The Challenge of Valuing a Deferred Revenue Liability- Part 1: Definition and Basic Valuation Principles
Advance payments happen every day, from subscription services to purchasing airfare or tickets to a sports game. For the companies accepting the advance payments, however, the deferred revenue liability that comes from those sales presents certain challenges, particularly if those companies were to undergo a business combination while holding the deferred revenue.
In a business combination, the acquired deferred revenue liability must be valued. Depending on the nature of the service, that valuation analysis may not be a cut and dried operation. Our series on valuing deferred revenue will take a closer look at the basic logistics involved in valuing deferred revenue. Part I will focus on the fundamentals of valuing the liability. Later articles in the series will focus on how recent accounting standard changes to revenue recognition affect the valuation of deferred revenue.
What is Deferred Revenue?
Deferred revenue, also known as unearned revenue, typically refers to advance payments a company receives for products or services that are to be delivered or performed in the future. The company that receives the prepayment records the amount of the prepayment as cash on the asset side, and unearned revenue on the liability side of the balance sheet. Deferred revenue is considered to be a liability because it refers to revenue that has not been earned and represents products or services that are owed to a customer. As the product or service is delivered over time, the deferred revenue liability on the balance sheet is decreased, and the amount of this decrease in the liability is recognized as revenue on the income statement.
Oftentimes, a company provides the product or service for which it was prepaid within a year. In such instances, the company books the deferred revenue as a current liability on its balance sheet. However, if a customer made an up-front prepayment for services that are expected to be delivered over multiple years, the portion of the payment that pertains to services or products to be provided after 12 months from the payment date should be classified as deferred revenue under the long-term liability section of the balance sheet.
Which Types of Businesses Generate the Most Deferred Revenue?
The types of companies that tend to have the most deferred revenue are those that accept significant amounts of payments prior to the delivery of their goods or services. Such companies may include magazine subscription companies, ticket sellers (such as airlines or sports agencies), subscription-based software, Software as a Service (SaaS), and telecommunications companies.
How Business Combinations Affect Deferred Revenue Valuation
If your company has deferred revenue, even for longer than a 12-month period, it would follow the relevant accounting guidance to report its deferred revenue on the financial statements. Valuing the deferred revenue liability would mainly be important in a business combination situation.
In a business combination, the acquiring entity (the acquirer) recognizes deferred revenue of the acquired company (acquiree) if it relates to a legal performance obligation assumed by the acquirer. When a legal performance obligation is assumed, the acquirer may recognize a deferred revenue liability related to the performance obligation.
After the acquisition, the acquirer recognizes revenue and subsequently unwinds the deferred revenue liability as the acquirer satisfies its obligation by providing the goods or services to the customer as required under the contract. The measurement of an assumed legal performance obligation is at fair value as of the date of acquisition, pursuant to the guidance in ASC Topic 820, Fair Value Measurement.
Methods for Estimating the Fair Value of Deferred Revenue
There generally are two acceptable methods for measuring the fair value of the assumed deferred revenue obligation. The first method is a cost build-up approach, which is based on a market participant’s estimate of the costs that will be incurred to fulfill the obligation plus a “normal” profit margin for the level of effort or assumption of risk by the acquirer after the acquisition date. The normal profit margin should be from the perspective of a market participant and should not include any profit related to selling or other efforts completed prior to the acquisition date.
The second and less frequently used method for measuring the fair value of an assumed deferred revenue obligation is by obtaining evidence from market information about the amount of revenues an entity would earn in a transaction to provide the remaining obligations under the contract, less the cost of the selling effort (which has already been performed by the acquiree prior to the acquisition date) and the profit margin on that selling effort. As noted previously, the profit margin should be from the perspective of a market participant.
Mathematically, the fair value of an assumed legal performance obligation is typically less than the amount recognized by the acquiree in its pre-acquisition financial statements. This will be important to note during the preparation for the business combination, as the acquiree’s stakeholders may have questions.
What Companies Can Do to Make Business Combinations with Deferred Revenue Easier
Working with an experienced provider can help ensure that the valuation of the deferred revenue liability in a business combination is based on reliable, supportable data. It’s also important to note that due to recent accounting standard changes, there will be some additional considerations related to deferred revenue valuation. Further articles in our deferred revenue valuation series will cover these topics in more detail.
For any questions, comments, or concerns about this article, please contact the author, Dimitar Krastev, at firstname.lastname@example.org.