Transcript:
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.
We will talk to you
later and if you enjoy the video please like it and share
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soon.
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