Business combinations can be one of the most complicated areas of accounting guidance. Under the rules in Accounting Standards Codification (ASC) 805, Business Combinations, an acquirer generally recognizes identifiable assets and liabilities assumed in a business combination and measures them at fair value. The newly effective rules in ASC 606, Revenue from Contracts with Customers, created a single comprehensive model for recognition and disclosure but did not change business combination accounting. For acquisitions after ASC 606’s adoption, preparers have requested guidance on the business combination accounting treatment of acquired contract liabilities resulting from unfulfilled performance obligations, a new concept created by ASC 606.
Under a recently issued proposal, ASC 805 guidance would be updated to incorporate ASC 606’s new concepts and clarify that an acquirer must recognize a liability assumed in a business combination from a contract with a customer if that liability represents an unsatisfied performance obligation under ASC 606 for which the acquiree has received consideration (or the amount is due) from the customer. The proposed amendments would be applied prospectively to business combinations occurring on or after the effective date, which will be determined after review of the comments received.
While deliberating this issue, a second, more challenging question arose—how to measure the fair value of a contract liability on acquisition. FASB issued an invitation to comment (ITC) to solicit feedback on measurement issues, specifically the effect of different payment terms and the treatment of fulfillment costs. Unlike an exposure draft, an ITC presents several possible approaches to help stakeholders understand the potential effect of changing current guidance. FASB also will consider additional alternative approaches.
Comments for both documents are due April 30, 2019.
For a liability to be recognized in a business combination, it must meet the definition in the FASB Concepts Statements: “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” In practice, many companies continue to use older, superseded guidance that limited recognition of deferred revenue on acquisition only to legal obligations. However, under ASC 606, a performance obligation is broader than a legal obligation since it includes “promises implied by an entity’s customary business practices, published policies, or specific statements if those promises create a reasonable expectation of the customer that the entity will transfer a good or service to the customer.” Most contract liabilities are legally enforceable; however, in some cases there may be differences, most commonly for licenses of symbolic intellectual property or goods or services that are provided as a customary business practice because the entity is not legally obligated to perform in those situations.
This is a narrowly focused change and would not include contract liabilities other than those from revenue contracts with customers, even if those liabilities are accounted for using guidance in ASC 606, i.e., contract liabilities from the sale of nonfinancial assets within the scope of Subtopic 610-20.
If finalized, more contracts would be recognized as assumed liabilities under business combination accounting compared to current generally accepted accounting principles.
In discussing the measurement of a contract liability after a business combination, FASB members generally agreed that payment terms should not affect the amount of subsequent revenue recognized—it would be inappropriate for two acquired revenue contracts with identical performance obligations and different payment terms to result in different amounts of post-acquisition revenue for the acquirer. However, under ASC 805’s current, complicated guidance, payment terms can affect the timing and amount of subsequent revenue recognized by an acquirer.
The ITC included detailed illustrations for full and partial upfront payments and payments at different times under two scenarios—if no changes were made to current guidance and if guidance was updated so that payment terms would not affect subsequent revenue recognition. The ITC also discusses the complexity of accounting for contingent payments like sales-based royalties after a business combination. Currently, ASC 805 has limited exceptions for assets and liabilities arising from contingencies, income taxes, employee benefits, indemnification assets and leases.
The ITC focuses on what costs should be included in the fair value measurement and not how an entity would determine fair value. The paper reviews two alternatives for the measurement of a contract liability’s fair value:
- Only include the activities and related costs the acquirer would incur after the acquisition
- Include a contributory charge for the use of the underlying asset (similar to the measurement of an unfavorable lease liability in a business combination for an operating lease that has been paid for upfront)
The ITC compares the outcomes under these two approaches for several transactions—a license to symbolic intellectual property, a hosting arrangement and indefeasible right-of-use arrangement.
A final standard on the recognition proposal could be released in late 2019. Given the ITC’s complexity on the measurement issue, a final standard on it is unlikely in 2019. The unintended consequences of updating the guidance may outweigh any resultant diversity in practice if no changes are made.