Acquisitions can be complicated as rules and regulations are constantly changing. Few are more impactful than those surrounding revenue recognition. Due to a recently issued Accounting Standards Update (ASU 2021-08), the rules for recognizing revenue are being modified and it’s imperative your organization understands and implements these changes to ensure accurate post-acquisition reporting.
In October 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2021-08 to provide guidance on revenue recognition for companies involved in a business combination. When companies receive payment from a customer before delivering a good or service, they typically recognize deferred (or unearned) revenue. Deferred revenue then becomes earned and recognized as revenue on the income statement once the performance obligation to the customer is fulfilled over time.
Suppose a construction company is paid $120,000 in advance to build an office building in six months. At contract inception, $120,000 would be recorded as deferred revenue and then recognized as revenue on the income statement spread evenly across six months ($20,000) as the building is constructed. If the construction company were to be acquired in the middle of this contract, how is the remaining deferred revenue accounted for and recognized by the acquirer?
In the past, acquiring companies were unable to recognize the full book value of an acquiree’s deferred revenue balances at acquisition and were forced to mark them down to a lower fair value. Since the acquiring company did not incur any costs to sell or provide the good or service outlined in the contract (i.e., marketing, selling, and operating costs), they were unable to recognize the full amount of deferred revenue remaining on the contract at the time of acquisition. To determine the fair value, acquiring companies were forced to mark down deferred revenue based on an estimation of the costs they would incur to fulfill the remaining term of the contract.
Let’s say the construction company was acquired by a larger firm four months into their contract. At this point, $40,000 ($20,000 x 2 remaining months) would be considered deferred revenue because it has not been earned yet. However, the acquiring company would be required to mark down this $40,000 based on an estimation of the costs they will incur over the next two months to complete construction of the building. The acquiring company will only be able to recognize the marked down deferred revenue balance as revenue. This is an example of disappearing revenue, a situation in which an acquirer is unable to recognize a portion of the acquired company’s pre-acquisition deferred revenue.
With the adoption of ASU 2021-08, acquiring companies now treat acquired contracts as if they entered into them on the same time and date as the acquiree, thus incurring the same costs (marketing, selling, and operating costs) to sell and provide the good or service outlined in the contract. Therefore, acquirers are no longer required to mark deferred revenue down to fair value. Acquirers now can determine the transaction price (total $ amount the acquiree is expected to receive for transfer of good of service to a customer) of each contract on the acquisition date and allocate that price across the contract’s remaining performance obligations. Revenue can then be recognized as each performance obligation in the contract is met.
In the example above, $120,000 would be considered the transaction price of the office building contract. $40,000 ($20,000 x 2 remaining months) would be considered deferred revenue and be recognized as revenue by the acquirer over the next two months as the office building is completed. This eliminates the need to record the acquiree’s deferred revenue at a lower fair value, and thus enables acquiring companies to recognize all deferred contract revenues of the acquiree. An acquirer can choose how to allocate revenue across performance obligations. It does not have to be based evenly on time, as described above.
Let’s look at a more detailed example from a different industry.
Cloud Inc. is a software company that provides cloud storage and maintenance services. Cloud Inc. sells annual plans where customers pay $1,200 in advance for one year of access to Cloud Inc.’s storage and maintenance services. On the first day of a customer’s subscription (let’s assume Jan. 1) Cloud Inc. will record $1,200 of Cash and $1,200 of Deferred Revenue. Cloud Inc. will then recognize $100 of Revenue each month through end of year.
On April 1, Cloud Inc. is acquired by Software Pro Inc., a larger software company that provides similar services. On April 1, Cloud Inc. would have $900 in Deferred Revenue that should be recognized as $100 in Revenue over each of the next nine months through the end of the year.
Prior to ASU 2021-08, Software Pro Inc. would be required to adjust this $900 in Deferred Revenue downward to fair value based on an estimation of the costs required to sell and provide (i.e. marketing, selling, and operating costs) the Cloud Inc. subscription services. Therefore, since the Deferred Revenue balance recognized by Software Pro Inc. would be lower than $900, less revenue would be recognized by Software Pro Inc.
After ASU 2021-08, Software Pro Inc. is able to determine the transaction price of this contract ($1,200) and proportionately allocate the deferred amount of revenue at the acquisition date (April 1) over the remaining months in the year. In other words, Software Pro inc. would not have to mark down the $900 Deferred Revenue balance to fair value and can recognize $100 of Revenue over each of the next nine months. This gives Software Pro Inc. the benefit of recognizing more revenue than they could before ASU 2021-08.
The new guidance laid out in ASU 2021-08 will go into effect for public business entities for fiscal years beginning after December 15, 2022, and for private business entities for fiscal years beginning after December 15, 2023. Companies should apply these updates prospectively to business combinations occurring on or after these dates. Early adoption is also permitted for any financial statements that have not been issued. If a company chooses early adoption, changes should be applied retrospectively to business combinations that occur on or after the beginning of the fiscal year in which these updates are applied. Changes should be applied prospectively to business combinations that occur on or after the date these updates are initially applied.
The implementation of ASU 2021-08 will allow acquirers to recognize more revenue from the company they acquire than they could before. Acquiring companies should therefore see an increase to gross profits and favorable financial multiples used by outside investors in company valuations. This can create an attractive investment opportunity for lenders and equity investors who are now more confident that the acquiring company will be able to meet interest obligations and dividend payments with higher profits and stronger financial ratios. On the flip side, since acquirers will recognize more revenue and thus higher pre-tax earnings, they could potentially have an increased income tax liability.
In summation, acquiring companies will now recognize higher levels of revenue from acquirees than before. It’s imperative for companies planning an acquisition to prepare for these changes to ensure effective integration and successful audits. These changes should be reflected in the acquiring company’s financial statements to provide investors with accurate reports.
Trenegy provides an array of services to help integrate companies going through a merger or acquisition. To chat with us about it, reach out to our team at info@trenegy.com.
