In this issue of the Alert, we discuss some of the challenges with respect to the valuation of deferred revenue, including the impact of the new accounting rules on revenue recognition.
Deferred revenue typically represents a performance obligation to provide a product or service in the future where payment has already been made for such product or service. Deferred revenues result from many different types of situations including the following:
- Customer deposits
- Multi-year arrangements
- Collection of dues
- Buy-back agreements
The creation of deferred revenue and resulting recognition of revenues are a regular occurrence for many types of businesses. The requirement to determine the fair value of deferred revenues results from a business combination. Under Accounting Standards Codification (ASC) 805, an acquirer must recognize any assets acquired and liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at fair value as of that date. Deferred revenue is a liability and meets the identification criteria. An acquirer must recognize the fair value of deferred revenue to the extent that a performance obligation exists, regardless of whether the target has deferred revenue recorded on the closing balance sheet.
The process of determining the fair value of the deferred revenues can result in a significant downward adjustment i.e. “haircut,” to the target company’s book value of the deferred revenues. The reason is that the amount deferred under the revenue recognition rules is not intended to represent the fair value of the performance obligation. The haircut to the target’s book value may also make it appear as though revenues have disappeared: the revenues associated with the haircut will not be recognized by the target or by the entity post-transaction.
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Historically, there has been industry-specific guidance on how to recognize revenue and, in turn, deferred revenues. On May 28, the FASB released Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers: Topic 606. When it becomes effective in 2017, ASU No. 2014-09 will replace current industry-specific guidance with one standard applicable to all industries. The new revenue recognition standard marks a significant change to current revenue recognition rules.
ASC Topic 606 outlines a five-step process for determining when to recognize revenue:
- Identify the contracts with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when the entity satisfies a performance obligation
Many believe that the new standard will allow companies to recognize revenue earlier. If so, the new standard will reduce the number of situations in which deferred revenue will be adjusted in a purchase price allocation.
Regardless of which accounting standard gives rise to deferred revenue, the valuation challenge is defining the performance obligation. For example, a software company may have a support contract in which its customers have effectively prepaid for both maintenance service and unspecified software upgrades on a “when and if available” basis. Is the performance obligation considered only the maintenance component or the maintenance and upgrades? The SEC staff has indicated that the fair value of deferred revenue should be based on the nature of the activities that are to be performed and the related costs that will be incurred to service the performance obligation.
Deferred revenues are generally valued using a bottom-up approach, where the costs needed to fulfill the performance obligation are added to an appropriate profit margin. The costs to fulfill are reflective of those that market participants would incur to fulfill the service and do not include costs such as marketing, recruiting, and training, which are either incurred prior to the business combination or are not needed to fulfill the obligation. The profit margin should reflect a market participant perspective, based on what a market participant would expect in completing similar types of services.
An alternative approach for valuing deferred revenue is the top-down approach. The top-down approach is based on taking the market price of the deferred component and subtracting costs which have already been performed and profit on those activities. The top-down approach is often used to measure the fair value of remaining post-contract support for software.
The valuation of deferred revenues, and the implied haircut continues to be a controversial topic that can have an unexpected impact on a company’s post-transaction financial statements. Changes to revenue recognition rules will likely result in the continuing evolution of valuation approaches and the resulting haircut to deferred revenue. For more information on the valuation of deferred revenue, contact your VRC representative.