The FASB on Sept. 23, 2020, said it would issue a proposal to clarify how to recognize and measure revenue generating contracts that have been acquired in a business combination.
The changes will be proposed during the fourth quarter with a 90-day comment period.
The board voted by 5 to 2 to provide an exception under Topic 805, Business Combinations, so that acquired revenue earning contracts would be recognized and measured in accordance with Topic 606, Revenue from Contracts with Customers.
Companies would report a liability of an acquired contract whereby the performance obligation is incomplete, the board agreed. The timing of payments should not affect the amount of subsequent revenue recognized by an acquirer after a business combination.
“The performance obligation tells me that the acquirer assumed an obligation in the acquisition and it should be accounted for accordingly, FASB Chairman Richard Jones said. “As a result I also don’t think payment terms should affect the amount of revenue recognized post acquisition. I’m also supportive of the Topic 606 [measurement approach].”
Jones said satisfying a performance obligation is the basis for revenue recognition under Topic 606 “and since those obligations exist when the entity’s acquired it seems like the satisfaction of those obligations should also match up with when revenue is recognized post a business combination.”
The issue would be important to companies in the software and technology industry, as companies in those sectors typically have a lot of deferred revenue stemming from payments they receive upfront. Companies that get paid upfront usually recognize a deferred revenue and as the contract is being fulfilled the deferred revenue is derecognized.
The board’s decision would be a change from what companies typically do, according to the discussions. Currently, for recognizing and measuring those types of acquired contracts that have a lot of upfront payments and therefore deferred revenue, companies follow the fair value measurement principle in Topic 805.
“Topic 606 was new thinking - I think we ought to align business combination accounting with that thinking,” FASB Vice Chairman James Kroeker said. “We knew when we finalized 606 that there were those open questions - very likely to be diversity in practice. I also think as applied in practice business combinations accounting today makes a big distinction in future revenue depending upon the timing of cash payment,” he said.
The board said it would not propose new disclosures on the topic. The changes would need to be applied prospectively.
The decision stems from discussions about whether to add a project to its technical agenda to address the recognition and measurement of revenue contracts with customers in a business combination, an issue the board has been studying for about two years. There’s a disconnect in the alignment of both standards and differences in practice have been bubbling up, according to the discussions.
FASB members Christine Botosan and Harold Schroeder were not in favor of the proposed changes but voiced different approaches for how to address the issue.
Botosan, the academic on the board, said she was not in favor of adding the project. The guidance in Topic 805 is clear that the acquirer should recognize the liabilities that they assumed and measure them at fair value and therefore the board should not be getting into the realm of providing specific guidance with respect to how fair value should be measured, Botosan said. “I think that is something that practice is charged with figuring out,” she said.
Botosan said that the changes would require “carry over basis” accounting for deferred revenues, which would change practice and could result in an overstatement of gross combination revenues. “Carry over basis does not provide a faithful representation of the economics – these are not orginated revenues, they’re purchased revenues and that gets lost in the accounting and it’s going to create pervasive incentives for entities to purchase revenues, which I’m very concerned about,” she said.
Moreover, Botosan said the changes would result in an increase in the goodwill balance “which is going to end up sitting potentially indefinitely on entities’ books because of the impairment model that we currently have.” It is also is going to reduce convergence between US GAAP and IFRS in this area, she said.
Botosan said she favored a project on disclosures so that investors can better understand the longer-term impact of the acquired revenues.
Schroeder, one of the two investor voices on the board, said he favored the project as the problem it addresses is sufficiently pervasive, but came to a similar conclusion as Botosan related to the issues she flagged. Schroeder however said he would be supportive of a net fair value measurement approach for the contracts.
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