Understanding Contract Terms
Many acquisitions are structured on a cash-free, debt-free basis to simplify the transaction structure and make sure that the purchase price represents the true enterprise value of the business. In turn, deferred revenue is often removed from net working capital and treated as debt-like since it is an obligation of the company to the customer in which cash has previously been received. However, structuring the purchase price becomes complex when a target company records deferred revenue without an offset to cash.
A company usually records accounts receivable after services have been performed or products have been delivered, and the company has a right to invoice the customer. A company typically records deferred revenue, aka unearned revenue or contract liability, as cash is received before services are performed or products are delivered. However, situations exist where accounts receivable is recorded before services are performed or products are delivered, resulting in situations where deferred revenue is recorded with no cash offset. This results in the recording of accounts receivable with an offset recorded to deferred revenue. Typically, this results from billing terms defined in customer contracts. The implications of this accounting treatment play heavily into how net working capital should be established for purchase price components in purchase agreements. Therefore, it’s important to understand customer contract terms and their potential impact on the accounting treatment required by a company before establishing net working capital associated with purchase price definitions.
GAAP/Financial Reporting
To decide the appropriate treatment, let’s look at the applicable GAAP guidance at a high level.
Accounts Receivable/Unbilled Receivables/Contract Assets: In practice, a company records accounts receivable when it has invoiced the customer and its right to consideration is deemed unconditional. As such, the only risk remaining on accounts receivable is collection risk. The difference between accounts receivable and unbilled receivable is that accounts receivable amounts have been invoiced, whereas unbilled receivable amounts have not yet been invoiced. Both accounts receivable and unbilled receivables are considered unconditional; thus, they are not subject to performance risk, just collection risk. A company records a contract asset when additional performance is required to fulfill the customer’s order. As such, the main risks remaining on contract assets are collection risk and performance risk. This right to consideration is conditional.
Deferred Revenue/Unearned Revenue/Contract Liabilities: In short, the accounting treatment for these is the same as the terminology is used interchangeably. The company has a performance obligation(s) to deliver goods or services and may or may not have received cash in advance.
Financial Statement Presentation: Contract assets and contract liabilities relating to the same customer contract should be presented on a net basis on the balance sheet. However, accounts receivable and contract liabilities relating to the same customer contract should not be presented on a net basis.
Customer Contract Terms
The terms of customer contracts can impact how a company should record the aforementioned net working capital accounts. For example, most customer contracts state the cancellation terms. A company may apply the same cancellation terms to all their customer contracts, or these may be tailored as negotiated on a customer-by-customer basis. Cancellation provisions can run the gamut, e.g., cancel at any time, cancel with 30, 60, or 90 days’ notice, noncancelable. Cancellation provisions play an important part on the right to consideration, conditional or unconditional. Suppose a company invoices a customer under the terms of a noncancelable contract. In that case, the company can record this as accounts receivable, given that the right to consideration is unconditional, even though performance under the contract has yet to occur.
Closing Statement Definitions
Cash-free, debt-free structured deals exclude cash and debt from the definition of net working capital. Consequently, deferred revenue is often excluded from the definition of net working capital and instead treated as debt-like given the fact that it’s often recorded with an offset to cash, e.g., tied to customer deposits or advance billing and collection practices. Furthermore, accounts receivable and contract assets are often included in the definition of net working capital, given the short-term nature of these current assets. However, additional analysis is warranted where accounts receivable is recorded with a corresponding amount recorded to deferred revenue, which can be the case when a company has invoiced a customer under a noncancelable contract and prior to performance obligations being satisfied.
To help ensure an apples-to-apples alignment of net working capital, it would be appropriate to include deferred revenue that is offset with accounts receivable within the net working capital definition, i.e., deferred revenue is included in net working capital and accounts receivable tied to that deferred revenue is included in net working capital. This treatment is similar to the aforementioned requirement to net contract assets and contract liabilities relating to the same contract on the balance sheet. Even though accounts receivable and deferred revenue are not subject to a net down for GAAP financial reporting purposes, making sure that both remain within net working capital would result in the same objective.
Examples
Example 1: ABC Company is a software development company that licenses software and provides maintenance services to customers. ABC Company has entered into a one-year, noncancelable contract with XYZ Customer for the year ending December 31, 2024. The terms of the contract stipulate that maintenance services will be invoiced on the first day of each month for maintenance services to be provided each month.
On January 1, 2024, XYZ Customer is invoiced $5,000 for maintenance services to be provided for the month of January. ABC Company shall record the following entry on January 1, 2024:
- Dr. Accounts Receivable $5,000
- Cr. Contract Liability $5,000
Accounts receivable is recorded since the contract is noncancelable; therefore, the right to consideration is unconditional.
Example 2: Let’s assume the same facts as Example 1, except the contract is cancelable with 30 days’ notice. Let’s also assume XYZ Customer decides to cancel the contract on January 20, 2024 and provides ABC Company of its intent to cancel the contract on this date. Based on this, ABC should record the same entry as presented in Example 1 on January 1, 2024 since the right to consideration for this invoice was unconditional as of that date and the 30-day cancellation notice would not apply until February 2024.
Example 3: Let’s assume the same facts as Example 1, except the contract is cancelable at any time. In this scenario, ABC Company would not record a transaction on January 1, 2024. On January 31, 2024, ABC Company would record the following entry:
- Dr. Accounts Receivable $5,000
- Cr. Revenue $5,000
ABC Company performed maintenance services during the month of January 2024, and by the end of the month, it satisfied its performance obligation related to those services. As such, revenue should be recorded with an offset to accounts receivable, which became unconditional once performance was complete.
Example 4: Merger and acquisition (M&A) transactions often close during the month instead of month-end or the first day of the month. Let’s suppose that a transaction closes on January 15, 2024 and the net working capital target was established to include deferred revenue on customer contracts that had a corresponding amount recorded to accounts receivable.
In Example 1 above, assuming that XYZ Customer has not paid the accounts receivable balance by January 15, ABC Company will be in the following financial statement position, assuming straight-line revenue recognition over the month for maintenance services:
- Accounts Receivable $5,000
- Contract Liability $2,500
- Revenue $2,500
Based on this scenario, ABC Company is being delivered with net working capital of $2,500 ($5,000 accounts receivable, minus $2,500 contract liability). If the net working capital target was established with the intent of providing a 1:1 offset, meaning $0 net working capital, then an adjustment of $2,500 would be required to pay the seller for delivering excess net working capital. This example excludes the potential impact of costs incurred and liabilities accrued through January 15 to perform maintenance services for XYZ Customer for this contract.
Based on the varying results presented in the examples above, an in-depth analysis needs to be performed on a target company’s billing patterns and the implications this could have on net working capital if the timing of the transaction closing does not align with the net working capital model.
Conclusion
It’s important to understand a company’s billing cycle and methodologies for recording accounts receivable, contract assets, and contract liabilities. It’s also important to have a strong knowledge of customer contract terms, especially regarding cancellation provisions. Cancellation terms can vary by customer, so understanding the breadth of terms is important and can impact the accounting for net working capital accounts. During the due diligence process, a detailed analysis should be performed on customer contracts to vet the invoicing terms, payment terms, and cancellation terms. By leveraging this analysis, an appropriate model can be established for determining the net working capital purchase price component and avoiding surprises during the purchase price adjustment phase to occur post-closing.
If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.