4.11 Assets and Liabilities Associated With Revenue Contracts — Before Adoption of ASU 2021-08
Sections 4.11.1 through
4.11.3 address the accounting for
assets and liabilities associated with revenue
contracts before an entity adopts ASU 2021-08. ASU
2021-08 was issued in October 2021 to reduce
diversity and inconsistency in the measurement and
recognition of contract assets and contract
liabilities acquired in a business combination.
After the adoption of ASU 2021-08, contract
assets and contract liabilities are measured in
accordance with ASC 606 rather than ASC 805 and
are therefore an exception to the recognition and
measurement principle in ASC 805. Thus, the
discussion of contract assets and liabilities
after adoption of ASU 2021-08 is included in
Section
4.3.13 under the topic of exceptions to
ASC 805’s recognition, measurement, and
designation or classification principles.
4.11.1 Contract Assets and Contract Liabilities — Before Adoption of ASU 2021-08
Before a business combination, an acquiree may have entered into revenue
contracts for which it has recognized contract
assets, contract liabilities, or both under ASC
606 in its preacquisition financial statements.
Contract assets and liabilities that arise outside
of a business combination are measured in
accordance with the measurement principles in ASC
606; however, contract assets and liabilities that
arise in a business combination before an entity
adopts ASU 2021-08 are measured on the basis of
the guidance in ASC 805 at their acquisition-date
fair values, and those values may be different
from the amounts that the acquiree recognized
under ASC 606. The acquisition-date fair value of
a contract asset or liability measured in
accordance with ASC 805 is not affected by the
timing of revenue recognition after the
acquisition (over time or point in time) or by the
acquirer’s revenue recognition policies.
4.11.1.1 Contract Assets — Before Adoption of ASU 2021-08
The ASC master glossary defines a contract asset as:
An
entity’s right to consideration in exchange for
goods or services that the entity has transferred
to a customer when that right is conditioned on
something other than the passage of time (for
example, the entity’s future
performance).
As described in ASC 606-10-45-1, the existence of a contract asset depends “on
the relationship between the entity’s performance
and the customer’s payment.” For example, a
contract asset exists when an entity has a
contract with a customer for which revenue has
been recognized (i.e., goods or services have been
transferred to the customer) but the customer’s
payment is contingent on a future event (e.g.,
billed on an agreed-upon future schedule or only
along with completion of additional performance
obligations). Such an asset might be referred to
as an unbilled receivable or as a progress payment
to be billed. If the entity’s right to
consideration is contingent only on the passage of
time, the right represents a receivable.
An acquiree’s contract assets and receivables are both recognized at fair value
in a business combination and are similar in that
they both represent an entity’s right to
consideration for the transfer of goods or
services, but there are different risks associated
with each. The fair value of a receivable takes
into account the time value of money and the
customer’s credit risk (see Section
4.5), whereas the fair value of a
contract asset incorporates the same risks as
receivables as well as other risks (e.g., risks
associated with additional performance obligations
or price variability). Contract assets should be
presented separately from receivables in the
financial statements.
4.11.1.2 Contract Liabilities — Before Adoption of ASU 2021-08
The ASC master glossary defines a contract liability as:
An
entity’s obligation to transfer goods or services
to a customer for which the entity has received
consideration (or the amount is due) from the
customer.
As described in ASC 606-10-45-1, the existence of a contract liability depends
“on the relationship between the entity’s
performance and the customer’s payment.” A
contract liability exists when an entity has
received consideration but has not yet transferred
the promised goods or services to the customer.
Such a liability might be referred to as deferred
revenue or unearned revenue.
An acquirer recognizes an assumed contract liability when the acquiree has
received consideration under a revenue contract
but still retained a performance obligation (even
if partially satisfied) as of the acquisition
date. The ASC master glossary (pending content)
defines a performance obligation as:
A promise in a contract with a
customer to transfer to the customer either:
-
A good or service (or a bundle of goods or services) that is distinct
-
A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
ASC 606-10-25-14 through 25-22 provide guidance on identifying performance
obligations. In accordance with ASC 606-10-25-19,
a promised good or service is distinct (and
therefore a performance obligation) if it is both
of the following:
-
Capable of being distinct — “The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.”
-
Distinct within the context of the contract — “The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.”
Under ASC 606, a performance obligation may be created not only on the basis of
the terms of a contract but also on a customer’s
reasonable expectations and may include promises
that are implied by an entity’s customary business
practices or industry norms.
If the acquirer determines that it has assumed an unsatisfied (or partially
satisfied) performance obligation, it recognizes a
contract liability at its acquisition-date fair
value, which is the amount the acquirer would have
to pay a third party to assume the liability.
Under ASC 606, the contract liability recognized
on the acquiree’s preacquisition balance sheet
typically represents the consideration the
acquiree received in advance from the customer,
less the amount recognized for services performed
to date. Therefore, the amount recognized by the
acquiree before the business combination is
unlikely to equal its fair value. After the
acquisition, the acquirer recognizes revenue and
derecognizes the contract liability as it
satisfies its obligation by transferring the
promised goods or services to the customer under
the contract.
In practice, there are two methods for measuring a contract liability at fair
value in accordance with ASC 820. Under one
method, sometimes called the cost build-up method,
the liability is measured as the direct
incremental cost of fulfilling the remaining
performance obligation, plus a reasonable profit
margin. Such a margin should take into account the
level of effort required or risk assumed by the
acquirer after the acquisition date but should not
include any profit related to the selling,
marketing, or other efforts completed by the
acquiree before the acquisition.
Under the other method, the liability is measured by using market data about the
amount of revenue that an entity would earn in a
transaction to provide the remaining performance
obligation in the contract, less the cost of the
selling effort that was already performed by the
acquiree before the acquisition date, plus a
reasonable profit margin on that effort. This
method is less common since relevant market data
are often unavailable.
Regardless of the method used, entities should perform the fair value
measurement from the perspective of a market
participant.
4.11.1.3 Costs of Obtaining a Contract
Before a business combination, an acquiree may have recognized an asset for the
incremental costs of obtaining a contract with a customer (e.g., sales
commissions) in accordance with ASC 340-40-25-1. While we do not believe
that the acquirer of such an entity should recognize an asset for those
costs in its postcombination financial statements, we do believe that the
costs incurred to obtain a customer may be reflected in the value of another
asset, such as a customer relationship intangible asset.
4.11.2 Long-Term Revenue Contracts — Before Adoption of ASU 2021-08
Long-term revenue contracts are common in the service, construction, and aerospace and defense
industries, and they arise in other industries as well. If an acquiree has long-term revenue contracts
that are partially complete at the time of a business combination, the acquirer must measure the assets
and liabilities related to such contracts at fair value as of the acquisition date by using the principles
in ASC 820, even though the assets and liabilities were probably not recognized at fair value in the
acquiree’s preacquisition financial statements.
Once these assets and liabilities are recognized and measured as of the
acquisition date, the acquirer will need to
determine whether the revenue from these contracts
should be recognized over time or at a point in
time under the guidance in ASC 606. For more
information about determining whether revenue
should be recognized at a point in time or over
time, see Deloitte’s Roadmap Revenue
Recognition.
The fair value of any assumed contract assets or liabilities is not affected by
the method that the acquirer will use to recognize
revenue under the assumed contract after the
acquisition. That is, regardless of the manner in
which revenue is recognized, the acquirer is
entitled to the same amount of cash flows from the
contract and will incur the same costs.
Often, an individual revenue contract (whether long term or not) may have
multiple assets or liabilities associated with it
and may therefore have several units of account.
For example, an acquired long-term revenue
contract may include a customer relationship
intangible asset, a backlog intangible asset, an
asset or a liability if the pricing in the
contract is not at market terms, or a contract
asset or liability if costs exceeded billings or
billings exceeded costs. Determining the
appropriate unit of account may be difficult
because of the interrelationships between the
various assets and liabilities. Generally, the
assets (and liabilities) would be recognized
separately if the assets’ useful lives and the
patterns in which their economic benefits are
consumed differ. In addition, some contracts may
result in the recognition of assets, and others
may result in the recognition of liabilities. It
is generally not appropriate to net the assets and
liabilities of different contracts.
For revenue contracts that qualify for revenue recognition over time, the measure of progress
should be based on the acquirer’s remaining effort after the acquisition date and should exclude the
acquiree’s efforts before the acquisition. For revenue contracts that qualify for point-in-time revenue recognition, the postacquisition revenue and project costs that are eligible for capitalization
should be recognized once control of the asset has been transferred to the customer.
4.11.3 Business Combinations Before the Adoption of ASC 606
An acquirer may have recognized assets or liabilities from acquired revenue contracts as part of a
business combination that occurred before it adopted ASC 606. An acquired revenue contract has
the same fair value regardless of whether it is subsequently accounted for under ASC 605 or ASC 606
(i.e., the cash flows related to a contract are the same regardless of the subsequent accounting).
Accordingly, we believe that entities should not remeasure those assets and liabilities upon adoption of
ASC 606.
Because the definitions of contract assets and contract liabilities did not
exist under ASC 605, we believe that entities
could recognize different assets or liabilities
for acquired revenue contracts after adopting ASC
606 than they recognized under ASC 605 (e.g., a
shift between a contract asset and a receivable or
a customer relationship intangible asset).
However, we do not believe that entities are
required to reclassify the assets or liabilities
recognized in association with revenue contracts
upon adopting ASC 606.