their depth of experience, independence and transparent documentation of processes.

The Ever-Changing Face of EBITDA

As the credit market has become hotter, panelists said the definition of EBITDA has become looser, with many credit agreements including multiple pages of add-backs and other adjustments to earnings. Not all such adjustments are unreasonable, but, as a VRC valuation professional quipped, “When we start seeing something called ‘adjusted proforma normalized run-rate EBITDA,’ that’s when we take a closer look.” This ties into an industry trend where EBITDA adjustments on M&A loans are as frequent as 40 percent, according to Wells Fargo. Not only are the EBITDA adjustments more frequent, but the actual amounts adjusted are also increasing. The goal is to truly identify a normalized base of cash flow, which EBITDA is often used as a proxy, for valuation measurement. VRC generally looks for adjustments that are easily measurable and achievable in the short term. For example, in a merger, eliminating ten duplicative corporate overhead positions that will save $3 million per year would be easily measurable and achievable and thus be deemed reasonable add backs to historical reported EBITDA. However, improving the efficacy of the sale force that will improve sales $10 million and EBITDA $2 million per year would be challenged as a reasonable add back.

If there are multiple adjustments associated with a single deal or if they simply seem egregious—one panelist gave the example of a two-year credit for allowing a new store to get up to speed—valuation teams at a minimum should demand monthly or quarterly reports from the deal team on how the adjustments are holding up over time. Similarly, the deal team that agreed to the adjustment should expect to report on adjustments and answer questions about them during quarterly valuation meetings. “The deal team is going to have to put up a tear sheet or valuation package—here is what EBITDA was when we underwrote it, with all the adjustments, and here it is currently,” said one panelist. “And when the adjustments roll off, you might have egg on your face and people are going to ask questions about why you underwrote it.”


Given the proliferation of non-bank lending institutions coupled with the continued growth of private equity investing, there has been material growth in both private debt and equity securities in general, and more specifically, the growth of those securities being held by both institutional and retail investors. Accordingly, there continues to be increased focus on the fair value measurement of these private securities, and more recently, on those valuation practitioners providing those measurements.

US capital regulators have called into question whether some of the individuals conducting fair value measurement estimates have the requisite training. Professional, technical and ethical standards have also come into question. Recently there has been a new accreditation for valuation professionals called the Certified in Entity and Intangible Valuations (CEIV) accreditation with the aim to alleviate some of the industry’s concerns with a set of standards that valuation practitioners must meet to obtain and maintain the designation. This has created a buzz in the industry as both valuation practitioners and users of valuation reports (fund managers, auditors, investors) assess its requirements and usefulness.

The CEIV credentialing initiative was undertaken by three prominent Valuation Professional Organizations (VPOs), the AICPA, the ASA and RICS. Although the VPOs worked in concert to develop the credential’s various requirements (experience, exam and continuing education), each is independently responsible for administering these to the applicants and credential holders that choose their pathways.

Typical candidates consist of valuation professionals who perform various fair value measurement duties for financial reporting purposes including valuations of businesses, intangible assets and certain liabilities. These individuals may already be credentialed by other organizations, which may satisfy the experience requirement of the accreditation process. However, all candidates must be a member of one of the three VPOs as mentioned earlier, pass an exam, comply with a Mandatory Performance Framework (MPF), meet continuing education requirements and submit samples to a periodic quality control program.

The MPF is a key component of the evolution of the CEIV credential and is expected to lead to enhanced consistency and transparency in the fair value measurement process. However, we note that the designation is still relatively new and familiarity among buy-siders was low. Furthermore, achievement of the CEIV credential is quite challenging, and the maintenance standards are rigorous and are still being finalized. This has led to limited early adoption in the industry, but considering the Stakeholders include the SEC, it is anticipated that interest in the CEIV will gain momentum in the foreseeable future.