Deferred Revenues & Haircut: How deferred revenue can vanish into thin air after M&A transactions

published on 18 April 2024 | reading time approx. 2 minutes

Software-as-a-Service (SaaS) companies are considered an attractive investment due to advancing digitalization and their subscription-based business models. This is reflected in an increasing number of SaaS transactions.

Deferred revenues and corresponding contract liabilities are often acquired with the acquisition of SaaS companies which frequently results in a shortfall in the planned revenue after the transaction due to regulations on initial accounting in the context of purchase price allocations (PPA). In the following article we explain the accounting of deferred revenues in business combinations and their accounting implications in the context of purchase price allocations.

Deferred revenue relates to income a company has received in advance for a service that it has not yet provided. Deferred revenue occurs with several companies, but are particularly common with SaaS companies, as they are often paid in advance for their services or products. For instance, if a customer signs up for a three-year subscription, the company recognizes the payment received upon signing the contract as a contract liability. As the service is provided over time, the payment is gradually recognized as revenue in accordance with IFRS 15 and removed from contract liabilities (percentage-of-completion method). From a financial perspective, deferred revenues are highly attractive for companies as they can generate a negative cash conversion cycle and serve as a pre-financing component.

According to IFRS 3, business combinations must be accounted for using the acquisition method, i.e. assets acquired and liabilities assumed must be recognized at their respective fair value as of the acquisition date. IFRS 3 does not specifically address how to account for contract liabilities in business combinations. However, based on the general recognition principle of IFRS 3, the acquirer must recognize a contract liability in a business combination if the acquiree has an obligation to fulfill after the acquisition. In the context of business combinations, it is necessary to assess on an individual basis whether contract liabilities need to be reevaluated.

The fair value of a contract liability can be assessed as the amount an independent third party would pay to acquire the contract liability. In general, this amount is calculated bottom-up as the present value of the cash flows required by the acquiring company to fulfill its obligation, plus an appropriate margin for which a third party would be willing to accept the assumption of this obligation. The expected amount of the costs to fulfill the obligation is generally measured on the basis of an estimate of the costs that will be incurred to fulfill the remaining term of the contract. In cases with an highly specific obligation or service, it may not be possible to reassess the underlying obligation due to a lack of market comparability.

The valuation approach at fair value can lead to a so-called haircut, i.e. a discount on the contract liability of the acquired company and thus lower expected revenue. Differences to the original valuation may arise both in the estimation of the expected costs and in the derivation of a (market-comparable) margin. For example, sales efforts were already incurred by the acquired company prior to the business combination and the associated marketing expenses were also already incurred by the acquired company and can therefore not be attributed to the acquiring company. The same may apply, for example, to expenses for a software platform in the case of multi-year SaaS contracts. Accordingly, the acquiring company cannot recognize the full amount of deferred revenue and contract liability that was reported at the time of acquisition.

As a result, in the periods following the acquisition of a company with recognized deferred revenues, companies can dissolve a lower contract liability over the remaining term and therefore report lower revenues. This can lead to lower sales and negative surprises after business combinations.

The adjustment of deferred revenues to their fair value is often complex and characterized by a high degree of discretion. The revaluation of deferred revenues therefore requires a critical examination of the revenue forecasts for the target company and the individual circumstances of the underlying transaction.