In late October, the Financial Accounting Standards Board (FASB) released a narrow scope change to the accounting for business combinations. This Accounting Standards Update (ASU) 2021-08 is expected to reduce diversity in practice for the recognition of contract assets and liabilities, such as deferred revenue, in a business combination, and will in some circumstances reduce cost and complexity of existing US GAAP.
Although the new standard is required to be adopted in calendar year 2023 for public business entities and 2024 for all others including, private companies, it is important to have a basic understanding of the key changes of the new guidance to consider early adoption for acquisitions completed before the required effective date. Read on to discover how the update could impact your business.
Who Is Affected?
Any entities that enter a business combination within the scope of ASC Topic 805, Business Combinations that include acquired contract assets and assumed contract liabilities arising from contracts accounted for under the guidance of ASC Topic 606, Revenue from Contracts with Customers will be impacted by this standard amendment. The change affects the acquirer— the company acquiring the other entity (the acquiree).
Why the Change?
Generally, the acquirer recognizes assets acquired and liabilities assumed in business combinations at fair value on the date of acquisition. Prior to the adoption of ASU 2021-08, this includes contract assets and liabilities resulting from revenue contracts with customers and similar contracts accounted for using ASC Topic 606. Financial statement users raised concerns that the fair value information was not useful because it can distort revenue trends, and preparers raised concerns about the cost, complexity and diversity in practice on determining fair value. Additionally, with the introduction of ASC Topic 606, it was unclear whether contract liabilities should only be recognized for promises in contracts with customers that met the definition of a performance obligation or if liabilities should be recognized at fair value for all, or only, legal obligations remaining in the acquired contracts.
To address these concerns, ASU 2021-08 requires the use of the guidance in ASC Topic 606 to measure contract assets and contract liabilities in a business combination, with the expected result that amounts recognized by the acquirer will be consistent with those of the acquiree immediately before the acquisition. This change will result in potential simplification by not requiring the fair value measurement of these assets and liabilities.
In addition, the new guidance requires that contract assets and liabilities be recognized for the performance obligations in the contracts, eliminating questions about evaluating other legal obligations within the contract.
The changes are expected to improve comparability for recognizing and measuring acquired revenue contracts with customers during a business combination. The elimination of the need to fair value measure the contract assets and liabilities may be attractive reason to early adopt these changes.
However, the change will not necessarily result in the ability to use the acquiree’s amounts for these assets and liabilities. The acquirer will need to consider differences in accounting policies, differences in judgments on estimates used to determine the amount of the contract asset and liability, and the potential for error or non-GAAP measurement done previously by the acquiree.
For example, if a company acquires a business that has not previously prepared financial statements on a US GAAP basis, the acquirer will need to assess the existing contracts of the acquiree and gather the information necessary to make all the judgements required by ASC Topic 606 in order to measure the contract assets and liability. Those judgements require information about the contract at inception and subsequent modification dates to evaluate the performance obligations and the standalone selling price of the performance obligations in the contract. It also requires up-to-date information in making determinations of the amount of the transaction price and the measurement of progress in transferring the promised goods and services.
To ease the burden of making the determination of the performance obligation, standalone selling price, and evaluating modifications to the contract, the FASB provided practical expedients that can be elected for each individual business combination. The practical expedients allow an entity to:
Evaluate contracts based on the aggregate effect of all modifications that occurred prior to the transaction date in identifying satisfied and unsatisfied performance obligations, determining the transaction price, and allocating the transaction price.
Determine the standalone selling price at the acquisition date for each performance obligation in the contracts acquired
Any practical expedient elected must be applied to all contracts within an acquisition, and disclosure of the expedient elected, and to the extent reasonably possible, the qualitative effect of the practical expedient is required.
Other Key Changes to Know About
The update also applies to contract assets and liabilities from other contracts to which the provisions of Topic 606 apply, like those from the sale of nonfinancial assets within the scope of Subtopic 610-20. However, the changes only apply to contract assets and liabilities. They do not apply to refund obligations, costs to obtain a contract or costs to fulfill a contract that are associated with contracts accounted for under Topic 606. Additionally entities are still required to recognize customer relationships, customer lists, and assets and liabilities arising from off-market contract terms when applicable.
Important to note for entities that report on both a U.S. GAAP and IFRS basis, the change results in a divergence from IFRS, which will continue to require measurement of contract assets and liabilities on the basis of fair value.
Effective Date and Transitions
If your business is a public entity, the amendments in ASU 2021-08 will be effective for fiscal years beginning after Dec. 15, 2022, and include interim periods within those fiscal years. For all other entities, the change is effective for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years. The amendments need to be applied prospectively to business combinations occurring on or after those effective dates.
Early adoption is permitted for financial statements that have not been issued or made available for issuance. If early adoption is elected, the amendments are applied prospectively from the initial date of application. If adoption occurs at an interim period, the amendments are applied retrospectively to all business combinations where the acquisition date occurs on or after the beginning of the fiscal year that includes the interim period of early application.
As an illustration of the effect of early adoption, assume a private company acquired two businesses, one in February and one in November of 2021. The private company elected to early adopt the new guidance for its calendar year end Dec. 31, 2021 financial statements. The accounting for the February acquisition was already completed by determining the fair value of the contract assets and liabilities, but had not yet completed the accounting for the November acquisition. In this circumstance, the private company is required to apply the guidance as of Jan. 1, 2021 and must revise its accounting for contract assets and liabilities for the February acquisition to be based on the guidance in Topic 606 and not fair value. The private company would also apply the new guidance as it determines the accounting for the November acquisition.
Where Can I Learn More?
For more information on the accounting change to business combinations, please contact us.