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Do You Have a Hidden Service Agreement Liability?

Nov. 6, 2013
Service agreements are the main assets of a contracting company.  They make your company more valuable.  Yet, they can also reduce your valuation if you do not properly account for them.

Why Service Agreements are Valuable

Service agreements are valued because service agreement customers represent the most loyal segment of your customer base.  As Ron Smith says, every service agreement customer represents a future change out.  In the meantime, service agreement customers are a source of cash flow and a lock to call you when repairs are necessary. 

Non-service agreement customers, by contrast, are fickle.  They may call you for future work.  They may not.  They may not even remember your company name.

In addition, your replacement sale close rate is better with service agreement customers.  Plus, your pricing can be higher.  Service agreement customers trust you, follow your recommendations, and do not shop around. 

Potential buyers know this.  Accordingly, they will find your company more attractive if you have a strong base of service agreement customers and may even pay more for it. 

Service Agreements on the Balance Sheet

On the balance sheet assets will always equal liabilities plus owner’s equity.  Owner’s equity is book value.  In theory, this is what would remain if you liquidated the company, sold all of the assets and paid all of the liabilities. 

The value of your service agreement customers does not show up on the company balance sheet before the business is sold.  It might show up after a sale, hidden in “goodwill” if buyer pays more than book value for the company.

Accounting for Service Agreements

The price of a service agreement must pay for the corresponding maintenance.  Anything left after the cost of service is gross profit.  Thus, each service agreement carries an unmet obligation for future maintenance work, which equals the cost of service.  This should be expressed as a liability on your balance sheet.  Offsetting the liability is revenue from the sale, of which a portion equal to the cost for you to perform the service should be debited to a reserve account.  The balance is gross profit and applied to company overhead. 

For example, you might sell a service agreement for $180.  This obligates you to perform two tune-ups, which cost you $70 each.  Your accountant should debit $140 to a reserve for maintenance and credit $140 to a maintenance liability account.  The $40 of gross profit can be added to cash, matched by an increase of $40 in owner’s equity.

Too many contractors fail to create a reserve account.  Instead, they recognize the revenue immediately, without recognizing the liability.  Thus, the revenue becomes an asset (cash) without the corresponding liability, causing book value to appear larger than it really is.  For example, all $180 is added to cash, causing owner’s equity to appear to increase by the same amount.

A buyer doing due diligence will account for the service agreement liability.  The buyer will reduce the book value accordingly.

Cash and Service Agreements

With accrual accounting, the presence of a reserve account to cover the future work does not necessary mean the cash is on hand.  Smart contractors set the cash aside (in another bank account if necessary) and do not tap into it until the work is performed.  In fact, it is not even necessary to recognize it as income until the work is done.

Unscheduled Maintenance

Some customers do not return phone calls and never schedule their service.   In theory, they should get a refund.  Few contractors offer any refund for unscheduled maintenance unless pressed by an unhappy customer. 

You can avoid the issue altogether by disconnecting the work from the payment.  Think of a pre-paid annual gym membership.  It gives you the right to use the gym for the next year, but if you fail to take advantage of this benefit of membership, you do not receive a refund after the fact.

Make the actual maintenance one of the “free” benefits of owning a service agreement.  The obligation to schedule the maintenance should reside with the customer.  This way, any liability ends when the term of the agreement expires. 

A Simplified Approach

To simplify the process, some contractors put all service agreement revenue into a separate bank account and recognize and transfer one twelfth of the balance as revenue each month.  This works well if you perform steady maintenance year round.  If not, match the revenue to the seasonality of your maintenance.

The Bottom Line

Properly accounting for your service agreement revenue and obligations does not change the underlying value of your company.  It does help you assess it more accurately.

For a FREE copy of the Comanche Marketing Guide to Lead Generation for the Bored Comfort Consultant, call the Service Roundtable at 877.262.3341 and ask to speak to a Success Consultant.

About the Author

Matt Michel | Chief Executive Officer

Matt Michel was a co-founder and CEO of the Service Roundtable (ServiceRoundtable.com). The Service Roundtable is an organization founded to help contractors improve their sales, marketing, operations, and profitability. The Service Nation Alliance is a part of this overall organization. Matt was inducted into the Contracting Business HVAC Hall of Fame in 2015. He is now an author and rancher.