Acquiring a business means going through the process of revaluing the acquired assets and liabilities at the acquisition date fair value. And if you acquired deferred revenue as part of the acquisition, that too must go through this revaluation process. But often that reevaluation results in a surprise for many purchasers — realizing they will have significantly less deferred revenue than what they acquired.
The concept of “writing down” deferred revenue as of the acquisition date can be difficult to grasp but in practice can have a substantial impact. If you are, or plan to be, purchasing a business and your target has deferred revenue, understanding what happens to it once you become the owner will be an important aspect of the deal.
What does happen to deferred revenue during a transaction? Under purchase price accounting rules, assets and liabilities acquired as part of a business must be revalued at their fair value as of the acquisition date. For most assets and liabilities, this is a straightforward process. When deferred revenue is one of those liabilities, it is often initially assumed the value will not change since the services/products will be provided after the acquisition date.
While it’s correct to say the services/products are yet to be provided — such as a subscription sale that was paid for in advance (sold at an annual price) or the construction of a machine that is paid for in installments per the contract — accounting rules do not allow you to recognize revenue for services/products you did not provide. Essentially, you can’t “take credit” (and the revenue) for efforts related to sales, engineering, marketing or technology, for example, the seller made before you bought the business. So, during the revaluation process you need to think about and document what it will cost you, the purchaser, to provide those yet-to-be-provided services/products.
Let’s look at an example. Say you acquired $100 of deferred revenue related to an annual software subscription that was paid for in advance. Most of the costs to sell the subscription were incurred prior to or at the time of the sale, such as the selling effort, any marketing costs, software platform, etc. So, for you to fulfill the remaining term of the contract you might have some customer service costs and minor maintenance costs for the platform, but that’s about it. As a result, once you tally those costs and add a reasonable mark-up, your actual cost to provide the service is roughly 25% of the balance. This results in a mark-down of $75 to the original $100; in other words, the deferred revenue balance at fair value as of the acquisition date is $25. In almost all situations, the final “write-down” value will result in a significant decrease to the deferred revenue balance you expected to gain in the acquisition.
Depending on the balance of the deferred revenue as of the acquisition date, this write down to fair value could be substantial and difficult to perform. Recognizing this calculation needs to be performed is the first step. Valuation specialists will be able to help you arrive at the fair value, and your accounting team can assist with arriving at a process to determine the value for future acquisitions. Just remember it is always better to ask the questions upfront than be surprised by the answer at the end.
Contact Beth Reho at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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