Deferred Revenue in a Business Combination

Introduction

As your company prepares for an acquisition, it’s crucial to be aware of how the deferred revenue of the acquiree will be treated on the acquirer’s financial statements. This article aims to explain the nuances of accounting guidelines to ensure your team accurately accounts for this portion of the transaction.

What is Deferred Revenue?

Deferred revenue is common in companies where cash is collected upfront from the customer, but goods or services are delivered in the future. For example, if you pay $120 on January 1 for an annual subscription to Disney’s streaming content, Disney is required to recognize revenue as it satisfies its performance obligation (ASC 606-10-25-23). Immediately after receiving the cash payment of $120, Disney would report a liability (generally called deferred or unearned revenue) of $120 to reflect the obligation to deliver the subscription services for which the company has already been paid. Simply put, Disney has received the cash but now has an obligation to provide the customer with access to its content. In Disney’s 10-K, filed November 25, 2020, the company states, referring to subscription revenue, “Fees charged to customers/subscribers and wholesale distributors for our streaming services are recognized ratably over the term of the subscription” (Disney 10-K). Because this is an annual subscription, Disney recognizes revenue ratably as it completes its obligation to provide streaming services to its customers. Thus, Disney would recognize revenue of $10 per contract per month as it satisfies its obligation.

Acquisition With Deferred Revenue

Under previous accounting standards, something interesting happened when a company was acquired with deferred revenue on its balance sheet. Under rules of purchase accounting, assets and liabilities are typically measured and recorded at fair value (ASC 805-20-30-1). Because deferred revenue is a liability, the acquiring entity has had to determine what the fair value of the acquired deferred revenue is. Conceptually, the FASB has defined the fair value of a liability as: “The price that would be paid to transfer a liability in an orderly transaction between market participants” (ASC 820-10-35-2).

ASC 606-10-32-34 provides guidance on three suitable methods to determine the value of performance obligations.

1. Adjusted market assessment approach
2. Expected cost plus a margin approach (cost build-up approach)
3. Residual approach

In practice, the expected cost plus a margin approach has seemed to be the most appropriate way to capture the value of the performance obligation liability. A comment letter from Plantronics, Inc. to the SEC dated March 10, 2020 illustrates this approach:

The Company advises the Staff that the adjustment entitled “Deferred revenue purchase accounting” represents the impact of deferred revenue related purchase accounting adjustments recorded in connection with the acquisition of Polycom on July 2, 2018. The deferred revenue assumed in the acquisition primarily relates to Service revenue associated with non-cancelable maintenance support on hardware devices which are typically billed in advance and are recognized ratably over the contract term as those services are delivered. ASC 805, Business Combinations, requires identifiable liabilities assumed to be measured at the acquisition-date fair value. The Company estimated the fair value of the deferred revenue obligations assumed using a cost build-up approach and determined the fair value was less than the carrying value. As a result, the deferred revenue assumed was adjusted to fair value. This adjustment represents the amount of additional revenue that would have been recognized during the period absent the fair value adjustment. (Comment Letter)

To summarize, after applying the cost build-up approach, Plantronics determined that the fair value of deferred revenue was less than the carrying value and adjusted the deferred revenue balance to fair value. To illustrate, let’s return to the Disney example mentioned previously. On the date the advanced cash payment is received, the “carrying value” of the deferred revenue from the transaction is $120. At this point, it’s important to understand what economic realities would cause the cost build-up method to give a number different than the carrying value. The main reason the fair value would be lower than the carrying value is that it often costs less for the acquiring company to satisfy the obligation than what the acquiree initially recognized as deferred revenue. In some sense, this difference represents a type of gross margin where the acquirer determines the cost to fulfill its obligation plus an appropriate margin to find the fair value of deferred revenue to be recognized. Let’s further assume that Disney were acquired. As part of the acquisition, the acquiring company applies the cost build-up approach and determines that $80 is the fair value of the obligation (including an appropriate margin) to provide the customer with access to streaming content. So, what happens to the difference between Disney’s $120 deferred revenue balance and the $80 fair value estimate? The answer is that under previous accounting guidance, it disappeared. The $40 difference would never have been recognized as revenue by Disney nor its acquiring company.

FASB Update

As one can imagine, disappearing revenue presented challenges, and the FASB recognized a need to update the standard. The Investor Advisory Committee (IAC) stated in the proposed accounting standards update on ASC 805 that “the current requirement to measure the deferred revenue (contract liability) balance at fair value (a) does not provide useful information, (b) is often challenging to understand, and (c) reduces comparability between the pre-acquisition and post-acquisition period, disrupting the ability to predict future cash flows and revenue” (FASB Proposed ASU).

Consequently, the main provision of ASU 2021-08 is for the acquiring company to recognize a deferred revenue balance following the acquisition equal to that of the acquiree’s balance before the acquisition assuming the acquiree is following GAAP revenue recognition policies.

At the acquisition date, an acquirer should account for the related revenue contracts in accordance with Topic 606 as if it had originated the contracts. To achieve this, 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]) (ASU 2021-08).

ASU 2021-08 has the potential to improve the way acquirers account for deferred revenue in a business combination. Because of the standard update, most companies will not have to adjust the acquired deferred revenue balance, drastically simplifying a process that has at times been “challenging to understand” (IAC). ASU 2021-08 goes into effect for public business entities in fiscal years beginning after December 15, 2022, and for all other entities with fiscal years beginning after December 15, 2023. While ASU 2021-08 goes into effect at the previously mentioned dates, it can be adopted early for retrospective and prospective application.

An entity that early adopts in an interim period should apply the amendments (1) retrospectively to all business combinations for which the acquisition date occurs on or after the beginning of the fiscal year that includes the interim period of early application and (2) prospectively to all business combinations that occur on or after the date of initial application (ASU 2021-08).

Conclusion

Under previous GAAP, companies that acquired deferred revenue as part of a business combination were likely to take a revenue “haircut” on the acquired deferred revenue balance as they adjusted the recorded liability amount to fair value. This practice was both challenging to implement and undesirable in that it caused revenue to simply disappear. The FASB has taken steps to improve the standard and to align it more closely with ASC 606. The updated standard outlined in ASU 2021-08 will generally eliminate revenue haircuts as well as complexity related to the previous guidelines.