Hey everyone it is David Barnett once again, I wanted to make a little video here about deferred revenue or what can sometimes be called a liability hidden in plain sight. And the reason I am making this video is because I had a conversation with a business broker recently who was telling me about a deal of his that had broken down and was looking for my advice in preventing this from happening again. But first before we can get into the story let me explain to you the concept of deferred revenue. It is basically how we treat sales for which were paid today but we have to deliver service over a period of time.
So, I have got a simple balance sheet here created and as you know assets always equal liabilities and equity when you are talking about a balance sheet. Let's consider for example a simple service business; let’s say house painting. SO for example I am going to paint a room in your house and I am going to charge you $120 and of course the cost of the paint that's on a separate statement, that is on the income statement were our income and expenses are listed. This is our balance sheet so let's say that I charge you $120 so now my cash goes up by $120 because I have accepted this money from you and let's say that I owe the paint store $60 so now I have got an account payable of $60. And I made a profit of $60 on the paint job, so my owners’ equity goes to $60. So you see a balance so $60 and $60 is $120, my cash has gone up, my owners’ equity has gone up and by taking the paint from the paint store but not paying them yet for $60 worth of paint my accounts payable have gone up as well so they balance.
Now let's take for example a fitness centre, so a fitness centre typically sells membership and they might sell an annual membership let's say for 12 months and for the purpose of ease that it is going to be $120 for an annual membership. So how do we represent that on the balance sheet? Let's say if you were to buy an annual membership for $120 on January 1st. Well our cash would still go up by $120 but what would happen on that day because we haven't delivered a year worth of fitness services. Is we would have what we call deferred revenue or deferred income of a $120. Now this can be called deferred revenue, deferred income it depends on your industry where you are in the world etcetera. But the idea is this is a liability for a service that we have yet to deliver to our customer. No let's fast forward one month; what happens when we go from January 1st to February the 1st? We have delivered one month worth of that service, so our deferred revenue or differed income goes down by $10 and our owners’ equity can go up by $10. The cash didn't change because we accepted that cash from January 1st. so as time goes on this deferred income or deferred revenue obligation, the liability associated with delivering the service will go down as we deliver the service.
The problem is most small businesses don't involve this level of sophistication in their book keeping. So if you were to look at the books of most small fitness centres they would simply record on January 1st. a sale of $120; they wouldn't go through the process of recognizing liability associated with having to do with the services associated with that customer or of course the year.
Now back to my story, in this particular case it was a business that sold equipment that came with one year of warranty protection provided by this seller the dealer; so in the balance sheet that was presented as part of the package of information given to buyers. There was a balance sheet that was showing the current status of the company but there was no differed income or differed liability there. In the documentation it said that all sales were given a twelve month warranty. So the buyers looked at the income of the business; they looked at the normalized income that the business broker was presenting. They use that as a basis for evaluating what they thought the business was worth; they negotiated back and forth with the seller and they arrived at a price. Once, they had that deal in hand they then went to due diligence which is the normal process. Their accountant started to investigate the numbers and said wait a second do you guys realize that if you buy this business and you take over the clientele you are going to spend money paying technicians to go and do warranty work for these customers that paid the seller. And you are not getting part of that revenue; they then went back to the seller and said look we need you to be responsible for the warranties that you issued for the sales that you made. And they tried several different things.
They said let's calculate what we feel this liability is worth and we can adjust the price of the business. They said why don't we simply build you back against the vendor take back note at $25 an hour for the tech work for what the technicians have to do to have to go service those warranties for which you were paid for. They tried several different things and you know what the seller came back and said every time? No, I am not going to compensate you for those warranties because; the warranty was disclosed to you upfront. You should have taken it into account when you take your offer. So basically, we have two people that now get entrenched in their positions and neither one is willing to budge because both feel they have sort of the moral high ground or both think that they are right. The seller said that he disclosed it upfront and the buyer says I didn't realize there was this cost associated with it at the time.
The business broker is asking me how can I get over this jam and I said one way to get the buyer and the seller to move again is for one of them to move. So, either the buyer has to really swallow the cost he wasn't thinking he was going to have to inquire or the seller is going to have to agree to a lower price. Or is going to have to agree to compensate the buyer for warranty work one to the clients that bought before the transaction. How could have the broker have avoided this problem? Easy, in the normalization of the financial statements this is typically done before a business is presented to a buyer. Business brokers and sellers are usually focused on removing none necessary expenses; like if a business has to pay for the owner's daughter cell phone. They are quick to add back and say this isn't a real business expense; because they are looking for ways to enhance the value of the company. They want to show the biggest possible income, but where business brokers sometimes fail is that they don't look at the other side of the coin. They don't say what additional expenses is a buyer going to have to undertake because they are in a different situation from the seller.
Maybe, the seller owns personal owned tools or equipment that are used in the business. Now, those tools and equipment aren't included in the sale so a buyer has to either buy them or go rent them for example. And that's going to impact the income of the business; I said to the broker is that you need to normalize that balance sheet and you need to disclose on that balance sheet that there is a liability associated with the sales that have already been made. Even if you have to calculate that figure on your own based on how many warranties were outstanding and just saying on average they require five hours of labour to maintain the warranties and using $25 an hour here is the figure.
In the case of the story I am telling you about that calculation added up to about $30,000. So, it was significant it was about 10% of the purchase price of the business. Anyway, I just wanted to share with you one of these hazards that can potentially happen in business that actually get prepaid for things that they do. Because, it is something we are not always looking for; usually businesses sell products and services and then have to wait to get paid but there are certain businesses that are in this prepayment sort of category which is great for their cash flow but has a business buyer you need to make sure that you understand what liabilities potential you are agreeing to take on when you buy the business.
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