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ASC 805-20-25-1 provides the recognition principle for assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree.

Excerpt from ASC 805-20-25-1

As of the acquisition date, the acquirer shall recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. Recognition of identifiable assets acquired and liabilities assumed is subject to the conditions specified in paragraphs 805-20-25-2 through 25-3.

An acquirer should recognize the identifiable assets acquired and the liabilities assumed on the acquisition date if they meet the definitions of assets and liabilities in FASB CON 6, Elements of Financial Statements (see Recent standard setting section below for additional information). For example, costs that an acquirer expects to incur but is not obligated to incur at the acquisition date (e.g., restructuring costs) are not liabilities assumed under ASC 805-20-25-2. An acquirer may also recognize assets and liabilities that are not recognized by the acquiree in its financial statements prior to the acquisition date, due to differences between the recognition principles in a business combination and other US GAAP. This can result in the recognition of intangible assets in a business combination, such as a brand name or customer relationship, which the acquiree would not recognize in its financial statements because these intangible assets were internally generated.
Certain assets acquired and liabilities assumed in connection with a business combination may not be considered part of the assets and liabilities exchanged in the business combination and will be recognized as separate transactions in accordance with other US GAAP, as described in BCG 2.7.
ASC 805-20-30-1 provides the principle with regard to the measurement of assets acquired and liabilities assumed and any noncontrolling interest in the acquiree.

Excerpt from ASC 805-20-30-1

The acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.

The measurement of the identifiable assets acquired and liabilities assumed is at fair value, with limited exceptions as provided for in ASC 805. Fair value is based on the definition in ASC 820-10-20 as the price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. See FV 7 for a discussion of the valuation techniques and issues related to the fair value measurement of the identifiable assets acquired and liabilities assumed.
The recognition and measurement of particular assets acquired and liabilities assumed are discussed in BCG 2.5.1 through BCG 2.5.19. The following table provides a summary of the exceptions to the recognition and fair value measurement principles in ASC 805, along with references to where these exceptions are discussed.
Summary of exceptions to the recognition and fair value measurement principles
Measurement principle
Recognition and measurement principles
In some instances, the SEC has expressed the view that significant differences between the acquired entity’s historical carrying value and the acquiring entity's estimated fair value could call into question whether the fair value determined by the acquiring entity and/or the carrying value reported by the acquired entity before the acquisition is appropriate. If it is determined that the pre-acquisition carrying value was not accurate in the acquired entity’s financial statements, the pre-acquisition financial statements may require adjustment.
Recent standard setting
In December 2021, the FASB issued two new chapters of Concepts Statement No. 8 (CON 8), Conceptual Framework for Financial Reporting. One of the chapters, Elements of Financial Statements, includes revised definitions of certain financial statement elements (e.g., assets and liabilities) and supersedes Concepts Statement No. 6, Elements of Financial Statements (CON 6). Despite this change, ASC 805-20-25-2 continues to reference CON 6. The FASB has an active project on its technical agenda to remove references to the Concepts Statements. Although the definitions of assets and liabilities were changed from CON 6 to CON 8, the recognition conditions for identifiable assets acquired and liabilities assumed as part of applying the acquisition method in a business combination are not expected to be impacted.

2.5.1 Assets that the acquirer does not intend to use

An acquirer, for competitive or other reasons, may intend to use the asset in a way that is not its highest and best use (i.e., different from the way other market participants would use the asset). Additionally, a company may acquire intangible assets in a business combination that it has no intention to actively use, but rather intends to hold them (lock them up) to prevent others from obtaining access to them (defensive intangible assets). ASC 805 specifies that the intended use of an asset by the acquirer does not affect its fair value. See BCG 4.5 for further information on the accounting and subsequent measurement of assets that the acquirer does not intend to use.

2.5.2 Valuation allowances (business combinations) after ASU 2016-13

As described in ASC 805-20-30-4, separate valuation allowances are not recognized for acquired non-financial assets that are measured at fair value, as any uncertainties about future cash flows are included in their fair value measurement.
The accounting for acquired financial assets within the scope of ASC 326 will depend on whether the financial assets are considered purchased with credit deterioration. Purchased financial assets without credit deterioration will be recorded at their acquisition date fair value. The fair value of short-term trade receivables generally incorporates only the time value of money and the customers’ credit risk. In certain situations, the fair value of acquired short-term trade receivables may approximate their carrying value if the receivables are short term in nature and customer credit risk is not significant in the context of their short-term nature. Additionally, consistent with ASC 805-20-30-4A, an allowance is recorded with a corresponding charge to credit loss expense in the reporting period in which the acquisition occurs for financial assets in the scope of ASC 326-20, such as receivables, net investments in leases, and held-to-maturity debt securities. Purchased financial assets in the scope of ASC 326 with credit deterioration are not recognized at fair value. They are an exception to the measurement principle in ASC 805. Instead, as described in ASC 805-20-30-4B, the acquirer will first determine the fair value of the financial asset as of the acquisition date and then will recognize an allowance calculated in accordance with ASC 326 with a corresponding increase to the cost basis of the financial asset as of the acquisition date.

Excerpt from ASC Master Glossary

Purchased financial assets with credit deterioration: Acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that, as of the date of acquisition, have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment.

ASU 2016-13 is effective for public business entities that are SEC filers, excluding entities eligible to be smaller reporting companies (SRCs) as defined by the SEC. For SRCs and all other entities, the revised guidance will be effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Early adoption is permitted. For additional information on the definition of SRCs and the effective dates of ASU 2016-13, refer to LI 13.1.
See LI 9 for additional information on purchased financial assets with credit deterioration.
Contract assets
In the basis for conclusions of ASU 2021-08, the FASB clarified that this ASU did not address the application of the credit loss guidance. ASC 606-10-45-3 requires contract assets to be evaluated for credit losses under ASC 326-20. ASC 326-20-45-1 and the definition of “amortized cost basis” in ASC 326-20-20 states that the credit loss allowance is separate from its related gross asset balance (i.e., an asset subject to a credit loss allowance does not have a cost basis net of the allowance). Accordingly, we believe an acquirer should record any contract assets of the acquiree at the acquisition date (see BCG 2.5.16.1) in accordance with ASU 2021-08 at its cost basis (which does not include an allowance for credit losses), and then should record an allowance on those contract assets with a corresponding charge to credit loss expense (consistent with ASC 805-20-30-4A) in the reporting period in which the acquisition occurs. Additionally, as contract assets do not meet the definition of “financial assets” and will not be recorded at fair value under the new guidance, we believe the guidance related to purchased financial assets with credit deterioration described in ASC 326-20 (including the related acquisition accounting guidance in ASC 805-20-30-4B) does not apply to contract assets.
Note about ongoing standard setting
The FASB has an active project related to acquired financial assets. Specifically, the FASB is considering changing the term “purchased with credit deterioration (PCD)” in ASC 326 to “purchased financial assets (PFA)” and expanding the scope of the PFA model to include most financial assets acquired in a business combination. Financial statement preparers and other users of this publication are therefore encouraged to monitor the status of the project, and if finalized, evaluate the effective date of the new guidance and the accounting implications.

2.5.2A Valuation allowances (business combinations) before ASU 2016-13

Separate valuation allowances are not recognized for acquired assets that are measured at fair value, as any uncertainties about future cash flows are included in their fair value measurement, as described in ASC 805-20-30-4. This precludes the separate recognition of an allowance for doubtful accounts or an allowance for loan losses. Companies may need to separately track contractual receivables and any valuation losses to comply with certain disclosure and other regulatory requirements in industries such as financial services. In accordance with ASC 805-20-50-1(b), in the reporting period in which the business combination occurs, the acquirer should disclose the fair value of the acquired receivables, their gross contractual amounts, and an estimate of cash flows not expected to be collected.
The use of a separate valuation allowance is permitted for assets that are not measured at fair value on the acquisition date (e.g., certain indemnification assets). Consequently, a valuation allowance for deferred income tax assets is allowed.

2.5.3 Inventory acquired in a business combination

Acquired inventory can be in the form of finished goods, work in process (WIP), and/or raw materials. ASC 805 requires inventory acquired in a business combination to be measured at its fair value on the acquisition date in accordance with ASC 820. Ordinarily, the amount recognized for inventory at fair value by the acquirer will be higher than the amount recognized by the acquiree before the business combination. See FV 7.3.3.1 for further information.

2.5.4 Contracts acquired in a business combination

Contracts (e.g., sales contracts, supply contracts) assumed in a business combination may give rise to assets or liabilities. An intangible asset or liability may be recognized for contract terms that are favorable or unfavorable compared to current market transactions or related to identifiable economic benefits for contract terms that are at market. See BCG 4 for further discussion of the accounting for contract-related intangible assets. Also see BCG 2.5.16 for further discussion of acquired revenue contracts.

2.5.5 Intangible assets acquired in a business combination

All identifiable intangible assets that are acquired in a business combination should be recognized at fair value on the acquisition date. Identifiable intangible assets are recognized separately if they arise from contractual or other legal rights or if they are separable (i.e., capable of being sold, transferred, licensed, rented, or exchanged separately from the entity). This includes research and development acquired in a business combination, which is recognized at fair value and capitalized as an indefinite-lived intangible asset. See BCG 4 for guidance on the recognition and measurement of intangible assets.

2.5.6 Reacquired rights in a business combination

An acquirer may reacquire a right that it had previously granted to the acquiree to use one or more of the acquirer’s recognized or unrecognized assets. Examples of such rights include a right to use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology under a technology licensing agreement. Such reacquired rights generally are identifiable intangible assets that the acquirer separately recognizes from goodwill in accordance with ASC 805-20-25-14. The reacquisition must be evaluated separately to determine if a gain or loss on the settlement should be recognized. See BCG 2.7.2.1 for further information.
Understanding the facts and circumstances, including those surrounding the original relationship between the parties prior to the business combination, is necessary to determine whether the reacquired right constitutes an identifiable intangible asset. Some considerations include:
  • How was the original relationship structured and accounted for? What was the intent of both parties at inception?
  • Was the original relationship an outright sale with immediate revenue recognition, or was deferred revenue recorded as a result? Was an up-front, one-time payment made, or was the payment stream ongoing? Was the original relationship an arm’s-length transaction, or was the original transaction set up to benefit a majority-owned subsidiary or joint venture entity with off-market terms?
  • Was the original relationship created through a capital transaction, or was it created through an operating (executory) arrangement? Did it result in the ability or right to resell some tangible or intangible rights?
  • Has there been any enhanced or incremental value to the acquirer since the original transaction?
  • Is the reacquired right exclusive or nonexclusive?

Contracts giving rise to reacquired rights that include a royalty or other type of payment provision should be assessed for contract terms that are favorable or unfavorable when compared to pricing for current market transactions. A settlement gain or loss should be recognized and measured at the acquisition date for any favorable or unfavorable contract terms identified. A settlement gain or loss related to a reacquired right should be measured consistently with the guidance for the settlement of preexisting relationships. See BCG 2.7.2.1 for further information. The amount of any settlement gain or loss should not impact the measurement of the fair value of any intangible asset related to the reacquired right.
The acquisition of a reacquired right may be accompanied by the acquisition of other intangibles that should be recognized separately from both the reacquired right and goodwill. For example, a company grants a franchise to a franchisee to develop a business in a particular country. The franchise agreement includes the right to use the company’s trade name and proprietary technology. After a few years, the company decides to reacquire the franchise in a business combination for an amount greater than the fair value of a new franchise right. The excess of the value transferred over the franchise right is an indicator that other intangibles, such as customer relationships, customer contracts, and additional technology, could have been acquired along with the reacquired right.

2.5.6.1 Determining value and useful life of reacquired rights

Reacquired rights are identified as an exception to the fair value measurement principle because the value recognized for reacquired rights is not based on market-participant assumptions. In accordance with ASC 805-20-30-20, the value of a reacquired right is determined based on the estimated cash flows over the remaining contractual life, even if market-participants would reflect expected renewals in their measurement of that right. The basis for this measurement exception is that a contractual right acquired from a third party is not the same as a reacquired right under FAS 141(R).B309. Because a reacquired right is no longer a contract with a third party, an acquirer that controls a reacquired right could assume indefinite renewals of its contractual term, effectively making the reacquired right an indefinite-lived intangible asset.
Assets acquired and liabilities assumed, including any reacquired rights, should be measured using a valuation technique that considers cash flows after payment of a royalty rate to the acquirer for the right that is being reacquired because the acquiring entity is already entitled to this royalty. The amount of consideration that the acquirer would be willing to pay for the acquiree is based on the cash flows that the acquiree is able to generate above and beyond the royalty rate that the acquirer is already entitled to under the agreement.
The FASB concluded that a right reacquired from an acquiree in substance has a finite life (i.e., the contract term); a renewal of the contractual term after the business combination is not part of what was acquired in the business combination.
Therefore, consistent with the measurement of the acquisition date value of reacquired rights, the useful life over which the reacquired right is amortized in the postcombination period should be based on the remaining contractual term without consideration of any contractual renewals. In the event of a reissuance of the reacquired right to a third party in the postcombination period, any remaining unamortized amount related to the reacquired right should be included in the determination of any gain or loss upon reissuance in accordance with ASC 805-20-35-2.
In some cases, the reacquired right may not have any contractual renewals and the remaining contractual life may not be clear, such as with a perpetual franchise right. An assessment should be made as to whether the reacquired right is an indefinite-lived intangible asset that would not be amortized, but subject to periodic impairment testing. A conclusion that the useful life is indefinite requires careful consideration and is expected to be infrequent. If it is determined that the reacquired right, such as a perpetual franchise right, is not an indefinite-lived intangible asset, then the reacquired right should be amortized over its economic useful life. See PPE 4.2.1 for guidance on identifying the useful life of an intangible asset.
Example BCG 2-7 illustrates the recognition and measurement of a reacquired right in a business combination.
EXAMPLE BCG 2-7
Recognition and measurement of a reacquired right
Company A owns and operates a chain of retail coffee stores. Company A also licenses the use of its trade name to unrelated third parties through franchise agreements, typically for renewable five-year terms. In addition to on-going fees for cooperative advertising, these franchise agreements require the franchisee to pay Company A an up-front fee and an on-going percentage of revenue for continued use of the trade name.
Company B is a franchisee with the exclusive right to use Company A’s trade name and operate coffee stores in a specific market. Pursuant to its franchise agreement, Company B pays to Company A a royalty rate equal to 6% of revenue. Company B does not have the ability to transfer or assign the franchise right without the express permission of Company A.
Company A acquires Company B for cash consideration. Company B has three years remaining on the initial five-year term of its franchise agreement with Company A as of the acquisition date. There is no unfavorable/favorable element of the contract.
What should Company A consider when recognizing the reacquired right?
Analysis
Company A will recognize a separate intangible asset at the acquisition date related to the reacquired franchise right, which will be amortized over the remaining three-year period. The value ascribed to the reacquired franchise right under the acquisition method should exclude the value of potential renewals. The royalty payments under the franchise agreement should not be used to value the reacquired right, as Company A already owns the trade name and is entitled to the royalty payments under the franchise agreement. Instead, Company A’s valuation of the reacquired right should consider Company B’s applicable net cash flows after payment of the 6% royalty. In addition to the reacquired franchise rights, other assets acquired and liabilities assumed by Company A should also be measured using a valuation technique that considers Company B’s cash flows after payment of the royalty rate to Company A.

2.5.7 Property, plant, and equipment acquired in a business combination

Property, plant, and equipment acquired in a business combination intended to be held and used should be recognized and measured at fair value. Accumulated depreciation of the acquiree is not carried forward in a business combination. See FV 7.3.3.2 for further information on the measurement of property, plant, and equipment. See BCG 4.3.3.7 for the recognition and measurement of right-of-use assets and lease liabilities of an acquiree in a business combination. Also, see BCG 2.5.8 for the recognition and measurement of long-lived assets acquired in a business combination classified by the acquirer as held for sale.

2.5.7.1 Government grants acquired in a business combination

Assets acquired with funding from a government grant should be recognized at fair value without regard to the government grant. Similarly, if the government grant provides an ongoing right to receive future benefits, that right should be measured at its acquisition-date fair value and separately recognized. For a government grant to be recognized as an asset, the grant should be uniquely available to the acquirer and not dependent on future actions. The terms of the government grant should be evaluated to determine whether there are on-going conditions or requirements that would indicate that a liability exists. If a liability exists, the liability should be recognized at its fair value on the acquisition date.

2.5.7.2 AROs in a business combination

An acquirer may obtain long-lived assets, such as property, plant, and equipment, that upon retirement require the acquirer to dismantle or remove the assets and restore the site on which it is located (i.e., asset retirement obligations (AROs)). If an ARO exists at the acquisition date, it must be recognized at fair value (using market-participant assumptions), which may be different than the amount previously recognized by the acquiree. Long-lived assets and any associated AROs acquired in a business combination should be recorded on a gross basis. In other words, the acquired long-lived assets should be recorded at fair value, unencumbered by future cash flows associated with the settlement of the asset retirement obligation. Separately, an ARO should be recorded at fair value on the acquisition date. The long-lived asset and ARO are separate units of account.
For example, a nuclear power plant is acquired in a business combination. The acquirer determines that an ARO of $100 million (fair value) associated with the power plant exists at the acquisition date. The appraiser has included the expected cash outflows of the ARO in the cash flow model, establishing the value of the plant at $500 million (i.e., the appraised value of the power plant would be $100 million higher if the ARO were disregarded). The acquirer would record the power plant and the ARO as two separate units of account. The acquirer would record the power plant at its fair value of $600 million (i.e., on an unencumbered basis) and an ARO of $100 million.

2.5.8 Acquired assets held for sale in a business combination

Assets held for sale are an exception to the fair value measurement principle because they are measured at fair value less costs to sell. A long-lived asset or group of assets (disposal group) may be classified and measured as assets held for sale at the acquisition date if, from the acquirer’s perspective, the classification criteria in ASC 360-10, Property, Plant, and Equipment, are met.
ASC 360-10-45-12 provides specific criteria which, if met, would require the acquirer to present newly-acquired assets as assets held for sale. The criteria require a plan to dispose of the assets within a year and that it be probable that the acquirer will meet the other held for sale criteria within a short period of time after the acquisition date (generally within three months). The other criteria in ASC 360-10-45-9 include (1) management having the authority to approve an action commits to sell the assets; (2) assets are available for immediate sale in their present condition, subject only to sales terms that are usual and customary; (3) an active program to locate a buyer and actions to complete the sale are initiated; (4) assets are being actively marketed; and (5) it is unlikely there will be significant changes to, or withdrawal from, the plan to sell the assets. If the criteria are not met, those assets should not be classified as assets held for sale until all applicable criteria have been met. See PPE 5.3 for further information on accounting for assets held for sale under US GAAP.
If the acquired disposal group is a business that upon acquisition meets the held for sale criteria, it must be presented as a discontinued operation. See FSP 27.3.1.1 for further information on this requirement.

2.5.9 Income taxes related to business combinations

Income taxes are identified as an exception to the recognition and fair value measurement principles. The acquirer should record all deferred tax assets, liabilities, and valuation allowances of the acquiree that are related to any temporary differences, tax carryforwards, and uncertain tax positions in accordance with ASC 740, Income Taxes.
Deferred tax liabilities are not recognized for goodwill that is not tax-deductible. However, see TX 10.8 for discussion of the treatment of tax-deductible goodwill. Additionally, deferred tax liabilities should be recognized for differences between the book and tax basis of indefinite-lived intangible assets.
Subsequent changes to deferred tax assets, liabilities, valuation allowances, or liabilities for any income tax uncertainties of the acquiree will impact income tax expense in the postcombination period unless the change is determined to be a measurement period adjustment. See BCG 2.9 for further information on measurement period adjustments.
Adjustments or changes to the acquirer’s deferred tax assets or liabilities as a result of a business combination should be reflected in earnings or, if specifically permitted, charged to equity in the period subsequent to the acquisition. See TX 10 for further information on the recognition of income taxes and other tax issues related to a business combination. Alternatively, if the tax change is not a part of the business combination, it should be accounted for as a separate transaction.

2.5.10 Employee benefit plans acquired in a business combination

Employee benefit plans are an exception to the recognition and fair value measurement principles. In accordance with ASC 805-20-25-23, employee benefit plan obligations are recognized and measured in accordance with the guidance in applicable US GAAP, rather than at fair value. Applicable guidance under US GAAP includes:
  • ASC 420, Exit or Disposal Cost Obligations
  • ASC 710, Compensation—General
  • ASC 712, Compensation—Nonretirement Postemployment Benefits
  • ASC 715, Compensation—Retirement Benefits

Under ASC 712, some employers may apply the recognition and measurement guidance in ASC 715 to nonretirement postemployment benefit plans (e.g., severance arrangements). In these situations, the ASC 712 plans of an acquiree should be accounted for by the acquirer in a manner similar to the accounting for ASC 715 plans in a business combination.
ASC 805 requires recognition of a pension asset or liability of a single-employer defined benefit pension plan in connection with recording assets and liabilities of a business combination. A pension liability is recorded for the excess of the projected benefit obligation over the fair value of the plan assets. A pension asset is recorded if the fair value of the plan assets exceeds the projected benefit obligation. The projected benefit obligation and the fair value of plan assets should be measured at the acquisition date using current discount rates and assumptions established by the acquirer. Unlike annual and interim remeasurements, there is no practical expedient to measure the plan assets and obligations as of the closest calendar month-end date in a business combination.
The amount recorded for the pension asset or liability in an acquisition essentially represents a "fresh start" approach; there are no amounts recorded in accumulated other comprehensive income that are carried over from the acquired company. Accordingly, subsequent net periodic pension cost should not include amortization of the acquired company's prior service cost/credit, net gain or loss, or transition amount. If a calculated "market-related value" is used, it is also appropriate to restart the calculation for the plan assets (i.e., use fair value at the acquisition date and phase into a new computed market-related value prospectively) at acquisition. Consistent with ASC 715-30-55-37, the methodology used to compute market-related value of the acquired plan should generally be consistent with the acquiring company's methodology.
When determining the funded status of the plan at the acquisition date, the acquiring entity should exclude the effects of expected plan amendments, terminations, or curtailments that it has no obligation to make at the acquisition date.
If the acquirer is not obligated to amend the plan in connection with the business combination, a post-acquisition amendment to the plan that gives rise to prior service cost or credit would be accounted for by the acquirer in the post-acquisition period. As a result, the impact of such an amendment would be recognized in the income statement of the acquirer in future periods. On the other hand, if the acquirer is obligated to make the amendment (e.g., for legal or regulatory requirements), the impact of a plan amendment would generally be incorporated into the initial measurement of the plan in acquisition accounting.
ASC 805-20-55-50 and ASC 805-20-55-51 state that a liability for contractual termination benefits and for curtailment losses under employee benefit plans that will be triggered by consummation of a business combination should be recognized when the combination is consummated, even if consummation (and therefore the liabilities) is probable at an earlier date.
If the business combination is consummated, but the pension assets are to be transferred from the seller's pension trust at a later date (i.e., based on a final valuation as of the merger date), the acquirer should estimate the amount to be received and record this as part of acquisition accounting, similar to a working capital adjustment. The acquirer then must determine if this receivable meets the definition of plan assets. If the pension assets will be transferred from the seller's pension trust directly to the acquirer's pension trust, we believe that this receivable would be a plan asset and result in a net presentation within the opening net pension asset or liability. If the pension assets will be transferred to the acquirer (rather than directly to the acquirer's pension trust), they would not meet the definition of plan assets and the acquirer would record a receivable separate from the opening net pension liability, resulting in gross presentation. Companies should consider disclosing both situations if material.
In some transactions, the seller agrees to reimburse the buyer for payments made under the plan to retired participants of the plan at the date of the business combination. If the payment is made directly to the acquirer (and not the acquirer’s pension trust), this reimbursement should be presented gross, with the recognition of a receivable and a pension liability. The receivable would be based on the corresponding actuarially determined pension liability. The receivable should also reflect the credit risk of the seller.
If enhanced pension benefits are offered as part of a voluntary termination program that is not contingent upon the acquisition, ASC 715 should take precedence over ASC 805. Therefore, the effects should only be included in the determination of the pension liability (asset) at the acquisition date to the extent the voluntary termination offer is accepted before that date.
For a multiemployer plan in which the acquired company's employees participate, an obligation to the plan for a portion of its unfunded benefit obligations should not be established at the acquisition date unless withdrawal from the multiemployer plan is probable. The FASB acknowledged in B298 in the basis for conclusions of FAS 141(R) that the provisions for single-employer and multiemployer plans are not necessarily consistent.
Question BCG 2-1
Can modifications to defined benefit pension plans be included as part of the acquisition accounting in a business combination if the modifications are written into the acquisition agreement as an obligation of the acquirer?
PwC response
Generally, no. ASC 805 generally requires employee compensation costs for future services, including pension costs, to be recognized in earnings in the postcombination period. Modifications to defined benefit pension plans are usually done for the benefit of the acquirer. A transaction that primarily benefits the acquirer is likely to be a separate transaction. Additionally, modifications to a defined benefit pension plan would typically relate to future services of the employees. It is not appropriate to analogize this situation to the exception in ASC 805 dealing with share-based compensation arrangements. That exception allows the acquirer to include a portion of the fair value based measure of replacement share-based payment awards as consideration in acquisition accounting through an obligation created by a provision written into the acquisition agreement. Such an exception should not be applied to modifications to defined benefit pension plans under the scenario described.
ASC 805-10-55-18 provides further interpretive guidance of factors to consider when evaluating what is part of a business combination, such as the reason for the transaction, who initiated the transaction and the timing of the transaction. See BCG 3.2 for further information on accounting for compensation arrangements.

2.5.11 Payables and debt assumed in a business combination

An acquiree’s payables and debt assumed by the acquirer are recognized at fair value in a business combination. Short-term payables are generally recorded based on their settlement amounts since the settlement amounts would be expected to approximate fair value. However, the measurement of debt at fair value may result in an amount different from what was recognized by the acquiree before the business combination. See FV 7.3.3.5 for further discussion of the measurement of debt at fair value. Unamortized revolving line of credit debt issuance costs of the acquiree do not meet the definition of an asset and, therefore, would not be recognized by the acquirer in a business combination.
An acquirer may settle (i.e., pay-off) some or all of the outstanding debt of the acquiree on, or in close proximity to, the date of the business combination. In these situations, it is important to determine whether the cash paid to settle the acquiree’s debt should be recognized (1) as a component of consideration transferred or (2) as the acquirer’s settlement of an assumed liability of the acquiree post-acquisition.
Cash paid by the acquirer to settle the acquiree’s outstanding debt on, or in close proximity to, the date of the business combination is generally recognized as a component of consideration transferred if the acquirer does not legally assume the outstanding debt. In this scenario, an assumed liability for the outstanding debt of the acquiree would not be recognized in acquisition accounting. However, if the acquirer legally assumes the acquiree’s outstanding debt through the business combination, an assumed liability should be recognized at fair value on the acquisition date. Any subsequent repayment of the debt is a separate transaction from the business combination and would not be a component of consideration transferred. See FSP 6.8.20 for discussion of the impact on the statement of cash flows.
In other situations, an acquirer may incur new debt with a third party to fund a business combination. The new debt incurred by the acquirer to fund the business combination is not an assumed liability.

2.5.12 Guarantees assumed in a business combination

All guarantees made by the acquiree and assumed by the acquirer in a business combination are recognized at fair value on the acquisition date. An assumed guarantee would be accounted for under ASC 460, Guarantees, and the acquirer should relieve the guarantee liability through earnings using a systematic and rational manner as it is released from risk.

2.5.13 Contingencies: recognition and measurement

ASC 805-20-20 defines contingencies as existing conditions, situations, or sets of circumstances resulting in uncertainty about a possible gain or loss that will be resolved if one or more future events occur or fail to occur. ASC 805-20-25-18A through ASC 805-20-25-20A include a framework that acquirers should follow in recognizing preacquisition contingencies.
An acquirer should first determine whether the acquisition-date fair value of the asset or liability arising from the preacquisition contingency can be determined as of the acquisition date or during the measurement period. If the acquisition-date fair value of the contingency can be determined, the corresponding asset or liability should be recognized at fair value as part of acquisition accounting. For example, an acquirer will often have sufficient information to determine the fair value of warranty obligations assumed in a business combination. Generally, an acquirer also has sufficient information to determine the fair value of other contractual contingencies assumed in a business combination, such as penalty provisions in a supply agreement. In contrast, the fair value of legal contingencies assumed in a business combination may not be determinable.
If the acquisition-date fair value of assets or liabilities arising from the preacquisition contingency cannot be determined as of the acquisition date or during the measurement period, the acquirer should recognize the estimated amount of the asset or liability as part of the acquisition accounting if both of the following criteria are met:
  • It is probable that an asset existed or a liability had been incurred at the acquisition date based on information available prior to the end of the measurement period. It is implicit in this condition that it must be probable at the acquisition date that one or more future events confirming the existence of the asset or liability will occur.
  • The amount of asset or liability can be reasonably estimated.

The above recognition criteria should be applied using the guidance provided in ASC 450 (i.e., application of similar criteria in ASC 450-20-25-2). In a business combination, this guidance applies to both assets and liabilities arising from preacquisition contingencies.
Contingencies identified during the measurement period that existed as of the acquisition date qualify for recognition as part of acquisition accounting. However, if the above criteria are not met based on information that is available as of the acquisition date or during the measurement period about facts and circumstances that existed as of the acquisition date, the acquirer should not recognize an asset or liability as part of acquisition accounting. In periods after the measurement period, the acquirer should account for such assets or liabilities in accordance with other GAAP, including ASC 450, as appropriate.
Example BCG 2-8, Example BCG 2-9, and Example BCG 2-10 illustrate the initial recognition and measurement of acquired contingencies.
EXAMPLE BCG 2-8
Recognition and measurement of a warranty obligation: fair value can be determined on the acquisition date
On June 30, 20X1, Company A purchases all of Company B’s outstanding equity shares for cash. Company B’s products include a standard three-year warranty. An active market does not exist for the transfer of the warranty obligation or similar warranty obligations. Company A expects that the majority of the warranty expenditures associated with products sold in the last three years will be incurred in the remainder of 20X1 and in 20X2 and that all will be incurred by the end of 20X3. Based on Company B’s historical experience with the products in question and Company A’s own experience with similar products, Company A estimates the potential undiscounted amount of all future payments that it could be required to make under the warranty arrangements.
Should Company A recognize a warranty obligation as of the acquisition date?
Analysis
Company A has the ability to estimate the expenditures associated with the warranty obligation assumed from Company B as well as the period over which those expenditures will be incurred. Company A would generally conclude that the fair value of the liability arising from the warranty obligation can be determined at the acquisition date and would determine the fair value of the liability to be recognized at the acquisition date by applying a valuation technique prescribed by ASC 820. In the postcombination period, Company A would subsequently account for and measure the warranty obligation using a systematic and rational approach. A consideration in developing such an approach is Company A’s historical experience and the expected value of claims in each period as compared to the total expected claims over the entire period.
EXAMPLE BCG 2-9
Recognition and measurement of a litigation related contingency: fair value cannot be determined on the acquisition date
In a business combination, Company C assumes a contingency of Company D related to employee litigation. Based upon discovery proceedings to date and advice from its legal counsel, Company C believes that it is reasonably possible that Company D is legally responsible and will be required to pay damages. Neither Company C nor Company D have had previous experience in dealing with this type of employee litigation, and Company C’s attorney has advised that results in this type of case can vary significantly depending on the specific facts and circumstances of the case. An active market does not exist to transfer the potential liability arising from this type of lawsuit to a third party. Company C has concluded that on the acquisition date, and at the end of the measurement period, adequate information is not available to determine the fair value of the lawsuit.
Should Company C recognize a contingent liability for the employee litigation?
Analysis
No. A contingent liability for the employee litigation is not recognized at fair value on the acquisition date. Company C would not record a liability by analogy to ASC 450-20-25-2, because it has determined that an unfavorable outcome is reasonably possible, but not probable. Therefore, Company C would recognize a liability in the postcombination period when the recognition and measurement criteria in ASC 450 are met.
EXAMPLE BCG 2-10
Recognition and measurement of a litigation related contingency: decision to settle on the acquisition date
In a business combination, Company C assumes a contingency of Company D related to employee litigation. Based upon discovery proceedings to date and advice from its legal counsel, Company C believes that it is reasonably possible that Company D is legally responsible and will be required to pay damages. Neither Company C nor Company D have had previous experience in dealing with this type of employee litigation, and Company C’s attorney has advised that results in this type of case can vary significantly depending on the specific facts and circumstances of the case. An active market does not exist to transfer the potential liability arising from this type of lawsuit to a third party. Company C has decided to pay $1 million to settle the liability on the acquisition date to avoid damage to its brand or further costs associated with the allocation of resources and time to defend the case in the future.
Should Company C recognize a contingent liability for the employee litigation?
Analysis
Yes. Company C would record the liability to settle the litigation on the acquisition date applying the guidance of ASC 805-20-25-20 (i.e., by analogy to ASC 450-20-25-2). Company C’s decision to pay a settlement amount indicates that it is probable that Company C has incurred a liability as of the acquisition date and that the amount of the liability can be reasonably estimated.

Question BCG 2-2
Should an accounting acquirer that has an accounting policy to expense legal fees as incurred accrue future costs to defend litigation assumed in a business combination as of the acquisition date if the fair value of the litigation contingency cannot be determined?
PwC response
No. Given that the accounting acquirer has historically elected an accounting policy to expense legal fees as incurred, it would not be appropriate to accrue future legal costs as of the acquisition date, even though the related litigation existed as of the acquisition date. Instead, such future legal costs should be expensed as incurred consistent with the acquirer’s policy.
However, if the litigation contingency was recognized at fair value on the acquisition date (i.e., if the fair value was determinable at the acquisition date), future legal fees would be included in the fair value measurement.

2.5.13.1 Contingencies: subsequent measurement

The acquirer should develop a systematic and rational approach for subsequently measuring and accounting for assets and liabilities arising from contingencies that were recognized at fair value on the date of acquisition. The approach should be consistent with the nature of the asset or liability. Although ASC 805 does not provide guidance on subsequent accounting for contingencies, we believe the acquirer should consider the initial recognition and measurement of the contingency when developing the systematic and rational basis. For example, the method developed for the subsequent accounting for warranty obligations may be similar to methods that have been used in practice to subsequently account for guarantees that are initially recognized at fair value under ASC 460-10-35-2. For other contingencies initially recognized at fair value, we believe that a systematic and rational approach may consider accretion of the liability as well as changes in estimates of the cash flows (e.g., an accounting model similar to asset retirement obligations under ASC 410-20 may be an acceptable method). Judgment is required to determine the method for subsequently accounting for assets and liabilities arising from contingencies.
It would not be appropriate to recognize an acquired contingency at fair value on the acquisition date and then in the immediate subsequent period value the acquired contingency in accordance with ASC 450, with a resulting gain or loss for the difference. In addition, subsequently measuring an acquired asset or liability at fair value is not considered to be a systematic or rational approach, unless required by other GAAP.
Companies will need to develop policies for transitioning from the initial fair value measurement of assets or liabilities arising from contingencies on the acquisition date to subsequent measurement and accounting at amounts other than fair value, in accordance with other GAAP.
If the acquirer recognized an asset or liability under ASC 450 on the acquisition date, the acquirer should continue to follow the guidance in ASC 450 in periods after the acquisition date.
If the acquirer did not recognize an asset or liability at the acquisition date because none of the recognition criteria are met, the acquirer should account for such assets or liabilities in the periods after the acquisition date in accordance with other GAAP, including ASC 450, as appropriate.

2.5.14 Indemnification assets (business combinations)

Indemnification assets are an exception to the recognition and fair value measurement principles because indemnification assets are recognized and measured differently than other contingent assets. Indemnification assets (sometimes referred to as seller indemnifications) may be recognized if the seller contractually indemnifies, in whole or in part, the buyer for a particular uncertainty, such as a contingent liability or an uncertain tax position.
The recognition and measurement of an indemnification asset is based on the related indemnified item. That is, the acquirer should recognize an indemnification asset at the same time that it recognizes the indemnified item, measured on the same basis as the indemnified item, subject to collectibility or contractual limitations on the indemnified amount. Indemnification assets recognized on the acquisition date (or at the same time as the indemnified item) continue to be measured on the same basis as the related indemnified item subject to collectibility and contractual limitations on the indemnified amount until they are collected, sold, cancelled, or expire in the postcombination period.
Question BCG 2-3
How should a buyer account for an indemnification from the seller when the indemnified item has not met the criteria to be recognized on the acquisition date?
PwC response
ASC 805 states that an indemnification asset should be recognized at the same time as the indemnified item. Therefore, if the indemnified item has not met the recognition criteria as of the acquisition date, an indemnification asset should not be recognized. If the indemnified item is recognized subsequent to the acquisition, the indemnification asset would then also be recognized on the same basis as the indemnified item subject to management’s assessment of the collectibility of the indemnification asset and any contractual limitations on the indemnified amount. This accounting would be applicable even if the indemnified item is recognized outside of the measurement period.
Question BCG 2-4
Does an indemnification arrangement need to be specified in the acquisition agreement to achieve indemnification accounting?
PwC response
No. Indemnification accounting can still apply even if the indemnification arrangement is the subject of a separate agreement. Indemnification accounting applies as long as the arrangement is entered into on the acquisition date, is an agreement reached between the acquirer and seller, and relates to a specific contingency or uncertainty of the acquired business, or is in connection with the business combination.
Question BCG 2-5
Should acquisition consideration held in escrow for the seller’s satisfaction of general representation and warranties be accounted for as an indemnification asset?
PwC response
General representations and warranties would not typically relate to any contingency or uncertainty related to a specific asset or liability of the acquired business. Therefore, in most cases, the amounts held in escrow for the seller’s satisfaction of general representations and warranties would not be accounted for as an indemnification asset. See BCG 2.6.3.3 for further information on consideration held in escrow for general representation and warranty provisions.

Example BCG 2-11 provides an example of the recognition and measurement of an indemnification asset.
EXAMPLE BCG 2-11
Recognition and measurement of an indemnification asset
As part of an acquisition, the seller provides an indemnification to the acquirer for potential losses from an environmental matter related to the acquiree. The contractual terms of the seller indemnification provide for the reimbursement of any losses greater than $100 million. There are no issues surrounding the collectibility of the arrangement from the seller. A contingent liability of $110 million is recognized by the acquirer on the acquisition date using similar criteria to ASC 450-20-25-2 because the fair value of the contingent liability could not be determined during the measurement period. At the next reporting period, the amount recognized for the environmental liability is increased to $115 million based on new information.
How should the seller indemnification be recognized and measured?
Analysis
The seller indemnification should be considered an indemnification asset and should be recognized and measured on a similar basis as the related environmental contingency. On the acquisition date, an indemnification asset of $10 million ($110 million less $100 million), is recognized. At the next reporting period after the acquisition date, the indemnification asset is increased to $15 million ($115 million less $100 million), with the $5 million adjustment offsetting the earnings impact of the $5 million increase in the contingent liability.

2.5.15 Liabilities related to restructurings or exit activities

Liabilities related to restructurings or exit activities of the acquiree should only be recognized at the acquisition date if they are preexisting liabilities of the acquiree and were not incurred for the benefit of the acquirer. Including a plan for restructuring or exit activities in the purchase agreement does not in itself create an obligation for accounting purposes to be assumed by the acquirer at the acquisition date. Liabilities and the related expense for restructurings or exit activities that are not preexisting liabilities of the acquiree should be recognized through earnings in the postcombination period when all applicable criteria of ASC 420 have been met. Liabilities related to restructuring or exit activities that were recorded by the acquiree after negotiations to sell the company began should be assessed to determine whether such restructurings or exit activities were done in contemplation of the acquisition for the benefit of the acquirer. If the restructuring activities were done for the benefit of the acquirer, the acquirer should account for the restructuring activities as a separate transaction. Refer to ASC 805-10-55-18 for more guidance on separate transactions.
Example BCG 2-12 and Example BCG 2-13 illustrate the recognition and measurement of liabilities related to restructuring or exit activities.
EXAMPLE BCG 2-12
Restructuring efforts of the acquiree vs. restructuring efforts of the acquirer
An acquiree has an existing liability/obligation related to a restructuring that was initiated one year before the business combination was contemplated. In addition, during negotiations and at the instruction of the acquirer, the acquiree closed a manufacturing plant and incurred a related liability prior to the business combination. Further, in connection with the acquisition, the acquirer identified several operating locations to close and selected employees of the acquiree to terminate to realize synergies in the postcombination period. Six months after the acquisition date, the recognition criteria under ASC 420 for this restructuring are met and a liability recorded.
How should the acquirer account for each of these restructurings?
Analysis
The acquirer would account for the restructurings as follows:
  • Restructuring initiated by the acquiree: The acquirer would recognize the previously recorded restructuring liability at fair value as part of the business combination, since it is an obligation of the acquiree at the acquisition date.
  • Acquiree restructuring initiated based on the acquirer’s instruction prior to the acquisition date: The guidance in ASC 805-10-55-18 should be considered to determine if the restructuring benefits the acquirer. In this case, the restructuring was requested by the acquirer, was initiated as a result of negotiations between the acquirer and acquiree, and is presumed to be for the benefit of the combined entity. Accordingly, the combined entity would account for the restructuring activities as a separate transaction. It is not a liability the acquirer will assume in the business combination.
  • Restructuring initiated by the acquirer subsequent to the acquisition date: The acquirer would recognize the effect of the restructuring in earnings in the postcombination period, rather than as part of the business combination. Since the restructuring is not an obligation at the acquisition date, the restructuring does not meet the definition of a liability and is not a liability assumed in the business combination.

EXAMPLE BCG 2-13
Seller’s reimbursement of acquirer’s postcombination restructuring costs
The sale and purchase agreement for a business combination contains a provision for the seller to reimburse the acquirer for certain qualifying costs of restructuring the acquiree during the postcombination period. Although it is probable that qualifying restructuring costs will be incurred by the acquirer, there is no liability for restructuring that meets the recognition criteria at the combination date.
How should the reimbursement right be recorded?
Analysis
The reimbursement right is a separate arrangement and not part of the business combination because the restructuring action was initiated by the acquirer for the future economic benefit of the combined entity. The purchase price for the business must be allocated (on a reasonable basis such as relative fair value) to the amount paid for the acquiree and the amount paid for the reimbursement right. The reimbursement right should be recognized as an asset on the acquisition date with cash receipts from the seller recognized as settlements. The acquirer should expense postcombination restructuring costs in its postcombination consolidated financial statements.

2.5.16 Acquired revenue contracts with customers (after adoption of ASU 2021-08)

New guidance
In October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers. The guidance affects all entities that enter into a business combination within the scope of ASC 805-10.
ASU 2021-08 is effective for public business entities for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. For all other entities, the guidance is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Entities should apply the guidance in ASU 2021-08 on a prospective basis to all business combinations with an acquisition date on or after the effective date.
Early adoption is permitted, including in an interim period, for any period for which financial statements have not yet been issued. However, adoption in an interim period other than the first fiscal quarter requires an entity to apply the new guidance to all prior business combinations that have occurred since the beginning of the annual period in which the new guidance is adopted.
No adjustment can be made to acquisitions that occurred in previous fiscal years, even if the “measurement period” described in ASC 805-10-25-14 is still open for such acquisition. See BCG 2.5.16A for applicable guidance before adoption of ASU 2021-08.
Summary
The acquiree in a business combination may have revenue contracts with customers for which it had recognized contract assets and/or contract liabilities in its precombination financial statements. In accordance with ASC 805-20-30-28, the acquirer should determine what contract assets and/or contract liabilities it would have recorded under ASC 606 (the revenue guidance) as of the acquisition date, as if the acquirer had entered into the original contract at the same date and on the same terms as the acquiree.
ASC 606 provides guidance on when certain assessments and estimates should be made (i.e., at contract inception or on a recurring basis). ASC 805-20-30-28 states that the acquirer should make those assessments as of the dates required by ASC 606. Accordingly, the acquirer should evaluate the performance obligations, transaction price (e.g., significant financing considerations), and relative standalone selling price at the original contract inception date or subsequent modification dates (unless certain practical expedients are applied—see BCG 2.5.16.6). The acquirer should then assess the measure of progress (for performance obligations satisfied over time) or timing of control transfer (for performance obligations satisfied at a point in time) compared to the amount of consideration received (or receivable) to determine the amount of contract asset or contract liability as of the acquisition date. The acquirer should also determine its estimate of variable consideration (subject to the constraint described in ASC 606-10-32-11 through ASC 606-10-32-13, or the exception for sales- or usage-based royalties described in ASC 606-10-55-65) as of the acquisition date. As noted in FSP 33.3.4, while the amounts are calculated based on individual performance obligations, a single net contract asset or contract liability should be determined for each acquired revenue contract. See PwC’s guide to Revenue from contracts with customers for further guidance on these calculations and estimates.
While the unit of account for the recognition and measurement of contract assets and liabilities in a business combination should be the customer contract, there may be acquired intangible assets or liabilities associated with customer contracts that meet the contractual-legal or the separability criterion for which separate recognition of these intangible assets would be required. For example, acquired contract-related intangible assets such as off-market contracts, customer relationships, or contract backlogs may require separate recognition. See BCG 4.3.5 and BCG 4.3.3.5 for further discussion of the accounting for customer contract-related intangible assets.
The recognition and measurement of contract assets and contract liabilities will likely be comparable to what the acquiree has recorded on its books under ASC 606 as of the acquisition date. However, the FASB noted in paragraph BC33 in the basis for conclusions of ASU 2021-08 that the accounting is not simply a “carryover” basis of the acquiree’s books and records. For example, the acquirer has to consider the reasonableness of the application of ASC 606 by the acquiree. Further, if the acquirer’s accounting policies differ from those of the acquiree (e.g., applying the practical expedient for a significant financing component when the time between performance and payment is less than one year), the acquirer’s policies are required to be applied.
Generally, the amount of revenue recognized by the acquirer subsequent to the acquisition date will be the same as the amount that would have been recognized by the acquiree absent the business combination, or that would be recognized for identical contracts entered into by the acquirer. However, as the FASB noted in paragraphs BC33 and BC43 in the basis for conclusions of ASU 2021-08, there may be differences due to the recording of off-market contract assets or liabilities (see discussion on off-market contracts in BCG 4.3.3.5) as well as differences arising from:
  • Situations when the acquiree has not applied ASC 606 (e.g., prepared financial statements under IFRS, statutory reporting requirements, or other financial reporting frameworks)
  • Differences in the acquirer’s and acquiree’s revenue recognition accounting policies
  • Differences in estimates between the acquirer and acquiree (e.g., estimates of variable consideration or measure of progress)
  • Errors in the ASC 606 accounting of the acquiree prior to the business combination

ASC 805-20-30-28 states the acquirer should measure the contract assets and contract liabilities of the acquired contract as if the acquirer originated the contract and then subsequently followed the guidance in ASC 606. Therefore, estimates (e.g., measurement of progress to completion) should be determined from the perspective of the acquirer, which may differ from the amounts recorded on the acquiree’s books immediately prior to the business combination (for example, due to a different cost structure of the acquirer or expected synergies arising from the acquisition).
Example BCG 2-14 illustrates the accounting by an acquirer in a business combination in which the acquiree entered into a long-term construction contract with a customer prior to the acquisition date, including how progress should be measured for that acquired in-progress performance obligation.
EXAMPLE BCG 2-14
Long-term construction contract
Company A enters into an arrangement with Company B on January 1, 20X1 to construct a new office building for total consideration of $40 million, which is paid in various installments as certain defined milestones are met over the construction period. The construction of the facility is considered a single performance obligation under ASC 606 that is satisfied over time, and is expected to take approximately two years to complete. Company A concludes that the contract does not include a significant financing component and determines that the most appropriate measure of progress is an input method based on costs incurred as compared to total anticipated costs to complete the building.
On January 1, 20X2, Company C acquires Company A in a business combination. Based on the measure of progress, Company A estimated the contract to be 50% complete immediately before the acquisition and had recognized $20 million in revenue (50% x total consideration of $40 million) and received $18 million in payments from Company B through that date. Therefore, as of the acquisition date, Company A would have recognized a contract asset of $2 million under ASC 606 since payment of this amount is conditioned on something other than the passage of time.
However, on the acquisition date, Company C estimates that the performance obligation is 55% complete based on its assessment of the cost of the remaining post-acquisition performance obligation and Company C’s cost structure (which differs from the cost structure of Company A due to Company C’s greater purchasing power).
How should Company C account for this arrangement in acquisition accounting?
Analysis
The measure of progress for a performance obligation satisfied over time should reflect the reporting entity’s performance in transferring control of goods or services. In a business combination, the acquirer should assess the measure of progress for a performance obligation satisfied over time (multiplied by the total consideration for the contract) compared to the amount of consideration received as of the acquisition date to determine the amount of contract asset or liability to record in acquisition accounting. Such calculations should reflect the acquirer’s estimates associated with the acquired contract.
Company C would record a contract asset or contract liability in acquisition accounting based on what it would have recorded if Company C had entered into the original contract with Company B at the same date and on the same terms. Based on its measure of progress toward completion (55%) at the acquisition date, multiplied by the total contract consideration of $40 million, less the $18 million of payments received from Company B to date, Company C would record a contract asset of $4 million. Note that this differs from the $2 million contract asset that Company A would have recorded as of that date, due to differences in estimates between the companies.

Scope
In accordance with ASC 805-20-25-28C(b), the guidance in ASU 2021-08 also applies to other contracts that apply the provisions of ASC 606, including contract liabilities from the sale of nonfinancial assets within the scope of ASC 610-20, Other Income--Gains and Losses from the Derecognition of Nonfinancial Assets. Additionally, the guidance could apply to other arrangements that apply the provisions of ASC 606 either directly or by analogy, such as those accounted for under ASC 808, Collaborative Arrangements.

2.5.16.1 Acquired customer contract assets (after adoption of ASU 2021-08)

ASC 606 distinguishes between a contract asset and a receivable based on whether receipt of the consideration is conditional on something other than the passage of time.

Definition from ASC Master Glossary

Contract asset: An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Excerpt from ASC 606-10-45-4

A receivable is an entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due…An entity shall account for a receivable in accordance with Topic 310 and Subtopic 326-20.

In a business combination, the acquirer will recognize a contract asset if the acquiree has already transferred goods or services to a customer but has not yet received (or is not yet due) payment as of the acquisition date and the right to consideration is conditioned on something other than the passage of time. A contract asset differs from a receivable because the right to consideration is conditioned on something other than the passage of time (e.g., the transfer of additional goods or services). See BCG 2.5.2 for consideration of the credit loss allowance for contract assets acquired in a business combination.
ASC 606-10-55-65 includes an exception for the recognition of revenue relating to licenses of intellectual property with sales- or usage-based royalties. Under this exception, royalty revenue is not recorded until the subsequent sale or usage occurs, or the performance obligation has been satisfied, whichever is later. For example, when the contract is a license of functional intellectual property in exchange for sales-based royalties, no amount of the future variable consideration can be recognized as a contract asset under ASC 606-10-55-65 until the underlying sales occur.
No contract asset would be recognized at the acquisition date for variable consideration that cannot be recognized under ASC 606 at that time, and any subsequent consideration received (or recognizable under ASC 606) would be recognized as revenue in the post-acquisition period. The FASB indicated that the estimated cash flows subject to the variable consideration constraint or the exclusion of sales- or usage-based royalties could still be included in the valuation of the customer-related intangible assets associated with the contract in acquisition accounting (see BCG 4.3.5.1).
Example BCG 2-15 illustrates the accounting by an acquirer in a business combination in which the acquiree licensed functional intellectual property to a customer in exchange for royalties.
EXAMPLE BCG 2-15
Pharmaceutical drug license
Company A is a pharmaceutical company. Company A acquires Company B in a business combination on January 1, 20X2. Company B, also a pharmaceutical company, previously licensed its approved oncology drug to Company Z on January 1, 20X1. The drug license arrangement has a term of five years with a 6% sales-based royalty paid by Company Z to Company B based upon Company Z’s sales of the drug to third parties. Company B previously delivered the oncology drug intellectual property at the contract inception date and has no remaining performance obligations.
How should Company A account for the functional intellectual property drug license arrangement with Company Z in acquisition accounting?
Analysis
ASC 606-10-55-65 includes an exception for the recognition of revenue relating to licenses of intellectual property with sales- or usage-based royalties. Under this exception, royalty revenue is not recorded until the subsequent sale or usage occurs, or the performance obligation has been satisfied, whichever is later.
Company A would not record a contract asset in acquisition accounting related to this arrangement. Company A would record revenue subsequent to the acquisition date as the royalties are generated by Company Z. On the acquisition date, Company A would record a customer-related intangible asset at fair value (which likely contemplates anticipated future royalties that will be generated for Company A from Company Z) and reflect amortization of that intangible asset as an expense ratably over the useful life of the asset.

2.5.16.2 Acquired customer contract liabilities (after adoption of ASU 2021-08)

Under ASC 606, an entity should recognize a contract liability if the customer’s payment of consideration precedes the entity’s performance (e.g., an upfront payment or a non-refundable deposit) or when an entity has an unconditional right to consideration in advance of performance. Contract liabilities may also be referred to as deferred or unearned revenue.

ASC 606-10-45-2

If a customer pays consideration, or an entity has a right to an amount of consideration that is unconditional (that is, a receivable), before the entity transfers a good or service to the customer, the entity shall present the contract as a contract liability when the payment is made or the payment is due (whichever is earlier). A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount of consideration is due) from the customer.

In a business combination, the acquirer should apply the definition of a performance obligation in ASC 606 to determine whether to recognize a contract liability. As described in ASC 606-10-25-16, a performance obligation includes not only legal and explicitly stated obligations in a contract, but also those that may be implied by an entity’s customary business practices, published policies, or specific statements. See RR 3.2.2 for further discussion.
The acquirer will recognize a contract liability if the customer has provided consideration to the acquiree (or the acquiree has a receivable from the customer), but the acquiree has not yet fully transferred the related goods or services to the customer (i.e., the acquiree has an unsatisfied performance obligation). The acquirer will also apply the provisions of ASC 606 to calculate the amount of such contract liability. Subsequent to the acquisition date, the acquirer should derecognize the contract liability and recognize revenue when or as the performance obligations are satisfied.
Example BCG 2-16 illustrates the accounting by an acquirer in a business combination in which the acquiree licensed functional intellectual property and provides distinct services to a customer.
EXAMPLE BCG 2-16
Software license with post-contract customer support
Company A provides a three-year, fixed-term software license to Company B on January 1, 20X1. Company B also receives post-contract customer support (PCS), which entitles Company B to “when and if available upgrades” that are developed by Company A. The total cash consideration paid at contract inception is $75 million. Company A determines the software license and PCS are separate performance obligations and allocates $60 million of the transaction price to the software license and $15 million to the PCS. Company A recognizes revenue allocated to the software license when the license term commences and recognizes the revenue allocated to PCS ratably over the three-year term.
Company C acquires Company A on January 1, 20X3. For the purpose of this example, any effects of significant financing are ignored, and the price associated with PCS in the contract is still considered market pricing at the acquisition date.
How should Company C account for the software license and PCS arrangements with Company B in acquisition accounting?
Analysis
Company C would not record a contract asset or contract liability related to the software license, as the acquiree already received the cash and delivered the software. Company C would recognize a $5 million contract liability for the unsatisfied portion of the performance obligation for the PCS arrangement ($15 million less $10 million recognized for the first two years, as performance is two-thirds complete as of the acquisition date of January 1, 20X3). This amount is based upon the original terms of the contract, the determination of the performance obligations and relative standalone selling prices of the performance obligation at contract inception, and the progress to completion through the acquisition date. This amount would be recognized as revenue over the next year post-acquisition as the remaining PCS service is provided to Company B.

Example BCG 2-17 illustrates the accounting by an acquirer in a business combination in which the acquiree licensed symbolic intellectual property to a customer and had received an upfront payment from that customer prior to the acquisition date.
EXAMPLE BCG 2-17
License of character images
Company A creates and produces early childhood educational programs, including a new animated television show. Company A grants a four-year exclusive license to Company B on January 1, 20X1 to use the images of the characters from the television show in exchange for an upfront payment of $80 million.
The intellectual property (IP) underlying the license is symbolic IP because the character images do not have significant standalone functionality. The license is therefore a right to access IP and Company A recognizes revenue over time under ASC 606.
On January 1, 20X4, Company C acquires Company A in a business combination. There is one year remaining on the symbolic IP license arrangement between Company A and Company B, and to date Company A has recognized $60 million in revenue. For the purpose of this example, any effects of significant financing are ignored, and the fee associated with the IP license is still considered market pricing at the acquisition date.
How should Company C account for this arrangement in acquisition accounting?
Analysis
Company C would record a contract liability in acquisition accounting based on what it would have recorded if Company C had entered into the original contract with Company B at the same date and on the same terms. As the license fee would be recognized over the four-year term of the license under ASC 606, Company C would record a contract liability in acquisition accounting for the remaining one-fourth of the license period that remains at the acquisition date of January 1, 20X4, or $20 million. This amount would be recognized as revenue by Company C in the one-year period subsequent to the acquisition.
The fair value of the intangible asset for the symbolic IP should consider that there will be no future cash flows associated with the licensed character images from Company B for the remaining term of the license arrangement, even though there will be future revenue recognized under this contract under the new guidance. Additionally, we believe that there is no customer relationship intangible asset to record in this situation, as there are no further cash flows to be received from the customer under the license arrangement subsequent to the acquisition date.

2.5.16.3 Costs to obtain/fulfill customer contract (after adoption of ASU 2021-08)

Costs to obtain or fulfill contracts with customers may be recognized as assets in the acquiree’s precombination financial statements under ASC 340-40. Similar to other types of deferred costs (e.g., debt issuance costs), unamortized contract acquisition and fulfilment costs of the acquiree do not meet the definition of an asset to the acquirer and therefore would not be recognized by the acquirer in a business combination. However, the fair value of these costs may be measured in the value of certain customer-related intangible assets recognized in acquisition accounting. See BCG 4.3.5.1 for further information on recognizing and measuring intangible assets relating to customer contracts and relationships.

2.5.16.4 Loss contracts acquired in a business combination (after adoption of ASU 2021-08)

A loss contract occurs if the unavoidable costs of meeting the obligations under a contract with a customer exceed the expected future consideration to be received. However, unprofitable operations of an acquired business do not necessarily indicate that the contracts of the acquired business are loss contracts. Additionally, outside of acquisition accounting, only certain types of contracts are eligible for recognition of losses in advance of costs actually being incurred. See further discussion in RR 11.5.1.
In limited circumstances, the acquirer may acquire contracts for which the acquiree had determined that the total costs to complete the contract exceed the total consideration to be received from the customer (i.e., loss contracts), and for which the acquiree recorded a loss accrual. A question arises as to how loss contracts should be recorded in acquisition accounting.
The scope of ASU 2021-08 only addresses contract assets and contract liabilities under ASC 606. Loss contracts are addressed under other US GAAP, such as ASC 605-35 for construction-type contracts or ASC 605-20 for separately priced extended warranty contracts. Therefore, we do not believe that loss contracts are subject to ASU 2021-08. A loss contract should be recognized as a liability at fair value in acquisition accounting if the contract is a loss contract to the acquiree at the acquisition date, which may be different from any loss accrual that the acquiree had previously recognized. This amount should be calculated using market participant assumptions about the prevailing market terms for such goods or services, rather than simply using the acquiree’s cost estimates. An acquirer should have support for certain key assumptions, such as market price and the unavoidable costs to fulfil the contract (e.g., manufacturing costs, service costs), if a liability for a loss contract is recognized. For example, Company A acquires Company B in a business combination. Company B is contractually obligated to fulfill a previous fixed-price contract to produce a fixed number of components for one of its customers. However, Company B’s unavoidable costs to manufacture the component exceed the sales price in the contract. As a result, Company B has incurred losses on the sale of this product and the combined entity is expected to continue to do so in the future. Company B’s contract is considered a loss contract that is assumed by Company A in the acquisition. Therefore, Company A would record a liability for the loss contract assumed in the business combination.
When measuring a loss contract, an acquirer should first consider whether the amount to be recognized should be adjusted for any intangible assets or liabilities recognized for contract terms that are favorable or unfavorable compared to current market terms (i.e., there should not be double-counting). A contract assumed in a business combination that becomes a loss contract subsequent to the acquisition should be recognized through earnings in the postcombination period based on the applicable framework in US GAAP.

2.5.16.5 Upfront payments made by the acquiree to its customer (after adoption of ASU 2021-08)

An entity may make an upfront payment to a customer to incentivize the customer to sign a contract. Under ASC 606, payments to a customer are recorded as a reduction of revenue, unless they reflect payment for a distinct good or service. If paid upfront, depending on assessments of recoverability, such amount may be deferred and recognized against subsequent revenue generated from that customer (see further discussion in RR 4.6.4).
Such deferred assets do not reflect separate assets to be recognized in acquisition accounting. The impact of an upfront payment made by an acquiree to its customer is generally included by the acquirer as part of the valuation of the customer relationship intangible asset in acquisition accounting. In essence, the upfront payment helped to obtain the future cash flows associated with the customer contract. The acquirer generally records the amortization of this intangible asset as an expense.
However, if the acquirer negotiated and/or directed the acquiree to make the upfront payment to a new customer in contemplation of the business combination, the payment should be viewed to be for the benefit of the acquirer/combined entity post-acquisition, and the subsequent amortization should be recorded as a reduction of revenue. This is consistent with the guidance issued in EITF 01-3, Accounting in a Business Combination for Deferred Revenue of an Acquiree. While this guidance was not codified in ASC 805, we believe it is consistent with the guidance in ASC 805-10-55-18 related to transactions that should be accounted for separate from the business combination, and the guidance in ASC 606 related to payments to customers.

2.5.16.6 Acquired revenue contracts: practical expedients (after adoption of ASU 2021-08)

The acquirer may elect to apply certain practical expedients when measuring contract assets and/or contract liabilities in a business combination, as described in ASC 805-20-30-29.

ASC 805-20-30-29

An acquirer may use one or more of the following practical expedients when applying paragraphs 805-20-30-27 through 30-28 at the acquisition date:
  1. For contracts that were modified before the acquisition date, an acquirer may reflect the aggregate effect of all modifications that occur before the acquisition date when:
    1. Identifying the satisfied and unsatisfied performance obligations
    2. Determining the transaction price
    3. Allocating the transaction price to the satisfied and unsatisfied performance obligations.
  2. For all contracts, for purposes of allocating the transaction price, an acquirer may determine the standalone selling price at the acquisition date (instead of the contract inception date) of each performance obligation in the contract.

These practical expedients are designed to provide relief for circumstances when the acquirer is unable to assess or rely on the acquiree’s accounting under ASC 606. In this case, the FASB observed that the acquirer would effectively have to adopt ASC 606 for the acquiree’s revenue contracts.
The first practical expedient in ASC 805-20-30-29(a) is similar to one applicable to the initial adoption of ASC 606, and permits an acquirer to utilize the terms that exist as of the latest modification of a contract to determine the performance obligations and transaction price.
The second practical expedient in ASC 805-20-30-29(b) relates to the timing of determining the standalone selling prices in order to allocate the transaction price to the performance obligations in the contract. This practical expedient permits an acquirer to determine the standalone selling prices at the acquisition date, rather than at the contract inception date as otherwise required by ASC 606. The FASB indicated that the purpose of this practical expedient is to alleviate circumstances in which it would be onerous for the acquirer to go back to the contract inception date if the acquiree lacks sufficient information or did not previously prepare financial statements in accordance with US GAAP.
An acquirer can elect to apply either or both of these practical expedients on an acquisition-by-acquisition basis. If practical expedients are elected for a particular acquisition, they should be applied to all revenue contracts associated with that acquisition. However, different elections can be made for different acquisitions.
If an entity elects to apply any of these practical expedients, the disclosures discussed in FSP 17.4.7 are required.

2.5.16A Acquired revenue contracts with customers (prior to adoption of ASU 2021-08)

The acquiree in a business combination may have revenue contracts with customers for which it had recognized contract assets and liabilities in its precombination financial statements. Contract assets and liabilities acquired in a business combination should be recognized and measured by the acquirer at their acquisition date fair values, which may be different from the amounts that the acquiree had previously recognized under ASC 606.
The unit of account for the recognition and measurement of contract assets and liabilities in a business combination should be the customer contract. However, there may be acquired intangible assets or liabilities associated with customer contracts that meet the contractual-legal or the separability criterion, in which case separate recognition of these intangible assets would be required. For example, acquired contract-related intangible assets such as off-market contracts, customer relationships, or contract backlogs may require separate recognition. See BCG 4.3.5 and BCG 4.3.3.5 for further discussion of the accounting for customer contract-related intangible assets.
The fair value of acquired customer contracts is not impacted by the acquiree’s method of accounting for the contracts before the acquisition or the acquirer’s planned accounting methodology in the postcombination period (i.e., the fair value is determined using market-participant assumptions).
For performance obligations satisfied over time, the acquirer will need to determine the measure of progress to recognize revenue during the post-acquisition period. The measure of progress should be based on the acquirer’s estimate of the remaining post-acquisition performance and should be determined in accordance with ASC 606. For example, if the “cost-to-cost” (i.e., input) method is used, the acquirer should measure progress based on the estimated cost to complete the contract as of the acquisition date as opposed to the estimated cost to complete the contract from inception. In other words, the acquired contract is effectively viewed as a new performance obligation that is 0% complete as of the acquisition date.
New guidance
In October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers. This guidance requires contract assets and contract liabilities (i.e., deferred revenue) acquired in a business combination to be recognized and measured by the acquirer on the acquisition date in accordance with ASC 606, Revenue from Contracts with Customers. See BCG 2.5.16 for additional information on ASU 2021-08, including effective dates, transition requirements, and post-adoption guidance.

2.5.16.1A Acquired customer contract assets (prior to adoption of ASU 2021-08)

ASC 606 distinguishes between a contract asset and a receivable based on whether receipt of the consideration is conditional on something other than the passage of time.

Definition from ASC Master Glossary

Contract asset: An entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Excerpt from ASC 606-10-45-4

A receivable is an entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due…An entity shall account for a receivable in accordance with Topic 310 and Subtopic 326-20.

An acquiree’s contract assets and receivables are recognized and measured by the acquirer at their acquisition date fair values. Although contract assets and receivables are similar in nature in that both represent the right to consideration from a customer, the measurement of each at fair value may be different. Since contract assets are conditioned on something other than the passage of time, such as the performance of future performance obligations, the fair value of these assets may need to incorporate assumptions regarding other factors, such as the satisfaction of future performance obligations. The fair value of receivables, however, generally incorporates only the time value of money and the customers’ credit risk. In certain situations, the fair value of acquired receivables may approximate their carrying value if the receivables are short term in nature and customer credit risk is not material. See BCG 2.5.2 and BCG 2.5.2A for information on recognizing asset valuation allowances for receivables. Additionally, see FSP 33.3.1 for information on distinguishing between contract assets and receivables, including the separate presentation of these assets in the financial statements.

2.5.16.2A Acquired customer contract liabilities (prior to adoption of ASU 2021-08)

Under ASC 606, an entity should recognize a contract liability if the customer’s payment of consideration precedes the entity’s performance (e.g., an upfront payment or a deposit) or when an entity has an unconditional right to consideration in advance of performance. Contract liabilities may also be referred to as deferred or unearned revenue.

ASC 606-10-45-2

If a customer pays consideration or an entity has a right to an amount of consideration that is unconditional (that is, a receivable), before the entity transfers a good or service to the customer, the entity shall present the contract as a contract liability when the payment is made or the payment is due (whichever is earlier). A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration (or an amount of consideration is due) from the customer.

The acquirer in a business combination recognizes an assumed contract liability at the acquisition date fair value when the contract liability represents a legal obligation assumed by the acquirer. The fair value of a contract liability recognized by the acquirer in acquisition accounting may be different from the contract liability recognized in the acquiree’s precombination financial statements. See FV 7.3.3.6A for further information on measuring deferred or unearned revenue (i.e., contract liabilities) at fair value.
Subsequent to the acquisition date, the acquirer should derecognize the contract liability and recognize revenue when or as the performance obligations are satisfied.

2.5.16.3A Costs to obtain/fulfill customer contract (business combinations) (prior to adoption of ASU 2021-08)

Costs to obtain or fulfill contracts with customers may be recognized as assets in the acquiree’s precombination financial statements under ASC 340-40. Similar to other types of deferred costs (e.g., debt issuance costs), unamortized contract acquisition and fulfilment costs of the acquiree do not meet the definition of an asset to the acquirer and therefore would not be recognized by the acquirer in a business combination. However, the fair value of these costs may be measured in the value of certain customer-related intangible assets recognized in acquisition accounting. See BCG 4.3.5.1 for further information on recognizing and measuring intangible assets relating to customer contracts and relationships.

2.5.16.4A Loss contracts acquired in a business combination (prior to adoption of ASU 2021-08)

A loss contract occurs if the unavoidable costs of meeting the obligations under a contract with a customer exceed the expected future consideration to be received. However, unprofitable operations of an acquired business do not necessarily indicate that the contracts of the acquired business are loss contracts. Additionally, outside of acquisition accounting, only certain types of contracts are eligible for recognition of losses in advance of costs actually being incurred. See further discussion in RR 11.5.1.
A loss contract should be recognized as a liability at fair value in acquisition accounting if the contract is a loss contract to the acquiree at the acquisition date, which may be different from any loss accrual that the acquiree had previously recognized. An acquirer should have support for certain key assumptions, such as market price and the unavoidable costs to fulfil the contract (e.g., manufacturing costs, service costs), if a liability for a loss contract is recognized. For example, Company A acquires Company B in a business combination. Company B is contractually obligated to fulfil a previous fixed-price contract to produce a fixed number of components for one of its customers. However, Company B’s unavoidable costs to manufacture the component exceed the sales price in the contract. As a result, Company B has incurred losses on the sale of this product and the combined entity is expected to continue to do so in the future. Company B’s contract is considered a loss contract that is assumed by Company A in the acquisition. Therefore, Company A would record a liability for the loss contract assumed in the business combination.
When measuring a loss contract, an acquirer should first consider whether the amount to be recognized should be adjusted for any intangible assets or liabilities recognized for contract terms that are favorable or unfavorable compared to current market terms (i.e., there should not be double-counting). A contract assumed in a business combination that becomes a loss contract subsequent to the acquisition should be recognized through earnings in the postcombination period based on the applicable framework in US GAAP.

2.5.17 Deferred charges arising from leases (acquiree is a lessor)

The balance sheet of an acquiree that is a lessor before the acquisition date may include deferred rent related to an operating lease, resulting from the accounting guidance in ASC 842 to generally recognize operating lease income on a straight-line basis if lease terms include decreasing or escalating lease payments. The acquirer should not recognize the acquiree’s deferred rent using the acquisition method because it does not meet the definition of an asset or liability. The acquirer may record deferred rent starting from the acquisition date in the postcombination period based on the terms of the assumed lease.
Although deferred rent of the acquiree is not recognized in a business combination, the acquirer may recognize an intangible asset or liability related to the lease, depending on its nature or terms. See BCG 4.3.3.7 for additional guidance on the accounting for leases in a business combination.
Example BCG 2-18 illustrates the recognition of deferred rent in a business combination.
EXAMPLE BCG 2-18
Recognition of deferred rent when the acquiree is a lessor
On the acquisition date, Company A assumes an acquiree’s operating lease. The acquiree is the lessor. The terms of the lease are:
  • Four-year lease term
  • Lease payments are:
    • Year 1: $400
    • Year 2: $300
    • Year 3: $200
    • Year 4: $100

On the acquisition date, the lease had a remaining contractual life of two years, and the acquiree had recognized a $200 liability for deferred rent. For the purpose of this example, other identifiable intangible assets and liabilities related to the operating lease are ignored.
How should Company A account for the deferred rent?
Analysis
Company A does not recognize any amounts related to the acquiree’s deferred rent liability on the acquisition date. However, the terms of the acquiree’s lease will give rise to deferred rent in the postcombination period. Company A will record a deferred rent liability of $50 at the end of the first year after the acquisition.

2.5.18 Classifying or designating identifiable assets and liabilities

ASC 805-20-25-6 provides the principle with regard to classifying or designating the identifiable net assets acquired.

ASC 805-20-25-6

At the acquisition date, the acquirer shall classify or designate the identifiable assets acquired and liabilities assumed as necessary to subsequently apply other GAAP. The acquirer shall make those classifications or designations on the basis of the contractual terms, economic conditions, its operating or accounting policies, and other pertinent conditions as they exist at the acquisition date.

The acquirer must classify or designate identifiable assets acquired, liabilities assumed, and other arrangements on the acquisition date, as necessary, to apply the appropriate accounting in the postcombination period. As described in ASC 805-20-25-6, the classification or designation should be based on all pertinent factors, such as contractual terms, economic conditions, and the acquirer’s operating or accounting policies, as of the acquisition date. The acquirer’s designation or classification of an asset or liability may result in accounting different from the historical accounting used by the acquiree. For example:
  • Classifying assets as held for sale: As discussed in BCG 2.5.8, the classification of assets held for sale is based on whether the acquirer has met, or will meet, all of the necessary criteria.
  • Classifying investments in debt securities: Debt securities are classified based on the acquirer’s investment strategies and intent in accordance with ASC 320, Investments—Debt Securities.
  • Re-evaluation of the acquiree’s contracts: The identification of embedded derivatives and the determination of whether they should be recognized separately from the contract is based on the facts and circumstances existing on the acquisition date.
  • Designation and redesignation of the acquiree’s precombination hedging relationships: The decision to apply hedge accounting is based on the acquirer’s intent and the terms and value of the derivative instruments to be used as hedges on the acquisition date.

See BCG 2.5.19 for further information on the classification or designation of derivatives on the acquisition date.
ASC 805-20-25-8 provides two exceptions to the classification or designation principle:
  • Classification of a lease of an acquiree in accordance with ASC 842-10-55-11
  • Classification of contracts as an insurance or reinsurance contract or a deposit contract within the scope of ASC 944, Financial Services—Insurance
    • The classification of these contracts is based on either the contractual terms and other factors at contract inception or the date (which could be the acquisition date) that a modification of these contracts triggered a change in their classification in accordance with the applicable US GAAP. See IG 12.1.3 for further information.

2.5.19 Classification or designation of financial instruments and hedges

An acquiree may have a variety of financial instruments that meet the definition of a derivative instrument. The type and purpose of these instruments will typically depend on the nature of the acquiree’s business activities and risk management practices. These financial instruments may have been (1) scoped out of ASC 815, Derivatives and Hedging, (2) used in hedging relationships, (3) used in an “economic hedging relationship,” or (4) used in trading operations. Generally, the precombination accounting for the acquiree’s financial instruments is not relevant to the postcombination accounting by the acquirer. Several issues could arise with respect to an acquiree’s financial instruments and hedging relationships and the subsequent accounting by the acquiring entity. The key issues are summarized below:
  • Re-evaluation of the acquiree’s contracts: All contracts and arrangements of the acquiree need to be re-evaluated at the acquisition date to determine if any contracts are derivatives or contain embedded derivatives that need to be separated and accounted for as financial instruments. This includes reviewing contracts that qualify for the normal purchases and sales exception and documenting the basis for making such an election. The determination is made based on the facts and circumstances at the date of the acquisition.
  • Designation and redesignation of the acquiree’s precombination hedging relationships: To obtain hedge accounting for the acquiree’s precombination hedging relationships, the acquirer will need to designate hedging relationships anew and prepare new contemporaneous documentation for each. The derivative instrument may not match the newly designated hedged item as closely as it does the acquiree’s item.
  • Potential inability to apply the short-cut method: Previous hedging relationships may not be eligible for the short-cut method because, upon redesignation of the hedging relationship, the derivative instrument will likely have a fair value other than zero (positive or negative) on the acquisition date, which will prevent the hedge from qualifying for the short-cut method.

2.5.20 Equity method investments acquired in a business combination

The acquiree may have an investment in another entity accounted for under the equity method. As part of the purchase price allocation, the acquirer should recognize and measure the equity method investment at its acquisition-date fair value in accordance with ASC 820. The acquirer should also determine any basis differences between that acquisition-date fair value and the acquirer’s share of the investee’s net assets following the guidance described in EM 3.3.1.
1 Deferred rent of the acquiree: straight-line income of $500 ((($400 + $300 + $200 + $100) / 4) × 2 years) less cash receipts of $700 ($400 + $300).
2 Deferred rent of the acquirer: straight-line income of $150 ((($200 + $100) / 2) × 1 year) less cash receipts of $200 (year 3 of lease).

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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