Deferred revenue represents an obligation to provide products or services to a customer when payment has been made in advance and delivery or performance has not yet occurred. Examples of deferred revenue obligations that may be recognized in a business combination include upfront subscriptions collected for magazines or upfront payment for post-contract customer support for licensed software.
The fair value of a deferred revenue liability typically reflects how much an acquirer has to pay a third party to assume the liability. The deferred revenue amount recorded on the acquiree’s balance sheet generally represents the cash received in advance, less the amount amortized for services performed to date. Accordingly, the acquiree’s recognized deferred revenue liability at the acquisition date is rarely the fair value amount that would be required to transfer the underlying contractual obligation.
In early 2019, the FASB issued an invitation to comment related to the measurement of deferred revenue in a business combination. As of the cut-off date of this guide, the proposed amendments have not yet been issued. Reporting entities should continue to monitor the status of these proposed amendments and any additional updates to the business combination guidance.
Fair value considerations when deferred revenue exists
Generally, there are two methods of measuring the fair value of a deferred revenue liability. The first method, commonly referred to as a bottom-up approach, measures the liability as the direct, incremental costs to fulfill the legal performance obligation, plus a reasonable profit margin if associated with goods or services being provided, and a premium for risks associated with price variability. Direct and incremental costs may or may not include certain overhead items, but should include costs incurred by market participants to service the remaining performance obligation related to the deferred revenue obligation. These costs do not include elements of service or costs incurred or completed prior to the consummation of the business combination, such as upfront selling and marketing costs, training costs, and recruiting costs.
The reasonable profit margin should be based on the nature of the remaining activities and reflect a market participant’s profit. If the profit margin on the specific component of deferred revenue is known, it should be used if it is representative of a market participant’s normal profit margin on the specific obligation. If the current market rate is higher than the market rate that existed at the time the original transactions took place, the higher current rate should be used. The measurement of the fair value of a deferred revenue liability is generally performed on a pre-tax basis and, therefore, the normal profit margin should be on a pre-tax basis.
An alternative method of measuring the fair value of a deferred revenue liability (commonly referred to as a top-down approach) relies on market indicators of expected revenue for any obligation yet to be delivered with appropriate adjustments. This approach starts with the amount that an entity would receive in a transaction, less the cost of the selling effort (which has already been performed) including a profit margin on that selling effort. This method is used less frequently, but is commonly used for measuring the fair value of remaining post-contract customer support for licensed software.
When valuing intangible assets using the income approach (e.g., Relief-from-royalty method or multiperiod excess earnings method) in instances where deferred revenues exist at the time of the business combination, adjustments may be required to the PFI to eliminate any revenues reflected in those projections that have already been received by the acquiree (because the cash collected by the acquiree includes the deferred revenue amount). If the excess earnings method is used, the expenses and required profit on the expenses that are captured in valuing the deferred revenue should also be eliminated from the PFI. However, if cash based PFI is used in the valuation, and therefore acquired deferred revenues are not reflected in the PFI, then no adjustment is required in the valuation of intangible assets using the income approach.