In October 2021, the Financial Accounting Standards Board released Accounting Standards Update (ASU) 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which clarifies how to properly account for deferred revenue in a business combination. This change was a long time coming after opposing views began to debate the proper treatment of deferred revenue after ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (also, ASC 606) went into effect.
Under current GAAP, acquiring entities are to use Accounting Standards Codification (ASC 805) for assessing deferred revenue, which requires the assets and liabilities acquired to be revalued at their fair value on the acquisition date. For many assets and liabilities, this process is straightforward. However, for deferred revenue, ASC 805 does not allow acquiring entities to recognize revenue for services/products that they did not provide. The logic here is that the acquiree would have facilitated the necessary marketing costs and selling effort to obtain the customer. Further, the cost to satisfy the future performance obligation in the post-acquisition period is nominal compared to the cost incurred when acquiring the customer. Thus, ASC 805 doesn’t allow entities to take credit for these efforts that occur prior to acquisition. An example of this may be a software as a service subscription in which the customer may have paid for the services up front (requiring deferred revenue to be recorded). Upon acquisition, the fair value typically results in a write-down of deferred revenue, as a means to normalize margin and given the costs would have already been recognized on the acquiree’s books. Many in the industry had opposition to this approach, especially as ASC 606 came onto the scene.
Under ASU 2021-08, entities are no longer required to use ASC 805 guidance for deferred revenue, but instead, will use ASC 606 guidance. In essence, this ASU no longer requires entities to write deferred revenue (referred to as a contract liability under ASC 606) to fair value. Instead, the contract liabilities are to be accounted for as if the acquirer originated the contact. To achieve this the ASU notes, “An acquirer may assess how the acquiree applied Topic 606 to determine what to record for the acquired revenue contracts. Generally, this should result in an acquirer recognizing and measuring the acquired contract assets and contract liabilities consistent with how they were recognized and measured in the acquiree’s financial statements (if the acquiree prepared financial statements in accordance with generally accepted accounting principles [GAAP]). However, there may be circumstances in which the acquirer is unable to assess or rely on how the acquiree applied Topic 606, such as if the acquiree does not follow GAAP, if there were errors identified in the acquiree’s accounting or if there were changes identified to conform with the acquirer’s accounting policies. In those circumstances, the acquirer should consider the terms of the acquired contracts, such as timing of payment, identify each performance obligation in the contracts and allocate the total transaction price to each identified performance obligation on a relative standalone selling price basis as of contract inception (that is, the date the acquiree entered into the contracts) or contract modification to determine what should be recorded at the acquisition date.” If the acquiree has been applying ASC 606 and has used a performance obligation approach, the acquirer would have the ability to maintain the contract liability balance as on the acquiree’s books pre-acquisition, and would be able to recognize the revenue as previously deferred, if the related requirements are met. If, however, the acquiree were not previously applying ASC 606, upon acquisition, the acquirer would effectively be adopting ASC 606 for the first time.
This ASU should improve comparability for both the recognition and measurement of acquired revenue at the date of and after the business combination. Comparability is achieved by specifying for all acquired revenue to be recognized similarly in a post-acquisition environment, regardless of timing of payment.
This amendment will be effective for public entities with fiscal years beginning after December 15, 2022, and for all other entities with fiscal years beginning after December 15, 2023, with early adoption permitted. The amendments should be applied prospectively to business combinations occurring on or after the effective date of the amendment.