Restoring deferred revenue in acquired tech companies

In the tech industry, pre- and post-acquisition revenues can differ due to fair value adjustments on deferred revenue. Learn how ASU 2021-08 preserves pre-acquisition deferred revenue.

Many professionals in the M&A world have seen it happen. A tech company has strong recurring revenues and large deferred revenue balances. Then the company gets acquired and its reported revenues drop inexplicably during the first few quarters after the acquisition. What happened?

Under existing accounting guidance, contract assets and contract liabilities (for example, deferred revenues) arising from revenue contracts initially are recognized at their fair value when a business combination occurs. For companies in the technology, media, and telecommunications (TMT) industries, this often can result in the post-acquisition combined entity recording – and ultimately realizing – materially lower balances of deferred revenues compared to what the acquiree would have realized without the acquisition.

This happens because the fair value of deferred revenue is calculated based largely on the remaining costs required to satisfy the underlying performance obligation, and, for companies in these industries, the costs remaining could be nominal. The key takeaway is that existing accounting guidance can make it difficult for investors to compare pre- and post-acquisition revenue trends of acquired companies with material deferred revenue balances because such balances may “go away” upon an acquisition.

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The following example demonstrates how the accounting for deferred revenue under legacy accounting guidance can complicate trend analysis.

Example 1: Recognized contract liabilities under legacy accounting guidance

Acquirer acquires Target on Jan. 1, 202X, in a business combination accounted for under Accounting Standards Codification (ASC) Topic 805, “Business Combinations.” As part of the acquisition, Acquirer assumes an existing revenue contract previously entered into by Target with Customer X. Under the terms of the contract, Target transfers at contract inception a hosted software license for five years. In exchange for the license, Customer X pays Target $5 million at the license commencement date. At the date of the acquisition, three years remain under the contract with Customer X. As a result, at the date of acquisition, Target has a $3 million deferred revenue balance recorded on its balance sheet ($1 million per year for the remaining three years of the license term). The contract with Customer X does not provide for additional support services or upgrades, and the only service Target must perform is to continue to provide Customer X access to the hosted software for the duration of the license.

Under legacy accounting guidance, Acquirer must record the acquired deferred revenue liability at its fair value. To determine its fair value, Acquirer considers the costs required to satisfy the remaining performance obligation. Based on its assessment, Acquirer determines the fair value of the deferred revenue liability is $200,000. Consequently, after the acquisition, Target is able to recognize only $200,000 of revenue related to the hosted software license over the remaining license term. The remaining $2.8 million of deferred revenue recorded on Target’s balance sheet pre-acquisition is never recognized.

FASB guidance

In an effort to improve the accounting for revenue contracts acquired in a business combination, in October 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2021-08, “Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities From Contracts With Customers,” which amends the accounting guidance to create a new exception to the general fair value measurement principle used for business combinations. Specifically, ASU 2021-08 requires reporting entities to measure at the acquisition date contract assets and contract liabilities arising from contracts with customers using the recognition and measurement guidance in ASC Topic 606, “Revenue From Contracts With Customers,” instead of at fair value. The practical effect of the amendment is that the post-acquisition entity generally will initially recognize contract assets and contract liabilities arising from revenue contracts at the same amounts recognized by the pre-acquisition entity.

The following example demonstrates how the guidance in ASU 2021-08 can significantly affect the accounting for acquired contract assets and contract liabilities.

Example 2: Recognized contract liabilities under ASU 2021-08

Consider the same facts as in Example 1, except that Acquirer has adopted ASU 2021-08 and, therefore, recognizes the acquired contract assets and contract liabilities using measurement principles in Topic 606 rather than at fair value.

In this scenario, on the acquisition date, Acquirer recognizes a contract liability for its remaining performance obligation to Customer X in the amount of $3 million (or $1 million per year with three years remaining) – that is, in an amount equal to the deferred revenue balance recognized by Target pre-acquisition. Subsequent to the acquisition, Acquirer recognizes into earnings the $3 million deferred revenue balance over the remaining license.

In this example, as a result of measuring contract assets and contract liabilities under measurement principles in Topic 606 instead of at fair value, Acquirer is recognizing $2.8 million more in revenue over the remaining license term. That is, Target’s pre- and post-combination revenues are preserved.

Practical considerations

While the basis for conclusions in ASU 2021-08 suggests the new measurement guidance generally will result in an acquirer recognizing contract assets and contract liabilities at amounts consistent with those recorded by the acquiree immediately prior to the acquisition, in certain scenarios this might not be the case. For example, the amounts recognized by the acquirer may differ in these situations:

The acquirer and the acquiree have elected different revenue recognition policies and the acquirer has decided to conform the acquiree’s policy to its own (for example, a change to the measure of progress used for certain types of performance obligations).
The acquirer determines that an adjustment is needed to previously recorded amounts due to a change in estimate (for example, a change in the measurement of variable consideration).
The acquirer identifies an error in the acquiree’s accounting.
The acquiree does not prepare financial statements in accordance with U.S. GAAP.

In all cases, the acquirer will need to evaluate how the acquiree applied Topic 606 to determine if adjustments to recorded amounts are needed. As part of that evaluation, the acquirer must ensure the acquiree’s measurements have been updated through the acquisition date. For example, if revenue is recognized over time, the acquirer should ensure the measure of progress reflects facts and circumstances as of the acquisition date (including costs incurred to date and estimated costs to complete).

Other changes

In addition to changing the measurement guidance for acquired contract assets and contract liabilities, ASU 2021-08 also clarifies that an acquirer must use the concept of a “performance obligation” as defined in Topic 606 to determine whether a contract liability should be recognized in a business combination from a revenue contract. Under legacy guidance, some acquirers used a “legal obligation” lens to determine which contract liabilities should be recognized in a business combination. The practical effect of the change in ASU 2021-08 is that some entities may end up recognizing more contract liabilities than previously recognized under legacy guidance because the definition of a performance obligation is broader than that of a legal obligation.

Effective date and transition

ASU 2021-08 applies prospectively to all business combinations that occur on or after the ASU’s effective date. For public business entities, the ASU is effective for fiscal years beginning after Dec. 15, 2022, including interim periods within those fiscal years. For all other entities, the ASU is effective for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years.

ASU 2021-08 also permits early adoption, even in a reporting period in which no business combination has occurred. If a reporting entity elects to early adopt the standard, the ASU’s provisions must be applied to all business combinations that occur in the fiscal year of adoption. For example, if an entity elects to early adopt the ASU in the fourth quarter of 2021, the ASU’s provisions must be applied retrospectively to all business combinations that occurred on or after the beginning of fiscal year 2021.

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