The proposed ASU clarifies when acquiring organizations should recognize a contract liability in a business combination. In the proposal, an organization should recognize deferred revenue from acquiring another organization if there is an unsatisfied performance obligation for which the acquired organization has been paid by the customer.
Deferred revenue represents prepayments received for goods or services. GAAP requires the revenue related to these prepayments not to be recognized until the goods are shipped or the services are rendered. Deferred revenue can be kind of a hot mess in an M&A transaction because, as this Skoda Minotti blog points out, it has a disturbing tendency to disappear:
In an acquisition, deferred revenue is typically adjusted down from its originally recorded amount to its “fair value,” which is based on the cost to deliver the related product or service (not the amount of cash collected prior to the related revenue being recognized). Because of the reduction in the deferred revenue balance to “fair value,” there is a portion of revenue (for which cash has been received) that never gets recorded on the company’s pre- or post-transaction books. Poof!
That revenue basically disappears and never gets recognized. For companies that receive meaningful prepayments, this can have a material impact on the amount of revenue that is recorded post-acquisition when the deferred revenue is reversed and recognized as revenue.
The FASB proposal doesn’t propose to change the fair value approach – but it does suggest the possibility that there may be some tinkering with the costs to be included in a fair value measurement.
– John Jenkins