How to Account for Deferred Revenue in Purchase Accounting

We are seeing a surge in activity in the deal-making space including business acquisitions or combinations. It’s important to remember that accounting rules for such transactions may have a significant impact on the financial statements of the companies that the buyer has acquired.

After the close of a business acquisition, the buyer must complete purchase accounting as part of the acquiree’s financial statement reporting requirements under U.S. Generally Accepted Accounting Principles (GAAP). When applying the acquisition method to measure the acquired business, existing U.S. GAAP requires that the contract assets and contract liabilities acquired be evaluated to determine if they should be recognized on the date of acquisition (i.e., that the contract assets or liabilities meet the definition of an asset or liability) and that they be measured at fair value. The measurement of these assets and liabilities, in the particular the measurement of deferred revenue, is an often overlooked element when accounting for the acquired business. Below is a quick primer to help buyer-entities better understand deferred revenue and how to avoid common mistakes that could complicate your acquisition accounting.

Defining Deferred Revenue

When a company receives advance payments for products or services to be performed in the future – think airfare or subscription services – the payments are a contract liability known as unearned or deferred revenue. Initially, companies record the prepayment amount as cash on the asset side, while the deferred revenue is accounted for as a liability. The deferred revenue in this case is considered a liability because it has not yet been earned; the product or service is still owed to the customer. When the product or service is eventually delivered, the amount of deferred revenue liability decreases and would become revenue on the company’s income statement.

When buyers are acquiring businesses, they must recognize the acquired company’s deferred revenue if the buyer assumes a legal performance obligation. In this case, the buyer may recognize a deferred revenue liability related to the performance obligation. After the acquisition, the buyer recognizes revenue and then unwinds the deferred revenue liability as it fulfills its obligation to the customer by providing goods or services according to the contract.

How to Avoid Common Mistakes in Acquisition Accounting

A potential problem with deferred revenue in purchase accounting is the tendency for it to “disappear” during mergers or acquisitions. Existing practice within U.S. GAAP requires that the deferred revenue be measured at fair value on the date of acquisition. U.S. GAAP does not specify the method that should be used to measure the fair value of deferred revenue. When deferred revenue is accounted for under Topic 606 Revenue from Contracts with Customers, the historical cost basis will often differ from the fair value for the amount of selling effort and margin expected on that effort. The reason why the fair value differs for this effort is because the selling effort has already been completed.

In practice, there are two methods that are typically used to measure fair value of deferred revenue. The first method relies on building up the costs that will be required to deliver the goods and services for which the deferred revenue relates considering a market participant’s estimate of the costs to be incurred and the expected margin to be earned on the costs incurred to deliver the good or service. The costs and margin excludes costs of selling and the related margin. The second method is to identify the amount a market participant would expect to earn to provide the same goods or services, less the costs and margin on the selling effort. Typically, the fair value of the deferred revenue is less than the historical cost basis. When the deferred revenue is adjusted down in purchase accounting, there is essentially an amount that never gets recorded as revenue in the future, which is sometimes referred to as a “haircut.”

Careful attention should be paid to this during due diligence phases so that forecasted amounts of top line revenue can be made accurately. If a business received meaningful prepayments that have not yet been recognized in the acquiree’s financial statements, this could have a significant impact on the amount of revenue recorded post-acquisition and the net income and EBTIDA the entity will achieve post acquisition as all the deferred revenue may not survive in purchase accounting and therefore is not recognized as revenue in the future.

Another common issue to be cognizant of is when the company acquired had the legal right to advance billed its customers but had not yet received the cash. Under GAAP, the acquiree would have recorded a receivable and deferred revenue, and the acquiree’s deferred revenue would be subject to the haircut. If the acquiree had advance billed but the customer was not obligated under the contract to pay such advance billing, then deferred revenue and accounts receivable would not be recorded or fair valued at the acquisition date because the “receivable” and “deferred revenue” would not meet the definition of an asset or liability. However, the arrangement to provide goods or services may still get recognized in the acquisition accounting as an intangible asset as backlog, a component of customer relationships, or as an asset or liability for the amount the contract is “off market.” Allow for additional consideration when there are advance billing customers close to an acquisition, as this situation can have an impact on future revenue recognition.

Potential Changes

The FASB is considering changing the accounting for contract assets and contract liabilities, including deferred revenue. In a recently proposed accounting standard update, the FASB proposed accounting for contract assets and liabilities in a business combination in accordance with Topic 606 instead of fair value. If finalized as proposed, the guidance would result in eliminating the requirement to determine the fair value of deferred revenue, meaning there would be no haircut on deferred revenues for an acquired contract as compared to an identical contract that resulted in deferred revenue being recognized after the acquisition date. If the acquirer adopted these finalized rules, instead of determining the fair value of acquired deferred revenue, entities would need to evaluate the acquiree’s historical accounting and make any necessary adjustments for differences in the acquirer’s and acquiree’s accounting policies. In addition, entities would need to evaluate differences in estimates made by the acquirer as compared to the acquiree, or errors in the acquiree’s accounting.

Where Can I Learn More?

One way to potentially avoid some of the common pitfalls is to work with an accounting expert to review your liabilities and assets involving deferred revenue. Accounting providers may also help ensure any recent accounting standard changes – such as those recently enacted to revenue recognition accounting under ASC Topic 606 – apply to your situation, and guide you through this sometimes-complex step of the process.

For more information on accounting for deferred revenue, contact us.

Published on April 20, 2021