Recognition of an Acquired Contract Liability in a Business Combination
BC27. The Board decided that an entity should use the definition of performance obligation as defined in Topic 606 to determine whether to recognize a contract liability from a revenue contract with a customer that is acquired in a business combination at the acquisition date.
BC28. An entity should evaluate whether it has a contract liability from a revenue contract that is assumed in a business combination if the acquiree has been paid (or consideration is due) for goods or services promised in the contract for which control has not been transferred to the customer (that is, an unsatisfied performance obligation). The acquirer would not need to perform this evaluation if the acquiree has not received payment or there is no consideration due (that is, a contract liability would not have been recognized under Topic 606).
BC29. The Board indicated that in many situations in which an acquired revenue contract has been paid upfront before the business combination, the recognition conclusion under a Topic 606 performance obligation would be the same as current practice if the acquirer used the legal obligation as the recognition criterion. However, the Board acknowledged that there may be circumstances in which the recognition conclusion could be different, such as for licenses of symbolic intellectual property or goods or services that are provided as a customary business practice because an entity is not legally obligated to perform in those situations (see paragraph BC9).
Payment Terms and Their Effect on Subsequent Revenue Recognized by the Acquirer
BC30. To address the issue that the timing of payment for an acquired revenue contract affects the subsequent amount of revenue recognized by the acquirer after the business combination, the Board decided that acquired contract assets and contract liabilities arising from revenue contracts with customers in a business combination should be measured in accordance with Topic 606 at the acquisition date. Therefore, the acquirer should no longer measure the remaining obligations of the acquired revenue contract at fair value but, instead, utilize the transaction price allocated to the remaining performance obligations in accordance with the principles of Topic 606.
Application of Topic 606 at the Acquisition Date
BC31. The overall result of the Board’s decisions on recognition and on payment terms will result in an entity (acquirer) accounting for contract assets and contract liabilities arising from revenue contracts with customers acquired in a business combination in accordance with Topic 606 at the acquisition date. At the acquisition date, an acquirer should account for the related revenue contract as if it had originated the contract. To achieve this, an acquirer may assess how the acquiree applied Topic 606 to determine what to record for the acquired revenue contracts. For example, if a revenue contract was paid fully upfront before the acquisition, the acquiree would have recognized a contract liability for the remaining, unsatisfied performance obligations in accordance with Topic 606. At the acquisition date, an acquirer would assess the acquiree’s accounting under Topic 606 to determine what to record for the acquired contract. There may be circumstances in which the acquirer cannot assess or rely on the acquiree’s Topic 606 accounting and, therefore, would have to perform the accounting for the contract in accordance with Topic 606, such as if the acquiree does not follow GAAP or there were errors identified in the acquiree’s accounting. Generally, either of those efforts would result in the acquirer recording a contract liability that is the same as, or similar to, the contract liability that would have been recorded by the acquiree before the acquisition (if the acquiree had prepared financial statements in accordance with GAAP).
BC32. Topic 606 contains comprehensive guidance about the judgments and estimates that an entity must make when accounting for revenue contracts with customers. Topic 606 requires that certain of those judgments and estimates be made at the contract inception date, such as identifying performance obligations and determining standalone selling prices. Other estimates must be made on a recurring basis, such as estimates of variable consideration and measure of progress toward satisfying performance obligations. Comment letter respondents asked the Board to clarify how to apply Topic 606 at the acquisition date, including when (that is, as of which date) an entity should assess the judgments and estimates discussed in Topic 606. The amendments in this Update do not alter the timing of these judgments and estimates required by Topic 606; thus, an acquirer should assess and/or determine judgments and estimates as of both the contract inception date (or modification date in circumstances in which the contract had been previously modified) and the acquisition date (for recurring estimates). For example, an acquirer would identify the performance obligations that exist in an acquired contract as of the contract inception date and estimate the transaction price as of the acquisition date. To clarify this point, the Board added paragraph 805-20-30-28, which describes how an acquirer should apply Topic 606 at the acquisition date to acquired contract assets and contract liabilities from contracts with customers and other in-scope contracts.
BC33. The Board indicated that differences between contract assets and contract liabilities recorded by an acquirer and those recorded by the acquiree before the acquisition generally would result from (a) differences in the acquirer’s and acquiree’s revenue recognition accounting policies and the resulting change to the acquiree’s policies, (b) differences in estimates between the acquirer and acquiree, or (c) errors in the Topic 606 accounting of the acquiree. Therefore, the Board acknowledged that the amendments in this Update may not always be as simple as carrying over the acquiree’s recorded contract assets or contract liabilities for some arrangements. Based on the outreach performed and comment letter feedback, the Board concluded that the information necessary to assess the acquiree’s recorded balance in accordance with Topic 606 should generally be available and that the assessment should be relatively straightforward for most revenue contracts acquired. The Board also explained that practical expedients and policy elections are not pervasive in Topic 606; therefore, conforming accounting policies and elections should not be overly burdensome. The Board acknowledged that certain areas in Topic 606 require the use of judgment, such as estimates of variable consideration or determining the method of measuring progress for performance obligations satisfied over time, especially for arrangements with longer contract terms. However, based on stakeholder outreach and comment letter feedback, the Board concluded that evaluating those areas of judgment should not be overly burdensome when compared with current practice and indicated that, in certain situations, acquirers are currently required to perform these assessments at the acquisition date and that acquirers subsequently account for those contracts in accordance with Topic 606 and their own accounting policies.
BC34. While a majority of comment letter respondents indicated that the amendments in this Update will simplify the current accounting for acquired contracts with customers in a business combination, several respondents expressed concerns about the complexity of the guidance related to circumstances in which (a) the acquirer has to assess long-term, complex contracts that may have been previously modified or (b) the acquirer is unable to assess or rely on the acquiree’s accounting under Topic 606. Specifically, respondents explained that in the above circumstances, it is likely that there would be a significant amount of judgment required to evaluate or determine certain estimates as of the contract inception date or, in cases in which the contract had been previously modified, at the modification date.
BC35. In response to those concerns, the Board decided to provide certain practical expedients in paragraph 805-20-30-29. The practical expedients are designed to alleviate the complexity of the amendments in those circumstances described by comment letter respondents. The Board indicated that in circumstances in which the acquirer could not assess or rely on the acquiree’s Topic 606 accounting, the acquirer would, in effect, need to adopt Topic 606 for all of the acquiree’s contracts with customers at the acquisition date. Therefore, the Board decided to provide a similar practical expedient to one of the transition practical expedients in paragraph 606-10-65-1(f). That practical expedient provides relief for contracts that have been previously modified before the acquisition date. Additionally, the Board provided a practical expedient about when (that is, at which date) an acquirer would have to determine the standalone selling price of each performance obligation in the acquired contract. Although no criteria must be met to apply the practical expedients, the Board’s primary reason for providing the practical expedients is to provide relief for situations in which the acquirer does not have the appropriate data or expertise to analyze the historical periods in which the contract was entered into.
BC36. The Board concluded that an acquirer would be more likely to utilize the practical expedients if it was unable to reasonably assess the acquiree’s Topic 606 accounting (for example, because of errors in the acquiree’s Topic 606 accounting or if the acquiree had not previously performed Topic 606 accounting) and, therefore, does not expect that the use of practical expedients would be widespread. Thus, the Board decided to provide those practical expedients to all acquirers and require that they be applied on an acquisition-by-acquisition basis. To be consistent with the requirements in Topic 606, the Board decided to require that entities disclose (a) the practical expedients that have been used and (b) to the extent reasonably possible, a qualitative assessment of the estimated effect of applying each of the expedients.
Other Topic 805 Considerations
BC37. The amendments in this Update relate only to contract assets and contract liabilities as defined in Topic 606. Therefore, the amendments do not affect the accounting for associated customer-related intangible assets (paragraph 805-20-55-20) or contract-based intangible assets (paragraph 805-20-55-31) that also may arise from revenue contracts with customers in a business combination. A majority of comment letter respondents explained that the existing guidance for intangible assets that may arise from revenue contracts in a business combination remains understandable and operable. However, several respondents requested that the Board clarify whether the process or result of evaluating contracts for off-market elements should be different under the proposed amendments. That is, because contract liabilities would not be measured at fair value under the proposed amendments, they questioned whether the proposed amendments would require recognition of additional off-market contracts. Additionally, other respondents questioned whether the amendments in the proposed Update on off-market contracts suggested that current practice for off-market contracts was no longer acceptable.
BC38. The Board considered the feedback provided and confirmed that contracts with customers should continue to be evaluated for related intangible assets and liabilities, such as customer relationships and contracts with off-market terms, in accordance with existing guidance. To alleviate the uncertainty expressed by comment letter respondents, the Board removed the proposed amendments that referenced customer-related intangible assets and contract-based intangible assets. Based on the outreach performed, the Board observed that assets and liabilities related to off-market contract terms in acquired revenue contracts are not currently prevalent in business combinations. Stakeholders should continue to assess revenue contracts for off-market terms and recognize and measure them in accordance with the current guidance in Topic 805.
BC39. Under the amendments in this Update, future expected variable consideration that is constrained under the constraint on estimates of variable consideration (paragraphs 606-10-32-11 through 32-14) or the guidance for sales-based and usage-based royalties (paragraph 606-10-55-65) in Topic 606 are precluded from being recognized in the acquired contract asset balance until the variable consideration is no longer constrained. While the future expected variable consideration that is constrained under Topic 606 is precluded from being measured and recognized in the contract asset balance, the fair value of that expected variable consideration could still be captured as part of the valuation of other intangible assets. The Board understands that this is similar to how revenue contracts with variable consideration are generally valued and accounted for in current practice.
BC40. The Board concluded that the amendments in this Update will simplify an area of business combination accounting that is complex and costly to apply. Both outreach participants and comment letter respondents explained that the amendments do not have significant implications on how other identifiable assets and liabilities that arise from revenue contracts are recognized and measured in a business combination in current practice. For acquired revenue contracts that do not have an associated contract liability at the acquisition date, the Board understands that the amendments are generally consistent with current practice. That is, the acquiree’s revenue accounting likely will be retained, and the fair value of those acquired revenue contracts will be captured within other identifiable assets or liabilities recognized in the business combination, such as customer-related intangible assets and contract-based intangible assets (for example, contracts with unfavorable terms compared with market terms).
BC41. The amendments in this Update generally align the accounting for acquired revenue contracts that were paid upfront before the acquisition and have an associated contract liability at the acquisition date with the current accounting for acquired revenue contracts that do not have an associated contract liability at the acquisition date. That is, the amendments likely will retain the acquiree’s revenue accounting under Topic 606 and if there are other identifiable assets or liabilities associated with the contract, they should be recognized in the business combination. For example, if an acquired contract with an associated contract liability is considered to have off-market terms, the off-market terms should be recognized and measured consistent with how they are currently recognized and measured for acquired contracts that do not have an associated contract liability (see paragraph BC38). The Board acknowledged that there is likely to be an increase in the acquired contract liabilities balance because of the amendments in this Update. The Board indicated that this is primarily because the preacquisition balance under Topic 606 would not be subject to the downward adjustments that usually result from fair value measurement of those liabilities related to the selling and marketing efforts to enter into the related contracts (see paragraph BC13). The Board believes that the corresponding increase to the acquired contract liabilities balance for those adjustments will generally be recognized in goodwill. The Board also believes that the resulting effects to the contract liabilities balance from these amendments should not affect how entities consider which underlying assets contribute to fulfilling contract liability obligations.
Postacquisition Revenue Recognition Considerations
BC42. The Board acknowledged that the expected increase in contract liabilities in a business combination will result in an increase in the subsequent revenue recognized by an acquirer, which a few stakeholders equated to creating an opportunity to “buy revenue.” That is, the acquirer may be able to recognize revenue for activities performed by an acquiree before the acquisition (for example, selling and marketing efforts to enter into the contracts). This concern was included in the basis for conclusions of Statement 141(R) as support for why previous business combination accounting under the pooling-of-interests method was inappropriate. However, the comprehensive guidance in Topic 606, which was issued after Statement 141(R), limited the number of arrangements that present this opportunity. Additionally, the model in Topic 606, which requires that an entity recognize revenue as the entity satisfies performance obligations, represents a faithful representation of performance and the revenue recognized for that performance. Accordingly, satisfying a performance obligation postacquisition will result in a consistent approach to recognizing revenue that is generally not affected by the timing of payment or by whether it was originated by the acquiree or the acquirer. The Board also indicated that stakeholders understand the Topic 606 guidance and its resulting outcomes and that the amendments in this Update provide subsequent revenue information that users seek when an entity completes a business combination. Additionally, the Board explained that certain intangible assets and liabilities (favorable or unfavorable contracts) would be recognized if the acquired revenue contract contains identified off-market terms or conditions, which limits the ability for an entity to acquire revenue contracts with favorable conditions and not depict those conditions in the financial statements.
BC43. The Board also acknowledged that there may be circumstances in which the revenue recognized by an acquirer after the acquisition may be different from what would have been recognized by an acquiree if there was no acquisition. For example, a contract liability balance may be higher or lower because of differences in accounting policies or an additional asset or liability may be recognized in the business combination for off-market contract terms (assuming the amortization of that asset or liability is presented in revenue). While this may cause users of financial statements some difficulty in analyzing revenue trends, the Board concluded that the subsequent revenue reported will provide decision-useful information because it better reflects future revenue of the acquirer. In situations in which there are adjustments recorded because of differences in accounting policies between the acquirer and acquiree, the resulting subsequent revenue will better indicate future revenue because it reflects how the acquirer will account for similar contracts after the acquisition. In situations in which contracts have off-market terms that are identified in accordance with current guidance and recorded as off-market terms (assuming the amortization of the asset or liability is presented as revenue), the resulting subsequent revenue will better indicate future revenue because it reflects the current market terms for the acquired contract.
BC44. As described in paragraphs BC20 through BC22, financial statement users explained that they currently seek additional information in order to reverse the effects of the fair value measurement of acquired revenue contracts with associated contract liabilities at the acquisition date. The Board indicated that the amendments in this Update provide the decision-useful information sought by users in the financial statements, which should further enhance the consistency and availability of this information.
Comparison of Recognition and Measurement Amendments with International Financial Accounting Standards (IFRS)
BC45. The Board acknowledges that the amendments in this Update create a potential difference between GAAP and IFRS Standards in an area for which the guidance in the respective standards has converged. Similar to GAAP, IFRS 3, Business Combinations, does not include specific guidance for the recognition or measurement of contract assets or contract liabilities. Therefore, entities follow principles similar to GAAP under which contract assets and contract liabilities are (a) recognized if they meet the conceptual framework definitions of assets and liabilities and (b) measured at fair value. However, while GAAP and IFRS Standards appear to converge in form, there are likely differences between the two sets of standards related to how contract liabilities are recognized and measured today because of differences in historical standard-setting efforts and existing diversity in how contract liabilities for certain arrangements are measured at fair value. Furthermore, under GAAP as discussed above, there is diversity in practice and inconsistency related to both recognition and measurement. Thus, while the written guidance is converged, consistent outcomes may not always be achieved today in practice. As indicated in paragraph BC24, the Board asked stakeholders whether divergence in this area of the guidance would create additional costs and complexity, and some stakeholders provided feedback that the benefit of decision useful information about revenue trends and acquired contracts from the amendments would outweigh the potential costs of divergence with IFRS Standards. As a result, although this will create a narrow difference between GAAP and IFRS Standards, given the facts and circumstances associated with this issue, the Board decided to adopt the amendments in this Update. Additionally, as explained in paragraph BC40, the amendments in this Update are generally consistent with how contract assets are accounted for under current practice.
BC46. The legal obligation concept included in Issue 01-3 that is used often in practice in the United States to determine whether an entity should recognize a contract liability (see paragraphs BC4 and BC5) did not previously exist in IFRS Standards. Therefore, the recognition criteria for contract liabilities in a business combination used by U.S. entities are likely different from the recognition criteria utilized by those entities that follow IFRS Standards. The difference in how the recognition criteria is applied between U.S. and international entities should be resolved by the amendments in this Update because the performance obligation criteria selected by the Board are more consistent with the conceptual definition of a liability.
BC47. Based on the research and outreach performed, the Board also observed that there is diversity in how an entity currently measures the fair value of contract liabilities for certain arrangements, such as licenses to intellectual property. That is, there may be diversity in considering which direct, incremental costs are necessary to fulfill the remaining performance obligation under fair value measurement techniques. Therefore, while both standards require that an entity measure the fair value of contract liabilities acquired in a business combination, the resulting measurement of similar contract liabilities may be inconsistent. The amendments in this Update address the diversity in current fair value measurement techniques for certain arrangements by requiring that an entity measure contract liabilities in accordance with Topic 606, although doing so will not result in enhanced convergence between GAAP and IFRS Standards.
Alternative Approaches Considered but Dismissed by the Board
BC48. The Board also considered an alternative approach that would have retained the fair value measurement principle in Topic 805. The net fair value approach would require that an entity (acquirer) measure the fair value of an acquired revenue contract at the acquisition date as the difference between the fair value of the expected remaining net contractual payments and the fair value of the remaining unsatisfied or partially unsatisfied performance obligation(s). Under this approach, an acquirer would recognize and present either a contract asset (when the fair value of the remaining contractual payments exceeds the fair value of the remaining performance obligations) or a contract liability (when the fair value of the remaining unsatisfied performance obligations exceeds the fair value of the remaining contractual payments) for acquired revenue contracts.
BC49. The approach theoretically would utilize the same contractual net cash flows to value an acquiree’s revenue contracts that are currently recognized and measured within customer-related intangible assets. The net fair value approach would have effectively reclassified those cash flows from intangible assets into a separate identifiable contract asset or liability for each acquired revenue contract or aggregated group of revenue contracts.
BC50. The Board ultimately rejected this approach because it concluded that the benefits may not justify the costs after all issues were considered. The Board agreed with stakeholders’ operability concerns both at the acquisition date when measuring the fair value of the acquired revenue contracts and after the acquisition date when accounting for the acquired revenue contracts under Topic 606. The Board indicated that the costs and complexity of this approach would be exacerbated by the existence of any acquired revenue contract that contained variable consideration. Additionally, the Board explained that the net fair value approach would likely have amplified the effect of fair value measurement on acquired revenue contracts and the subsequent amount of revenue recognized from those contracts. Therefore, financial statement users would have continued to request non-GAAP disclosures or supplemental information from preparers about the fair value adjustments and their effect on the revenue recognized subsequently by the entity.