250  Analyzing Performance its own financial data, you can construct pro forma statements manually by combining revenue of the acquirer and target for the prior year. But beware: the bidder will include partial-year revenues from the target for the period after the acquisition is completed. To remain consistent from year to year, reconstructed prior years also must include only partial-year revenue. Exhibit 12.8 presents the hypothetical purchase of a target company in the seventh month of year 3. Both the parent company and the target are grow- ing organically at 10 percent per year. Whereas the individual companies are growing organically at 10 percent, consolidated revenue growth is reported at 22.8 percent in year 3 and 18.2 percent in year 4. To create an internally consistent comparison for years 3 and 4, adjust the prior year’s consolidated revenues to match the current year’s composition. To do this, add seven months of the target’s year 2 revenue (7/12 × $22 million = $12.8 million) to the parent’s year 2 revenue ($110.0 million). This leads to adjusted year 2 revenues of $122.8 million, which matches the composition of year 3. To compute an organic growth rate, divide year 3 revenues ($135.1 mil- lion) by adjusted year 2 revenues ($122.8 million) to get the correct 10 percent organic growth of the two companies. Even though the acquisition occurs in year 3, the revenue growth rate for year 4 also will be affected by the acquisition. Year 4 contains a full year of revenues from the target. Therefore, to estimate year 4 organic growth, you must increase year 3 revenue by five months of target revenue (5/12 × $24.2 million = $10.1 million). EXHIBIT 12.8  Effect of Acquisitions on Revenue Growth $ million Year 1 2 3 4 5 Revenue by company Acquiring company 100.0 110.0 121.0 133.1 146.4 Target company 20.0 22.0 24.2 26.6 29.3 Consolidated revenues Revenue of acquirer 100.0 110.0 121.0 133.1 146.4 Revenue from target 14.1 26.6 29.3 Consolidated revenues1 100.0 110.0 135.1 159.7 175.7 Growth rates of acquirer, % Reported growth1 10.0 22.8 18.2 10.0 Organic growth 10.0 10.0 10.0 10.0 1 Only consolidated revenues are reported in a company’s annual report. Analyzing Revenue Growth  251 Accounting Changes and Irregularities Each year, the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) make ­recommendations concerning the financial treatment of certain business trans- actions through either formal standards or topic notes issued by assigned task forces. Changes in a company’s revenue recognition policy can significantly affect revenues during the year of adoption, distorting the one-year growth rate.4 You therefore need to eliminate their effects in order to understand real historical revenue trends. Consider the new revenue recognition standards that replaced existing IFRS and GAAP revenue rules in 2017.5 These standards introduced a require- ment that companies follow a five-step process to determine the allocation of revenue over the life of a contract, implied or written. In some cases, initiating this process caused revenues to be delayed to later in the contract, causing a one-time drop in like-for-like revenues. For example, automobile companies that provide free maintenance saw a one-time drop as revenues were delayed. Other industries, including cell phone providers, experienced a one-time in- crease in revenue as cell phone equipment sales can now be recognized im- mediately, rather than over the life of the contract.6 If an accounting change is material, a company will document the change in its section on management discussion and analysis (MD&A). For instance, as shown in Exhibit 12.7, Sodexo specifically called attention to an unusual 53-week year in 2017. The longer time period in 2017 artificially raised 2017 growth rates while lowering 2018 growth rates. Decomposing Revenue Growth to Develop an Integrated Perspective of Growth Drivers Once you have removed the effects of mergers and acquisitions, currency translations, and accounting changes from the year-to-year revenue growth numbers, analyze organic revenue growth from an operational perspective. The most standard breakdown is: Revenues Revenues Units Units = × 4 Revenue recognition changes can also affect margins and capital turnover ratios. They will not, how- ever, affect free cash flow. 5 ASC 606 and IFRS 15, “Revenue from Contracts with Customers,” was issued jointly by the FASB and IASB on May 28, 2014. Implementation began in 2017. 6 F. Norris, “New Standards for Companies’ Revenue Accounting Will Begin in 2017,” New York Times, May 28, 2014.