Beware of disappearing revenues post-acquisition
You finally found the right technology company to acquire to help grow your business. You anticipate the synergies to have a huge impact on your profits and margins, and you have negotiated a fair purchase price. Unfortunately, the elation of acquiring a company can end abruptly when you realize your company will never get a chance to recognize a significant portion of the acquired company’s pre-acquisition deferred revenue.
For those less familiar with business combination accounting, you may be surprised by this. The impact of business combination accounting on financial statements makes it appear as if a portion of a target’s revenues disappears post-transaction.
Under Accounting Standards Codification (ASC) 805, Business Combinations, an acquirer must recognize assets acquired and liabilities assumed at fair value as of the acquisition date. The process of determining the fair value of deferred revenues acquired often results in a significant downward adjustment (i.e. haircut) to the target’s book value of deferred revenues.
Deferred revenue typically represents a performance obligation to provide a product or service in the future for which payment has already been made. The reason for this haircut is that the amount of revenue deferred under the revenue recognition rules is not intended to represent the fair value of the performance obligation.
The size of the deferred revenue haircut is valued based on how much performance obligation is required to fulfill a company’s duty to the customer. Deferred revenues are generally valued using a bottom-up approach, where the costs needed to meet the performance obligation are added to an appropriate profit margin. The fulfillment costs are reflective of those that market participants would incur to perform the service, and the profit margin should be based on what a market participant would expect in completing similar types of services.
For example, a company selling perpetual software licenses often completes the majority of its performance obligation upfront when it delivers the license. A customer’s upfront payment of annual support and maintenance results in the recognition of deferred revenue over the service period. Since the cost to perform support and maintenance is often a fraction of the cost to deliver the license, deferred support and maintenance is haircut considerably in a business combination.
The deferred revenue haircut affects technology, services, and telecommunications businesses more severely than others as companies in these industries receive upfront customer payments and have low costs associated with incremental services for additional customers or subscribers. The effect of lower revenue in periods post-acquisition tends to be most dramatic in the first year but can impact revenue for years going forward when acquired deferred revenue relates to multi-year contracts.
So where did the revenue go?
The revenue that would have been recognized, except for the effects of this purchase accounting rule, is never recorded post-acquisition. Acquisitive companies should carefully review target revenue projections with this accounting rule in mind.
Impact of FASB Accounting Standards Update (ASU) No. 2014-19, Revenue from Contracts with Customers: Topic 606.
Many believe the new revenue standard will allow companies to accelerate the recognition of revenue compared to the current revenue recognition standards. If so, the new standard will reduce the severity and number of situations in which deferred revenue will be adjusted in purchase accounting.
How Holtzman Can Help
If you need assistance determining how this may affect your business, Holtzman’s team of professionals is happy to help. With diverse experience across many industries, Holtzman has earned a strong reputation for delivering customized transaction advisory services to help our clients achieve their goals and strengthen business value. With clients ranging from startups and middle-market leaders to large multinational conglomerates, we dedicate ourselves to delivering stellar results for our clients. Learn more about our Transaction Advisory Services.