Accrued, Deferred Revenue Accounting Updates: What Acquirers Should Know
When businesses combine, varied accounting practices often exist for acquired assets and liabilities. This has spurred regulators to encourage better comparability and reduced complexity of revenue reporting post-acquisition. With that aim in mind, the accounting standards for business combinations (ASC 805) have recently been updated,[1] refining the guidance around the initial recognition and subsequent measurement of acquired contract assets and liabilities. For business combinations currently taking place, companies can take advantage of this simplified guidance in the current year.
A look at legacy accounting approaches
Accounting teams that decide to adopt early should consider whether the company entered into any other acquisitions during the respective fiscal year of adoption.
Under legacy guidance, companies have been required to measure contract assets and contract liabilities assumed in a business combination at fair value as of the acquisition date. Contract assets are acquired in a business combination in situations where the acquiree has transferred control of goods or services to a customer but has yet to invoice the customer (i.e., accrued revenue). Contract liabilities acquired in a business combination arise from situations where the acquiree has unsatisfied performance obligations in which the acquiree has not billed to the customer or received payment from the customer as of the acquisition date (i.e., deferred revenue). Under accounting guidance in ASC 805 prior to the recent updates, both accrued revenue and deferred revenue would be recorded at fair value on the acquirer’s balance sheet. Those amounts would likely differ from the amounts recorded under ASC 606.
How the updates could benefit acquirers
The amendments in this update now require acquirers to apply ASC 606 – Revenue from Contracts with Customers when measuring the value of these assets and liabilities as opposed to measuring them at fair value as of the acquisition date. The amendment applies to all contract assets and contract liabilities acquired in a business combination, including assets and liabilities within the scope of ASC 610-20, Other Income – Gains and Losses from the Derecognition of Nonfinancial Assets.
The changes to the guidance could benefit the preparers of financial statements in several ways:
Simplifying fair value calculation: Overall, the amendments will benefit acquirers by reducing the complexity and costs of determining the fair value of contract assets and liabilities acquired in a business combination. Companies often engage third-party valuation specialists to evaluate the fair value of these assets, which will no longer be required.
Making reporting more consistent between buyers and sellers: Under the revised guidance, the consistency between acquirer and acquiree revenue reporting will be improved. For instance, if the acquiree applied ASC 606 appropriately, contract liabilities will be recorded on the opening balance sheet at their pre-acquisition values, as opposed to being subject to a fair value analysis and haircut of the liability, which results in a decrease to revenue recognized post-acquisition under the current guidance. This change will allow the acquirer to continue to recognize revenue consistent with how the acquiree recognized revenue prior to the transaction at the full transaction price.
Improving post-acquisition ability to compare cash flow and revenue: The amendments will improve the cash flow and revenue comparability post-acquisition, including resolving potential payment term inconsistencies going forward. For instance, under current guidance, there is the potential for two identical contracts in which one contract was paid up front, and the other was paid overtime to result in different revenue recognition post-acquisition as these contracts could result in a different fair value as of the acquisition date. The amendments resolve these types of inconsistencies by providing specific guidance on the initial recognition of these assets and liabilities at the acquisition date.
In limited cases, acquirers can streamline accounting using practical expedients: Companies might also run into situations in which Management is unable to rely on how the acquiree applied ASC 606 prior to the acquisition. This includes situations in which the acquiree was reporting on a non-GAAP basis or if the acquiree made errors in judgment in applying the principles of ASC 606. Companies may also need to make adjustments to how the acquiree accounts for revenue under ASC 606 to align and conform the acquiree’s accounting policies with the acquirer. In these cases, the acquirer should take steps to ensure a thorough evaluation is performed over the acquired contracts and make any adjustments required prior to finalizing the opening balance sheet.
If the acquirer must assess long-term, complex customer contracts that were modified prior to the acquisition or is unable to assess or rely on the acquiree’s ASC 606 application and accounting, the amendment allows the application of a practical expedient to ease the application burden on acquirers.
The practical expedient allows acquirers to reflect the aggregate effect of all contract modifications that occurred prior to the acquisition date when (1) identifying satisfied and unsatisfied performance obligations, (2) determining the transaction price and allocating the transaction price to satisfied and unsatisfied performance obligations. Further, the acquirer is also allowed to determine the standalone selling price at the acquisition date vs. at contract inception as it relates to allocating the transaction price to performance obligations in the contract.
This practical expedient should be used in limited circumstances and should be applied to all contracts acquired in a business combination on an acquisition-by-acquisition basis. Further, companies must disclose if the practical expedient was utilized and a qualitative assessment of the effects of applying the expedient, if reasonably possible.
Making the transition
For public companies, the amendments are effective for fiscal years beginning after December 15, 2022, including interim periods. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2023, including interim periods. Entities are allowed to adopt the standard early, and upon adoption, companies must apply the amendments to any business combinations entered into prospectively after the adoption date.
Companies that decide to adopt early should consider whether the company entered into any other acquisitions during the respective fiscal year of adoption and ensure these acquisitions are accounted for in accordance with the amendments, regardless of whether or not the (ASC 805-permitted) measurement period has closed. This would require the acquirer to remeasure the contract assets and contract liabilities in accordance with ASC 606 as of the respective acquisition date, including reviewing any post-acquisition accounting that would be impacted by the change.
[1] In October 2021, the Financial Accounting Standards Board (FASB) issued an update to ASC 805, Business Combinations (ASU 2021-08) which amends the current guidance around initial recognition and subsequent measurement of contract assets and liabilities acquired in a business combination.
