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Disappearing Revenue in Business Combinations

Disappearing Revenue in Business Combinations

Did you know that accountants can perform magic tricks with numbers? In some situations, they can make future revenue disappear from a company, never to be recognized. This magic trick is unique and only applied when one business is acquired by another. Under United States Generally Accepted Accounting Principles (US GAAP) pertaining to business combinations, the assets acquired and liabilities assumed in the transaction, including deferred revenues, are required to be recorded at fair value, unless an exception exists under US GAAP. In US GAAP, deferred revenue represents any prepayment made by a customer for future goods or services.

How Can Future Revenue Disappear?

Determining the fair value of deferred revenue involves numerous inputs that are sometimes best left to experts, but the basic premise revolves around the cost to service the contracts – i.e., if I were to hire a third party to service these contracts, what would I pay? Unless the contracts cost more to service than the associated contract price, the fair value of the deferred revenue is typically less than the stated contract price, leading to the “disappearance” of future revenue.

This is best demonstrated with an example. Business A has 10 contracts with customers and all contracts are paid upfront at the start of the year. Each contract has a stated contract price of $120, leading to $1,200 of deferred revenue on day one. Two months after the first day of the year, when the deferred revenue balance is $1,000, Business A is acquired by Business B. A valuation expert determined the fair value of this deferred revenue at the acquisition date was $800. Business B will now record $800 of revenue over the remaining 10 months of the year as compared to original contractual deferred revenue of $1,000, leading to $200 of revenue “disappearing.”

Additionally, reporting results can be significantly different when identical customer contracts are entered either immediately before or immediately after a transaction. The former results in lower revenues than the latter, even though only a day or two may separate the contracts.

Planning for the Future

As a potential buyer looks to acquire companies with a significant amount of deferred revenue, advance knowledge of this accounting rule is necessary. If not considered in planning for an acquisition, deferred revenue may lead to debt covenant compliance failures, negative compensation arrangement impacts, and improper financial reporting, especially when legacy systems track deferred revenue at historical cost rather than fair value.

The Financial Accounting Standards Board (FASB), who sets accounting rules for private companies, is bringing good news for the future. FASB has proposed a change to the accounting rules for business combinations related to deferred revenue. Under the proposed change, a company would be allowed to recognize contract assets and liabilities (deferred revenue) at their historical value carried by the acquired company before the acquisition. In this case, the revenue that would have disappeared under the old rules would no longer disappear. As of August 2021, there has been no change in the rules; however, the FASB is evaluating how and when to apply the change, which may be released in late 2021 or early 2022. The old rules still apply until a new standard is released, but as common with most changes in standards, early adoption could be allowed. For more information on fair value accounting or the valuation of deferred revenue, contact Michael Schaefer at Boulay PLLP at 952-841-3052.

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