Accounting for deferred revenue in a business combination

From the IFRS Institute – June 2, 2023

Under IFRS® Accounting Standards, acquirers recognize contract liabilities assumed in a business combination at fair value as of the date of acquisition. This often results in a ‘haircut’ (or reduction) of the deferred revenue balance of the acquiree, which causes the acquirer to recognize less revenue than if it had originated the contract. While US GAAP has issued guidance to eliminate the reduction and narrow differences caused by the timing of customer payments, there is currently no similar amendment expected under IFRS Accounting Standards, resulting in a GAAP difference.

What’s the issue?

In a business combination¹, through what is referred to as ‘acquisition accounting’, an acquirer generally measures identifiable assets acquired and liabilities assumed at their fair value, at the date of acquisition. There are no exceptions to this general measurement principle for assets or liabilities arising from acquired contracts in scope of the revenue recognition guidance in IFRS 15². This requirement is not new but can be sensitive because it may affect the amount of revenue recognized by the acquirer post-acquisition.

For example, revisiting the accounting for contract liabilities³ of the acquiree often results in a ‘haircut’ to the deferred revenue balance recognized by the acquiree before the acquisition. Even different contractual payment terms for otherwise similar contracts can affect the amount of post-acquisition revenue recognized by the acquirer. This article explores where complexities may arise.

Accounting for assumed contract liabilities under IFRS Accounting Standards

Recognition of contract liabilities

IFRS 3 does not specifically address the accounting for assumed contract liabilities. Applying the general recognition principle in IFRS 3⁴, an acquirer recognizes a contract liability only if the acquiree has an obligation to perform after the acquisition.

Example 1 – Obligation to perform exists at the date of acquisition

Parent acquires Target. At the date of acquisition, Target has built a fiber-optic network and sold a five-year right to specified amounts of capacity and routes to Customers, for an up-front payment. Target accounts for the up-front payments as a contract liability and recognizes the revenue over the five-year term of the contracts.

Target has an obligation to perform services under the contracts – i.e. Target is required to provide the capacity and routes to customers. Therefore, Parent recognizes a contract liability in its acquisition accounting.

Measurement of contract liabilities

In acquisition accounting, contract liabilities are initially measured at fair value in accordance with IFRS 13⁵ . Measuring contract liabilities at fair value often reduces deferred revenue – i.e. the fair value of the assumed contract liability is lower than the carrying amount of the same contract liability recorded by the acquiree before the acquisition. This difference often occurs because fair value reflects the amount that would be paid to a third party to assume the liability, and therefore would exclude the costs to enter into the contract (e.g. selling costs) that have already been incurred by the acquiree.

In practice, two methods are generally used by valuation specialists to measure the fair value of contract liabilities.

Under the ‘top-down’ method, the acquirer uses market data to determine the market price that it would receive in a transaction to fulfil the performance obligation. The fair value of the assumed contract liability is determined by subtracting from this amount the costs that have already been incurred towards fulfilling the obligation (e.g. selling or marketing costs) plus a reasonable profit margin on those costs; and
Under the ‘bottom-up’ method, the fair value of the assumed contract liability is measured as the costs required to fulfil the performance obligation plus a reasonable profit margin on those costs, discounted to present value.

If assumptions between these two approaches are consistent, the resulting fair value measurements should be similar.

Example 2– Fair value of contract liability when Customer has paid up-front

On January 1, Year 1, Target enters into a two-year service contract with Customer that will be satisfied ratably over time. Target concludes the contract does not have a significant financing component. Customer pays Target the full contract price of $1,000 at contract inception.

On January 2, Year 1, Parent acquires Target, before any performance under the contract.

The following additional facts are relevant. Effects of discounting are ignored for simplicity.

Contract price (fully deferred by Target at the date of acquisition): $1,000
Contract market price: $1,000 (for simplicity, assumed to be the same as the contract price)
Expected fulfillment cost: $750 (market participant view)
Reasonable profit on expected fulfillment costs: $150 (market participant view)
Selling efforts plus a reasonable profit: $100 (market participant view)

On January 2, Year 1, Parent records a contract liability at fair value for $900 in its acquisition accounting.

Fair value of the assumed contract liability is determined using either:

the top-down method: contract market price ($1,000) less selling efforts plus a reasonable profit ($100); or
the bottom-up method: expected fulfillment costs ($750) plus a reasonable profit margin ($150). Costs incurred by the acquiree as part of selling activities completed before the date of acquisition are excluded.

In Year 1 and Year 2, Parent recognizes $450 ($900 / 2 years) as revenue for this contract. Absent the acquisition, Target would have recognized $500 ($1,000 / 2 years) each year.

Timing of payments

Another consequence of measuring contract liabilities at fair value is that different contractual payment terms for otherwise similar contracts can affect the amount of post-acquisition revenue recognized by the acquirer. For example, a relatively higher amount of revenue is recorded for contracts paid in arrears than contracts that are prepaid before the acquisition, even when the acquirer’s post-acquisition performance is the same.

Example 3 – Contract liability when Customer has not yet paid

Assume the same facts as Example 2, except that Customer pays Target the contract price in four installments of $250 at the end of each six-month period.

Parent recognizes no contract liability at the date of acquisition because there has been no payment by Customer.
In Year 1 and Year 2, Parent recognizes $500 ($1,000 / 2 years) as revenue for this contract applying IFRS 15, which is the same amount that Target would have recognized each year.

Comparison to US GAAP

Under US GAAP, acquirers were similarly required to measure contract liabilities assumed in a business combination at fair value at the date of acquisition. In response to stakeholder feedback, the FASB has issued updated guidance, which is effective in 2023⁶ . The updated guidance requires an acquirer to recognize and measure contract assets and contract liabilities from acquired contracts with customers using the revenue recognition guidance in ASC 606⁷ . Under this approach, the acquirer applies the revenue model as if it had originated the contracts. However, the acquirer cannot simply carry over the acquiree’s balances. Rather, it needs to assess how the acquiree applied ASC 606 to identify differences with the acquirer’s accounting policies, estimates and judgments, as well as any errors in the acquiree’s accounting.

Unlike US GAAP, under IFRS Accounting Standards, there is currently no amendment expected to IFRS 3 for acquired contract assets and contract liabilities. Consequently, there will be differences in the measurement of these assets and liabilities because US GAAP preparers will no longer measure them at fair value. This difference could make it more difficult to directly compare the results of companies under IFRS Accounting Standards versus US GAAP, in the periods immediately following a large acquisition.

Example 4 – US GAAP

Assume the same facts as Example 2, except that Parent and Target apply US GAAP.

On January 2, Year 1, Parent records a contract liability for $1,000 in its acquisition accounting, using the revenue recognition guidance in ASC 606.

In Year 1 and Year 2, Parent recognizes $500 ($1,000 / 2 years) as revenue for this contract, which is the same amount that Target would have recognized each year.

The takeaway

Under IFRS Accounting Standards, acquirers measure assumed contract liabilities at fair value, at the date of acquisition. Measuring the fair value of contract liabilities can be complex and often results in a haircut to the acquiree’s deferred revenue and a reduction of post-acquisition revenue. Starting in 2023, US GAAP preparers are no longer required to perform this exercise, which is expected to simplify the accounting but also preserve post-acquisition revenue as if the acquirer had originated the acquired contract with the customer.

This could result in ongoing differences between IFRS Accounting Standards and US GAAP that acquirers will have to track if they have dual reporting requirements. Users of the financial statements should also consider those differences when comparing post-acquisition revenues between companies reporting under IFRS Accounting Standards and US GAAP.

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What’s the issue?

Accounting for assumed contract liabilities under IFRS Accounting Standards

Recognition of contract liabilities

Example 1 – Obligation to perform exists at the date of acquisition

Measurement of contract liabilities

Example 2– Fair value of contract liability when Customer has paid up-front

Timing of payments

Example 3 – Contract liability when Customer has not yet paid

Comparison to US GAAP

Example 4 – US GAAP

The takeaway

Footnotes

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Relevant Results

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Accounting for deferred revenue in a business combination

What’s the issue?

Accounting for assumed contract liabilities under IFRS Accounting Standards

Recognition of contract liabilities

Example 1 – Obligation to perform exists at the date of acquisition

Measurement of contract liabilities

Example 2– Fair value of contract liability when Customer has paid up-front

Timing of payments

Example 3 – Contract liability when Customer has not yet paid

Comparison to US GAAP

Example 4 – US GAAP

The takeaway

Footnotes

Meet the IFRS team

Explore more

Learn more KPMG Executive Education

Meet our team

Get the latest from KPMG Regulatory Insights

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