In lower-middle-market M&A, it is common to see financial statements prepared for tax reporting, lender reporting, or internal management purposes rather than for strict GAAP presentation. That does not mean the business is bad, but it can create real transaction risk when the company has received customer deposits, progress payments, or advance payments and recorded those amounts as revenue before the related goods or services were delivered.

This issue affects two of the most sensitive areas of a transaction, adjusted EBITDA and net working capital. If it is not handled correctly, the seller can suffer a purchase price reduction, a working capital shortfall, or both. The key is to separate the accounting correction from the economic negotiation and to make sure the working capital target and the closing working capital calculation use the same methodology.

Why Customer Deposits Create a Working Capital Problem

Under ASC 606, revenue generally is recognized when, or as, the seller satisfies its performance obligation to the customer. A performance obligation is the promise to transfer goods or services to the customer, and if the customer pays before that transfer occurs, the seller generally has a contract liability, often referred to as deferred revenue or customer deposits.

FASB’s revenue standard states that when a customer pays before the entity transfers goods or services, the entity presents the contract as a contract liability when payment is made or due, whichever is earlier. Grant Thornton’s ASC 606 guide similarly explains that, upon receipt of a customer prepayment, an entity recognizes a contract liability for the obligation to transfer or stand ready to transfer goods or services in the future, and recognizes revenue when that obligation is satisfied.

In plain English, if the customer paid a deposit but the product has not shipped, the work has not been completed, or the customer has not accepted the deliverable, the deposit usually should not be treated as earned revenue yet. It should sit on the balance sheet as a liability until the seller has performed.

This matters in an M&A transaction because net working capital is intended to measure the normal level of operating current assets and current liabilities needed to run the business after closing. Net working capital analysis is a key part of financial diligence and can result in a dollar-for-dollar purchase price adjustment if the company has more or less working capital than the agreed target.

When customer deposits are incorrectly booked as revenue, several things may be misstated at once:

The income statement may overstate revenue and EBITDA in the period the deposit was received.
The balance sheet may understate current liabilities because the customer deposit or deferred revenue liability was not recorded.
Inventory, WIP, job costs, or cost of goods sold may also be misstated, depending on whether costs were expensed, capitalized, or ignored.
The company’s backlog and future obligations may appear more favorable than they really are because the buyer is inheriting work that still must be performed, potentially without receiving additional cash from the customer.

The First Step, Recast the Accounting Before Negotiating the Peg

The seller and its advisors should not wait until the buyer’s quality of earnings provider discovers the issue. The better approach is to identify the issue before going to market, normalize it, and explain it clearly.

The seller should prepare a customer deposit analysis by order, job, contract, or customer. For each deposit, the schedule should identify:

Customer name.
Order, project, or invoice number.
Date cash was received.
Amount received.
Amount properly earned under GAAP.
Amount not yet earned.
Expected shipment, completion, or acceptance date.
Refundability or cancellation terms.
Related inventory, WIP, or cost-to-complete.
Gross margin expected on the remaining work.

This analysis allows the seller to distinguish between a timing issue and a real economic liability. A $500,000 customer deposit is not always economically equivalent to $500,000 of debt. If the company has already purchased materials, built WIP, and expects a strong gross margin, the buyer is not simply inheriting a cash obligation, it is inheriting a customer order with revenue and margin attached. However, from a GAAP balance sheet standpoint, the unearned portion still generally needs to be recorded as a liability until performance occurs.

The Corrected Working Capital Calculation

Once the deposit schedule is complete, the company should prepare a normalized working capital schedule. This usually starts with the company’s historical balance sheet and then adjusts it to a transaction-ready basis.

A simplified correction might look like this:

Assume a manufacturer received a $300,000 customer deposit in November for a custom machine that will ship in February. The seller recorded the $300,000 as revenue when the cash was received. As of closing, the machine has not shipped, and the customer has not accepted it.

The normalized treatment would generally be:

Cash increased by $300,000 when the deposit was received.
Revenue should not yet be recognized, unless the facts support over-time recognition.
A customer deposit or deferred revenue liability should be recorded for the unearned amount.
Inventory or WIP should reflect costs incurred to date, assuming those costs relate to goods not yet transferred to the customer.

For M&A purposes, cash is usually excluded from net working capital in a cash-free, debt-free transaction. That means the seller may not get credit for the deposit cash if it was distributed or retained as excluded cash, but the buyer may still argue that the related customer obligation should reduce working capital. This is where the negotiation becomes important.

The Working Capital Peg Must Be Calculated on the Same Basis as Closing Working Capital

The most important protection for the seller is consistency. If closing working capital will include a properly stated customer deposit liability, then the working capital target, or peg, should also be calculated using the same corrected methodology.

BDO notes that the working capital peg is typically based on normalized or adjusted net working capital over a trailing period, often the latest twelve months, although a shorter period may be used when it better reflects the current business. BDO also emphasizes that normalizing, non-operating, and non-recurring items are identified during diligence.

That concept is critical here. If the seller’s historical monthly balance sheets did not record customer deposits properly, the historical working capital average is artificially high. If the buyer then records the customer deposit liability at closing but the peg was based on unadjusted historical statements, the seller may be charged for a working capital deficit that is really just an accounting correction.

A fairer approach is to recast each monthly balance sheet in the peg period to reflect customer deposits correctly. Then the peg and the closing calculation are apples-to-apples.

For example:

Unadjusted historical average NWC: $2,000,000.
Average unrecorded customer deposit liability during the peg period: $350,000.
Normalized historical average NWC: $1,650,000.
Closing NWC after recording customer deposits: $1,700,000.

If the peg were incorrectly set at $2,000,000, the seller would appear to have a $300,000 shortfall. But if the peg is properly normalized to $1,650,000, the seller actually delivered $50,000 of excess working capital. The difference is not operational performance, it is methodology.

Avoid the “GAAP Consistently Applied” Trap

Purchase agreements often say working capital will be calculated in accordance with GAAP, consistently applied with the seller’s past practices. That phrase can create a problem when the seller’s past practices were not GAAP-compliant.

Financier Worldwide has noted this exact tension, explaining that if parties specify “GAAP consistently applied,” GAAP may conflict with the target’s historical financial statement practices. The parties should be clear about when a variation from the accounting standard is allowed, how differently treated items will be handled, and which principles prevail if accounting standards and past practices conflict.

In this situation, the purchase agreement should not rely on a vague reference to “GAAP consistently applied.” It should include a specific accounting principles exhibit that states exactly how customer deposits, deferred revenue, WIP, inventory, accrued costs, and related items will be treated.

A seller-favorable but still credible hierarchy might read conceptually as follows:

Working Capital shall be calculated in accordance with the specific accounting principles set forth on Exhibit __. To the extent not addressed on Exhibit __, Working Capital shall be calculated in accordance with GAAP. Historical accounting practices shall apply only to the extent they are consistent with the specific accounting principles and GAAP.

The exhibit should then specifically address customer deposits:

Customer deposits, advance billings, and deferred revenue shall be recorded as current liabilities only to the extent the related goods or services have not been delivered, completed, accepted, or otherwise earned under the revenue recognition principles used in preparing the normalized working capital schedule.
The same methodology shall be used in calculating both the Target Working Capital and Closing Working Capital.
Customer deposits shall not be treated both as indebtedness and as a current liability in working capital unless expressly stated.
Inventory and WIP related to open customer orders shall be included consistently with the treatment used in the normalized peg calculation.

This is not a substitute for legal drafting, but it illustrates the level of specificity needed to avoid a post-closing dispute.

Should Customer Deposits Be Included in Working Capital or Treated as Debt-Like?

There is no single answer. The treatment depends on the transaction structure, industry, margin profile, cash-free/debt-free terms, and negotiating leverage.

In many cash-free, debt-free deals, buyers argue that deferred revenue should be excluded from working capital and treated as debt-like because the buyer must fulfill an obligation for which the seller has already collected cash. Forvis Mazars has noted that deferred revenue is often removed from net working capital and treated as debt-like because it represents an obligation to the customer for which cash has already been received. Maxwell Locke & Ritter similarly describes several possible treatments, including excluding deferred revenue from NWC and treating it as debt-like, including it in both the peg and closing NWC, or excluding it while having the seller leave sufficient cash to service the obligation.

From a seller’s perspective, treating 100% of customer deposits as debt-like can be overly punitive, especially in a manufacturing business with a profitable backlog. The seller’s argument should be that the buyer is not merely assuming a liability; it is also receiving the associated revenue opportunity, customer relationship, backlog, inventory, WIP, and gross margin. If the buyer receives the future revenue and margin, the seller should resist a dollar-for-dollar debt-like reduction unless the facts support it.

A more balanced treatment is often one of the following:

Include customer deposits in both the peg and closing working capital.

This is often the cleanest approach when deposits are part of the company’s normal operating cycle. The liability reduces working capital, but only relative to a normalized target that also includes comparable historical deposit levels.

Treat only abnormal or excess deposits as a special adjustment.

If deposits at closing are materially higher than the normal historical level, the buyer may have a legitimate concern. The parties can include normal deposits in the peg and separately address excess deposits.

Leave cash or escrow based on cost-to-complete, not gross deposits.

This can be appropriate when the buyer’s real economic burden is the cost required to fulfill the order, not the entire customer deposit. For example, if the seller received a $500,000 deposit and the remaining cost to complete is $280,000, the parties may negotiate around the cost-to-complete rather than the full deposit amount.

Treat long-term deferred revenue differently from short-term operating deposits.

If the obligation extends well beyond the normal operating cycle, buyers are more likely to argue debt-like treatment. Short-term deposits tied to normal production orders may be better addressed within working capital.

Avoid Double Counting Between EBITDA and Working Capital

This issue can easily produce double-counting.

Assume the seller recorded $500,000 of customer deposits as revenue before the related products shipped. During quality of earnings, the buyer removes that $500,000 from TTM revenue and adjusts EBITDA downward by $150,000, representing the profit effect. Then, at closing, the buyer also records a $500,000 deferred revenue liability and demands a dollar-for-dollar purchase price reduction outside the working capital mechanism.

That may or may not be appropriate, depending on the facts, but it must be analyzed carefully. If the buyer is already reducing enterprise value based on corrected EBITDA, and the working capital mechanism also captures the same liability relative to a normalized peg, a separate debt-like reduction may over-penalize the seller.

The right question is not simply, “Was revenue recorded incorrectly?” The right questions are:

Was the EBITDA adjustment correcting a one-time timing issue or recurring accounting policy?
Was the working capital peg normalized using the same corrected accounting?
Will the buyer receive future revenue and margin when the obligation is fulfilled?
Are related inventory, WIP, prepaid costs, or accrued costs properly reflected?
Is the deposit balance normal for this business, or unusually high at closing?
Is the deposit refundable?
What cash, if any, is being left in the business?

Only after answering those questions can the parties determine whether the issue belongs in adjusted EBITDA, working capital, debt-like items, escrow, indemnity, or some combination.

Practical Seller Strategy

The seller should address the issue before the buyer controls the narrative. The recommended process is:

Identify all customer deposits and advance payments.
Build a detailed schedule by customer, job, and order.
Determine whether revenue was actually earned.
Review shipment terms, customer acceptance, milestones, over-time recognition criteria, installation obligations, cancellation rights, and refund terms.
Recast the historical financial statements.
Prepare a normalized income statement and monthly working capital schedule.
Separate accounting correction from business economics.
Show the buyer whether deposits are attached to profitable orders, supported by inventory/WIP, and consistent with normal business practice.
Negotiate the treatment in the LOI.
Do not leave the treatment of customer deposits to be resolved after diligence. The LOI should state whether deferred revenue/customer deposits are included in working capital, treated as debt-like, handled through cash left in the business, or addressed separately.
Attach a sample working capital calculation to the purchase agreement.
The sample calculation should include actual line items and show exactly how customer deposits are treated.
Make the accounting hierarchy explicit.
The agreement should not allow a buyer to choose GAAP when it helps them, past practices when that helps them, and debt-like treatment when that helps them. The methodology should be specific, consistent, and mechanical.

Conclusion

Customer deposits that were prematurely recognized as revenue are not just an accounting cleanup item. They can materially affect adjusted EBITDA, the working capital peg, closing working capital, debt-like items, and post-closing purchase price true-ups.

The seller’s objective should not be to deny the GAAP issue. The better strategy is to acknowledge it, quantify it, normalize it, and control how it flows through the transaction. The core principle is simple: the buyer is entitled to receive the business with a normal level of working capital and properly stated obligations, but the seller should not be penalized twice for the same accounting correction.

The most defensible approach is to prepare a normalized GAAP working capital schedule, recast the historical peg period on the same basis, specifically define customer deposits and deferred revenue in the purchase agreement, and make sure related inventory, WIP, cost-to-complete, backlog, and future margin are considered in the economic negotiation.

Working Capital Calculations in M&A When Customer Deposits Were Improperly Recorded as Revenue