The issuance of ASU 2021-08 appears to align with FASB’s recent movement to simplify GAAP. An additional benefit will result where the same amount of revenue will be recognized regardless of the timing of the payments of the contracts. Under the previous guidance, contracts with advanced payments were reduced by a “haircut” adjustment to the contract liability and subsequently resulted in a reduction of recognized revenue. A “haircut” represents the costs of acquiring the contract plus a reasonable profit. Under ASU 2021-08, the timing of the payments will not affect the amount of the revenue recognized over the life of the contract. In a closer examination, however, the authors believe that CPAs may encounter unintended complexities when applying ASU 2021-08. Measurement of revenue and the resulting contract assets and contract liabilities under ASC 606 is complex and requires significant management judgment, especially if the acquisition results in modifications in the cumulative progress of completing the contract. Additional judgments in an acquisition will also result when the accounting policies of the acquirer are not the same as the acquiree.
This article reviews the new requirements of ASU 2021-08, which generally adopts the carrying values of contract assets and contract liabilities rather than their fair values in a business acquisition. The journal entries below illustrate how to account for a contract asset or liability for the acquiree prior to being acquired in a business acquisition. This is followed by a review of the acquisition journal entries as well as the acquirer’s accounting requirements after the acquisition. Additional discussion focuses on the accounting for a contract-based intangible asset (CBIA) wherein contract payments are made ratably or at the end of the contract. A CBIA will continue to be measured at fair value in a business acquisition and will require an analysis of the present value of the future net cash flows of the revenue contract. This article also presents the required journal entries when the acquirer changes the acquiree’s progress estimates.
This article reviews the key provisions of ASU 2021-08, provides a background of the accounting for contract assets and contract liabilities under ASC 606, as well as the accounting for contract assets and contract liabilities acquired in a business combination prior to the issuance of ASU 2021-08. A hypothetical example with three potential alternative circumstances will be used to demonstrate how to apply this new standard, and the significant changes between the prior guidance and the new standard are covered.
The primary goal of this article is to demonstrate the harmonization of how revenue is recognized for contract assets and contract liabilities under ASC 605 and ASC 805. It also discusses how ASU 2021-08 may result in diverse recognition of income relating to a contract, mainly due to the timing of the payment. Specifically, advance contract payments will result in greater recognition of income compared to deferred payments. The new standard requires the acquirer to assume the same accounting values used by the acquired company. The continuation of using the acquired company’s carrying value was intended to prevent the diverse accounting reporting under the fair value approach.
Guidance Prior to ASU 2021-08
The guidance for accounting for contract assets and contract liabilities was previously governed by ASC 805, under which all assets and liabilities were recorded at their fair values as of the acquisition date in a business combination. As for revenue recognition, contract assets and contract liabilities were recognized under the guidance in ASC 606. Contract assets were recognized where the performance of the contract exceeded the related cash receipts and other considerations. Contract liabilities were recognized where such payments exceeded the performance of the contract. The guidance under ASC 805 would usually result in values assigned by the acquirer to contract liabilities that were less than the amounts recorded by the acquired company. In addition, the timing of the payments would affect the amount of revenue recognized over the contract period. Advance payments for a similar contract would generally result in less revenue recognized over the contract period than deferred payments due to a haircut adjustment.
Guidance under ASU 2021-08
Under the provisions of ASU 2021-08, the acquirer is required to record any contract asset or contract liability as if it originated the contract. The intent of the new guidance is to have consistent and comparable accounting for contract assets and contract liabilities, regardless of whether an entity is acquired in a business combination. By using the same carrying values of the acquiree’s reported contract assets or contract liabilities, FASB intended to eliminate the requirements for fair value adjustments at the acquisition date. As a result, there would be no difference in the valuation of contract assets or contract liabilities for an entity that is acquired (or not acquired) in a business combination. Although this results in an exception to the valuation of net assets at fair value in acquisition accounting, FASB has cautioned that it should not be characterized as simply using the acquired company’s carrying values. Revisions to the acquired company’s valuations may result, if the acquirer’s accounting policies or cost structures differ from the acquiree, or if the acquired company failed to apply the appropriate accounting standards. In addition, in assuming it originated the contract, the acquirer must use its own cost estimates, which will often result in revisions in the progress of the project due to the acquirer’s economies of scale and potential synergies.
Prior to the issuance of ASU 2021-08, FASB issued an exposure draft on contract assets and contract liabilities for a business acquisition on December 15, 2020. FASB received 43 comment letters (FASB, 2020, Online Comment Letters, https://bit.ly/3FPo8jO), of which 40 respondents favored the amendment to ASC 805. The exposure draft referred to the conflicting guidance of recognizing deferred revenue only when a legal obligation exists under Emerging Issues Task Force (EITF) 01-03 (FASB/EITF, 2001, “Accounting in a Business Combination for Deferred Revenue of an Acquiree,” https://bit.ly/40kbzoP), or under Financial Accounting Concepts (FAC) 6 (FASB/FAC, 1985, Elements of Financial Statements,https://bit.ly/40gKOkV), where liabilities may include obligations expected to be performed under business practices. ASU 2021-08 made the following amendments to ASC 805:
- Contract assets and contract liabilities acquired in a business acquisition should generally be recorded using the carrying values of the acquired company that were recognized under ASC 606.
- Contract liabilities include legal liabilities as well as obligations that are common business practices. An example of such an obligation was expressed in a comment letter by RSM US LLP as the acquisition of a license symbolic intellectual property that was paid in advance (https://bit.ly/3K7Yl90). Under the previous guidance of ASC 805, no contract liability would be recognized by the acquirer, whereas the new standard requires the assumption of the acquiree’s obligation (https://bit.ly/3K7Yl90).
- Practical expedients are provided for the following situations wherein the acquirer cannot use the acquiree’s carrying values:
- For contracts that were modified before the acquisition date, an acquirer may reflect the aggregate effect of all modifications that occur before the acquisition date when:
- identifying the satisfied and unsatisfied performance obligations
- determining the transaction price
- allocating the transaction price to the satisfied and unsatisfied performance obligations.
- For all contracts, for purposes of allocating the transaction price, an acquirer may determine the stand-alone selling price at the acquisition date (instead of the contract inception date) of each performance obligation in the contract (ASU 2021-08, p. 8).
- For contracts that were modified before the acquisition date, an acquirer may reflect the aggregate effect of all modifications that occur before the acquisition date when:
The new guidance for the recording of contract assets and contract liabilities is effective for public business entities for fiscal periods beginning after December 15, 2022, including interim periods. The effective date for all other entities is fiscal periods beginning after December 15, 2023.
An Illustrative Example
The following examples demonstrate how the timing of receiving the consideration of a contract will result in diverse recognition of revenue under the previous guidance. Specifically, a contract that is pre-paid will result in a lower amount of revenue recognized than an identical contract where the payments are received over time. For simplicity purposes, this example will ignore the time value of money and assume that all the contracts do not require significant financing.
Ocean Technologies (OT) purchased Aquatic Industries (AI) on January 1, 2022. The following is the related consolidation information for both companies on December 31, 2021 (amounts in thousands):
On December 31, 2021, AI (acquiree) entered into a two-year contract to develop a kelp farm for Mia Seaweed & Company (MSC) for $50 million. AI received the full payment upon signing the contract. The anticipated cost to complete all the related work was $30 million. The relevant data is shown in Exhibit 1: The carrying value of property, plant & equipment (net) is $115 million, with a fair value of $149.5 million; the note payable is $100 million, with a fair value of $110 million; and the contract liability is $50 million with a fair value of $45 million. The carrying values of all the other accounts are equal to their fair values.
Exhibit 1
Consolidation and Related Information (Contract Liability)
Prior to being acquired by OT, AI entered into a two-year contract with MSC and recorded the journal entry in Exhibit 2. There were no entries for the $30 million construction cost because the work has not been commenced.
Exhibit 2
Pre-acquisition Journal Entry by the Acquiree
On January 1, 2022, OT acquired AI for $80 million. The acquisition journal entry shown in Exhibit 3 was the same under the previous guidance and ASC 2021-08. We have assumed a statutory merger for purposes of providing a simple illustration.
Exhibit 3
Acquisition Journal Entry by the Acquirer
The purpose of the journal entry in Exhibit 4 is to show the dissolution of the business in order to present the values assigned to the assets and liabilities under the previous guidance and ASU 2021-08, with particular attention to the contract liability. Under the previous guidance, the contract liability was recorded at the fair value of $45 million. The contract liability has been reduced by the haircut, 10% of the contract price (10% × $50 million) which represents the marketing costs plus a normal profit margin incurred by the acquiree in obtaining the contract. Because the acquirer did not need to incur these costs, $5 million was deducted from the contract liability, resulting in a fair value of $45 million. In contrast, under the provisions of ASU 2021-08, the acquirer recorded the contract liability for $50 million as if it had originated the contract. The new guidance satisfies FASB’s objective of avoiding the complexity of estimating the fair value of the contract liability. Using the carrying value of $50 million avoids the diversity that existed under previous guidance; thus, the contract liability of $50 million is recorded regardless whether an entity was acquired or not.
Exhibit 4
Dissolution Journal Entry by the Acquirer
All of the identifiable assets and liabilities under the previous guidance and ASU 2021-08 were recorded at their fair values and the residual value was assigned to goodwill. Therefore, the contract liability of $50 million under the previous guidance was reduced by the $5 million haircut, resulting in a balance of $45 million; the residual value of $25.5 million was assigned to goodwill. In contrast, under ASU 2021-08, the contract liability is recorded at the carrying value of $50 million; the residual value of $30.5 million is assigned to goodwill. In general, if there are advance payments for a contract, the new guidance will assign more value to goodwill than the previous guidance. Goodwill is not amortized and is subject to an annual impairment review. The new guidance will result in higher future earnings, assuming the goodwill is not impaired in the future.
The post-acquisition entries by the acquirer in Exhibit 5 compare the recognition of revenue for the two-year period under the previous guidance and under ASU 2021-08. For simplicity, all finance considerations and time value of money are ignored. The incurrence of construction costs of $21 million was recorded under both the previous and current standards. Assuming the acquirer used an input-method measure of construction progress (total costs incurred of $21 million/estimated total construction costs of $30 million), the entity completed 70% of the contract performance and resulted in $35 million (70% × $50 million) of recognized revenue. Under the previous guidance, only $31.5 million (70% × $45 million) of revenue would be recorded because of the $5 million haircut was deducted from the contract liability. Similar entries were recorded for 2023 for the remaining 30% completion of the contract. Two takeaways are evident: 1) revenue recognition under ASU 2021-08 will exceed the amount reported under the previous guidance when there are advance payments that exceed the performance of the contract due to the haircut; 2) the availability of greater future revenue may encourage businesses to shop for these types of contracts in order to augment future revenue.
Exhibit 5
Post-acquisition Journal Entries by the Acquirer (Paid in Advance)
In order to demonstrate that the timing of the payments will have no effect in revenue recognition under ASU 2021-08, Exhibit 6 shows an example where the payment was made at the completion of the contract. Assume the same facts and circumstances, but instead of AT receiving payment upon signing the contract on December 31, 2021, MSC will receive the payment of $50 million at the completion of the construction. This was an executory contract because no consideration was exchanged. Because this was not an accounting transaction, no entry was recorded. As indicated in the basic information in Exhibit 6, AT has only $10 million in cash because it did not receive any payments from MSC. The new intangible asset identified as CBIA had a fair value of $15 million on the acquisition date. The acquirer will record this asset in the dissolution entry (Exhibit 8) after the acquisition. This represents the future net cash flow that OT would expect to receive after the satisfaction of the performance of the contract and is analyzed in Exhibit 7.
Exhibit 6
Consolidation and Related Information with Payments at the End of the Contract
Exhibit 7
Value of the Contract-based Intangible Asset (CBIA)
Exhibit 8
Dissolution Journal Entry by the Acquirer
The entry to record the acquisition for $80 million would be the same under the previous guidance and ASU 2021-08 as depicted in Exhibit 3. All the amounts in the dissolution entry, as shown in Exhibit 8, are the same under the previous guidance and ASU 2021-08. The CBIA will be recorded at $15 million, and goodwill at $15.5 million. The CBIA will be amortized over the two-year period at $7.5 million each year.
The transaction illustrated in Exhibit 8 assumes the same facts and circumstances, with the exception that the $50 million contract price will be paid at the completion of the contract. Prior to the acquisition, the basic data (Exhibit 6) indicates that because no payment has been received and performance of the contract has not commenced, no amounts were reported for a contract liability or contract asset at the commencement date.
As presented in Exhibit 9, OT recognized the same amount of revenue of $35 million in 2022 and $15 million in 2023 under both the previous guidance and ASU 2021-08. In contrast to the contract with payments in advance, the major difference was the amortization of the CBIA for $7.5 million for each year. Income therefore fell from $35 million to $27.5 million for 2022, and from $15 million to $7.5 million for 2023. Although the same total revenue of $50 million was reported for both years, the income was reduced by $15 million because of the deferral of the cash payments that resulted in the amortization of the CBIA. In short, under the new guidance, the schedule of cash payments will not affect the amount of revenue recognized; however, the timing of the payments will affect the recognition of the contract income. Recognized income will be greater for a contract with advanced payments than a contract with deferred payments.
Exhibit 9
Post-acquisition Journal Entries by the Acquirer (Pay at the End)
Changes in Estimates Affect Revenue Recognition
The acquirer may revise the construction progress schedule, which will affect the amount of revenue recognized for a contract where the payment is made at the commencement date. An acquirer may revise the contract liability for reasons such as superior operating efficiency or economies of scale. For example, if the acquirer revised the total estimated construction costs to $25 million, this would increase the amount of revenue recognized from $35 million to $42 million in 2022. Assuming that the same construction costs of $21 million were incurred in 2022, the contract progress would be revised to 84% ($21 million ÷ $25 million). The key takeaway is that contracts with advance payments may make revenue shopping even more attractive for acquirers.
Enhancing Comparability
In its recent attempt to simplify accounting procedures and enhance comparability, FASB has carved out an exception to recording contract assets and contract liabilities under ASC 805 in a business combination. Under the previous guidance, acquired assets and liabilities were required to be recorded at fair value on the acquisition date. ASU 2021-08 now amends ASC 805 when the acquirer applies the guidance of revenue recognition under ASC 606. Acquirers, with some permitted variations, will now record the contract assets and contract liabilities at the same carrying values applied by the acquiree. The new guidance will result in the same values assigned to these contracts whether an entity is acquired or not. This will enhance the comparability between these contracts before and after an acquisition. In addition, under the previous guidance, the schedule of contract payments had affected the amount of the revenue recognized. The total revenue will not be affected under the new guidance by how the payments are scheduled.
The elimination of using a fair value measurement was not supported by Christine Ann Botosan, the only FASB member to dissent from ASU 2021-08. She stated that she believes “simply carrying over the same basis does not faithfully represent the economics of a business acquisition transaction and could result in an overstatement of postacquisition [sic] revenues and income” (ASU 2021-08, p. 11). Three of the 43 comment letters (FASB, 2020, Online Comment Letters, https://bit.ly/3FPo8jO) on the exposure draft similarly did not favor using the acquiree’s carrying values rather than fair value for these contracts.
As illustrated above, deferred contract payments will require the recognition of the CBIA, which will impact the amount of income recognized and affect comparability. Additional complexities could occur if the acquirer cannot use the values assigned to the contract. Although the guidance achieves consistency in revenue recognition, the timing of payments will result in diverse recognition of income. This may result in increased “revenue shopping,” an issue also addressed by Botosan. Despite this and various other caveats, by promulgating ASU 2021-08, FASB has favored consistency and comparability of reporting revenue contracts over a fair value approach.
