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By Josef Rashty and John O'Shaughnessy

Recent developments in generallyaccepted accounting principles(GAAP) for business combinations

have, among other things, expanded theapplication of fair value accounting. It isimportant to understand the impact of thebusiness combination guidelines on thetreatment of post–business combinationaccounts. The discussion below dealsspecifically with deferred revenue liabili-ties in post–business combination accountsin the acquirer’s financial statements. Thefocus is mostly on software companies;however, many of these concepts trans-late easily to other industries as well.

Deferred revenue liabilities that had beenrecognized by the acquiree or the acquir-er on their pre-combination balancesheets do not necessarily qualify as deferredrevenue liabilities in the acquirer’s post-combination financial statements. Anacquirer should determine whether theliability recognized by the acquiree repre-sents a post–business combination perfor-mance obligation, and, if so, the fairvalue of such deferred revenue liabilitiesshould be reflected in the financial state-ments. The guidance on this subject is cov-ered in FASB’s Accounting StandardCodification (ASC) Topic 805, BusinessCombinations.

Statement of Financial AccountingStandards (SFAS) 141(R), BusinessCombinations, was issued in December2007, effective for annual reporting periodsbeginning after December 15, 2008.Paragraph 20 of SFAS 141(R) (ASC 805-20-30-1) requires that the “acquirer shallmeasure the identifiable assets acquired, theliabilities assumed, and any noncontrollinginterest in the acquiree at their acquisition-date fair values.” This applies to deferredrevenue, which is often an assumed liabili-

ty in post–business acquisition, providedlegal obligations exist to perform the relat-ed services. This guidance is part of the con-vergence effort that attempts to make U.S.GAAP compatible with InternationalFinancial Reporting Standards (IFRS).

Prior to the issuance of SFAS 141(R),Emerging Issues Task Force (EITF) Issue01-3, Accounting in a Business Combinationfor Deferred Revenue of an Acquiree, pro-vided guidance in this area. SFAS 141(R)superseded EITF 01-3, but it did notchange the general guidance. Both guide-lines require 1) the fair value estimate atthe time of acquisition and 2) the recogni-tion of liability when performance obligationexists.

Deferred Revenue Liability and Performance Obligations

An acquiree records deferred revenueliabilities in its financial statements for avariety of reasons. Deferred revenues couldrepresent upfront payments for services orproducts that have not yet been delivered,or payment for delivered goods or servicessold as part of a multiple-elementarrangement that cannot be accounted forseparately from undelivered items includ-ed in the same arrangement. For example,the acquiree may not have vendor-specif-ic objective evidence (VSOE) under ASC605-25-30-8 to be able to recognize therevenues associated with different elementsseparately in a multiple-element arrange-

Accounting for Deferred Revenue Liabilities in Post–Business Combination Statements

A C C O U N T I N G & A U D I T I N Ga c c o u n t i n g

ment contract. (VSOE refers to the pricecharged for a deliverable in a multiple-ele-ments arrangement when sold separately.)

An acquirer, however, reflects theacquiree’s deferred revenue at fair valuepost–business combination, as long as itrepresents obligations to provide productsor services to customers. There are casesin which an acquiree has recorded deferredrevenue liabilities but the acquirer does notnecessarily have any obligation to deliverany goods and services. For example, theacquiree might have recorded a revenuetransaction as deferred revenue, becausethe transaction has not met the revenuerecognition criteria for a reasonable assur-ance in collectability or lack of VSOE. Inthese scenarios, the acquirer does nothave any performance obligation related todeferred revenue liability of the acquiree,and as a result it will not record anydeferred revenue liability in post–businesscombination financial statements.

Fair Value Measurement of Deferred Revenue Liabilities

The acquirer should record liabilities forthe deferred revenues based on the fairvalue of the obligation on the acquisitiondate. This amount could very well be dif-ferent from the amount previously recog-nized by the acquiree. The deferred rev-enue that an acquiree has recognized as aliability generally represents the cash thatit has received and does not necessarilyreflect the fair value at the time of acqui-sition. The fair value of deferred revenueliabilities for an acquirer is generally theamount that an acquirer is willing to payto a third party to assume such liabilities.

There are two different methods to deter-mine the fair value of deferred revenue lia-bilities. The first method is called the bot-tom-up approach, and an alternativemethod is referred to as the top-downapproach.

According to the bottom-up approach(the accounting literature has also referredto this method as the “cost build-upapproach”), the deferred revenue liabilityis measured as: 1) direct costs, 2) any incre-mental costs (such as overhead), 3) a rea-sonable profit margin, and 4) any additionalpremium for price variability. The directand incremental costs are related to theremaining performance obligation subse-quent to the merger and not any upfront

expenses that were incurred prior to thebusiness combination. A reasonable prof-it margin would be the profit that a mar-ket participant would expect to earn for thecompletion of the activities related to thedeferred revenue liabilities.

The less frequently used top-downapproach, on the other hand, relies on mar-ket indicators to estimate the expected rev-enues for deferred revenue obligations.Under this approach, the acquirer measuresthe fair value of the obligation based onthe estimated selling price for the prod-ucts and services, minus any selling effortand profit thereon.

The acquirer should also consider the“unit of accounting” in certain multiple-element arrangements when measuring thefair value of deferred revenues. Forexample, a software company providesone-year maintenance or post-contract ser-vices (PCS) to its customers, and, as partof this arrangement, provides unlimited bugfixes, telephone support, and unspecifiedsoftware upgrades and enhancements.The acquirer has the following two alter-natives: ! The unbundled unit of accounting mea-sures the fair value of each element sepa-rately and on its own. Under this approach,the when-and-if-available upgrades are notconsidered performance obligations,because there is no contractual obligationon the part of the vendor to deliver suchproducts. ! Based on the guidance in ASC 985-605(formerly Statement of Position 97-2,Software Revenue Recognition) the entirePCS arrangement would be considered as thelowest level of a unit of accounting. Underthis view, the fair value of the deferred PCSrevenue equals all the costs expected to beincurred (i.e., the costs of providing supportservices and bug fixes as well as the cost ofdeveloping upgrades and enhancements), plusa normal profit margin.

Generally, both views are acceptable, aslong as they are applied in a consistentmanner.

Fair Value Measurement of Reacquired Rights

An acquirer may reacquire a right thatit had previously granted to an acquiree.One example might be rights to the acquir-er’s technology under a technology licenseagreement for a certain period of time, for

an upfront fee and certain amount of roy-alties. In post–business combinationaccounting, the acquirer usually recognizessuch reacquired rights as intangible assetsseparate from goodwill (ASC 805-20-25-14). When an acquirer reacquires a previ-ously granted right, it should recognize andmeasure its fair value based on the remain-ing life of the contract without taking intoaccount any expected renewals or exten-sions. Paragraph 55 of IFRS 3, BusinessCombinations, contains similar guidance.

Valuation of reacquired rights, unlikeother assets that are based on market par-ticipation assumptions, is based on the esti-mated cash flows over the remaining lifeof the contract (ASC 805-20-30-20).

Therefore, there could be a differencebetween the values derived from market par-ticipation assumptions (“at market” value)and fair values estimated based on cashflows. This difference (“off market”value) makes a reacquired right favorableor unfavorable from the acquirer’s per-spective. As a result, the fair value of a con-tract consists of an off-market element inaddition to an inherent at-market element.

ASC 805-10-55-20 and 21 require thatan acquirer should recognize a gain or lossfor the effective settlement of a preexist-ing relationship based on the lesser of thefollowing:! The amount by which the contract isfavorable or unfavorable from the per-spective of the acquirer when comparedwith pricing for current market transactionsfor the same or similar items. If the acquir-er has previously recognized an amountrelated to the reacquired right, the settle-

31APRIL 2011 / THE CPA JOURNAL

The acquirer should record liabilities

for the deferred revenues based on

the fair value of the obligation on

the acquisition date.

ment gain or loss related to the preexist-ing relationship should be adjusted for thepreviously recognized amount.! The amount of any stated settlementprovisions in the contract available to thecounterparty to whom the contract is unfa-vorable. If this amount is less than theamount mentioned above, the differenceshould be included as part of the businesscombination accounting.

Paragraphs 17 and 18 of a November2010 International Accounting StandardsBoard (IASB) staff paper confirm that theabove wording mirrors paragraph B52 ofIFRS 3(www.ifrs.org/NR/rdonlyres/F98BBE13-7C2E-416E-973B-2FC95DF07629/0/1011obs15IFRS3Effectivesettlementofapreexistingrelationship.pdf). Theargument in this guidance is that a busi-ness combination does not extinguish therelationship between the acquirer andacquiree per se, but rather settles what isthe off-market portion of the relationship.

The value assigned to the reacquiredrights should exclude any amounts recog-nized as a settlement gain or loss andwould be limited to the value associatedwith the remaining contractual terms andcurrent market terms. Therefore, theamount of any settlement gain or lossshould not affect the measurement of thefair value of any intangible asset relatedto reacquired rights.

At the 2005 AICPA National Conferenceon Current SEC and PCAOB Developments(www.sec.gov/news/speech/spch120505bkr.htm), SEC staffer Brian K. Roberson indi-cated that the fair value of reacquired rightsshould be estimated as if the registrantwere purchasing a right that it previously did

not own. SEC staff acknowledge that valu-ation of reacquired rights is difficult, as therights often are not transacted on a stand-alone basis.

At the 2006 AICPA National Confe-rence on Current SEC and PCAOBDevelopments (www.sec.gov/news/speech/2006/spch121106jbu.htm), SEC stafferJoseph B. Ucuzoglu specifically identi-fied in-process revenue contracts asexamples of executory contracts that shouldbe recognized as unfavorable contract lia-bilities, to the extent that the terms of thecontracts are less favorable than the termsthat could be realized in the current mar-ket. Conversely, even though not directlydiscussed by SEC staff, an in-process rev-enue contract with terms favorable to theacquirer on the acquisition date should berecognized as favorable contract assets inpost–business combination reporting.

ExampleEntity A (acquirer) acquires Entity T

(acquiree, or target). Assume that they bothdevelop and sell computer software pro-grams. At the time of the acquisition, thefollowing deferred revenue liabilitieswere reflected in the acquiree and acquir-er’s financial statements:1. Entity T sold a license agreement priorto acquisition for $1,000 and is not reason-ably sure that it can collect the fee, becausethe customer is facing financial difficulties.Management plans to recognize this amountas revenue on a cash basis upon collection.Entity T reflected $1,000 in its deferredrevenue liabilities prior to acquisition.2. Entity T had agreed to extensively mod-ify one of its programs for a customer. The

modifications were complete at the time ofacquisition, but the customer did not signthe acceptance form until two days afterthe acquisition date. The selling price ofthe software program was $500, and theamount of the modifications on a cost-plusbasis was an additional $300. The customerpaid Entity T $800 prior to acquisition, andEntity T reported this amount in itsdeferred revenue liabilities.3. Entity T has a commitment to provideprofessional services for $200. Entity Treceived $200 from the customer prior toacquisition but has not performed anypart of these services prior to acquisition.Entity T expects to complete such servicesone month after acquisition. Entity T rec-ognized $200 in its deferred revenue lia-bilities.4. Entity T has deferred $100 in cashreceived for training services (as part of thetransaction in 2 above) because it did nothave VSOE for it. All training serviceswere completed to the satisfaction of thecustomer prior to the acquisition.5. Entity T has a $2,000 deferred rev-enue for PCS at the time of acquisition.6. Entity A sells a license to Entity T toembed the software in the products thatEntity T sells to its customers. Entity Aprovides Entity T with a “gold disk” forthe unlimited deployment of licenses forthe two-year duration of contract. Entity Areceives a payment of $1,200 at inceptionand a royalty fee based on each productsale to Entity T customers. Entity A doesnot have VSOE for the transaction andrecords the cash receipt as a deferred rev-enue liability and amortizes it ratablyover the next two years. The balance ofdeferred revenue liability at the time ofacquisition was $600. Entity T, on the otherhand, recorded the transaction as anadvance payment and amortized it basedon the number of units sold. The balanceof advance payment at the time of acqui-sition was $500.

The first two columns of the Exhibitreflect the effects of the above informationin Entities T and A’s financial statementsprior to the business combination.

The post–business combination column(the last column) of the Exhibit reflects thefollowing additional information regardingthe fair value of the deferred revenue lia-bilities in the post–business combinationfinancial statements of Entity A:

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Entity T at Entity A at Post–BusinessAcquisition Acquisition Combination

1 $1,000 $ – $ –

2 800 – –

3 200 – 100

4 100 – –

5 $2,000 – $500

6 – $500 –

EXHIBITDeferred Revenue Liabilities

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1. Entity A will not recognize any deferredrevenue liabilities post-combinationbecause it does not have any performanceobligation.2. Entity A will not recognize any deferredrevenue liabilities post-combinationbecause it does not have any performanceobligation.3. Entity A has used the bottom-upapproach to determine the fair value ofdeferred liabilities for professional servicesand estimated it to be $100.4. Entity A will not recognize any deferredrevenue liabilities post-combinationbecause it does not have any performanceobligation.5. Entity A has used the bottom-up approachand considered the whole PCS arrange-ment as a unit of accounting to arrive at thefair value of the PCS arrangement, and hasestimated it to be $500.6. Entity A has determined that the fairmarket value of the license agreement atthe time acquisition was $1,500. This fairmarket value consists of $600 at-market(based on market participants’ estimates)and $900 off-market components (basedon the excess of fair value derived fromcash flow estimates over at-market val-ues; $1,500 ! $600). The off-marketcomponent is favorable to Entity T andunfavorable to Entity A, as royalty rateshave increased considerably in compara-ble markets since the initiation of the con-tract. The contract does not have any can-cellation clause or any minimum royaltypayment requirements.

The accounting for the combined enti-ty, post-combination, would be as follows:! Entity A would recognize a settlementloss on the reacquired rights equal to theamount that agreement is unfavorable (i.e.,the $900 off-market component). This off-market component is related to thebelow-market revenue-based royalty thatEntity T pays to Entity A. Entity A, how-ever, reduces this amount by the amountof deferred revenue liability that is out-standing at the time of acquisition (i.e.,$400). Therefore, Entity A recognizes asettlement loss of $500 ($900 ! $400).Entity A reflects $900 in its purchaseaccounting journal entry, which ultimate-ly impacts goodwill. Entity A will notrecognize any portion of the $400 deferredrevenue as revenue in its post–businesscombination accounting.

! Entity A will record the remainingvalue (i.e., the at-market value) of the reac-quired rights at $600 as an intangible asset,separate from goodwill, and will amortizeit ratably over the next year. The $500advance payment that Entity T has record-ed pre–business combination will not gettransferred to Entity A; it will be replacedby $600 (based on the SEC requirementthat the fair value of reacquired rightsshould be estimated as if the registrants

were purchasing a right that it previouslydid not own). The difference between $600(at-market value) and $500 (the balance ofunamortized advance payments) will bereflected in goodwill.

Recent DevelopmentsFASB recently issued EITF Issue 08-01,

Revenue Arrangements with MultipleDeliverables, which amends certain provi-sions of ASC 605-25 (Accounting StandardsUpdate [ASU] 2009-13). This guidance iseffective for arrangements entered into ormaterially modified in fiscal years beginningon or after June 15, 2010; early adoption ispermitted. ASU 2009-13 is not applicable tosoftware companies, but other technologycompanies and cloud-based computingarrangements are within the scope of thisASU. This guidance made two significantchanges to the following: the determinationof unit of accounting, and the allocation oftransaction consideration to identified unitsof accounting. ASU 2009-13 allows com-panies to account for delivered items as aseparate unit of accounting if the delivered

item has value to the customer on a stand-alone basis. It also allows the use of third-party evidence and a best estimate of the selling price if VSOE is not available. Theadoption of this guidance could acceleraterevenue recognition and, as a result, reducethe amount of deferred revenue liabilities.

On June 24, 2010, FASB and the IASBjointly issued an exposure draft that super-sedes all prior guidance in revenue recog-nition issues arising from contracts with cus-tomers. This guidance will impact revenuerecognition in both software companies andother industries. The proposed treatmentmay significantly affect how software com-panies determine what elements can beaccounted for separately, particularly soft-ware licenses. This guidance will impact thedeferred revenue liabilities, which are themirror image of recognized revenues. It isexpected that FASB and the IASB willjointly issue a converged revenue recogni-tion standard in 2011, with an effective datein 2014 or 2015.

Revenues May Be AffectedDeferred revenue liabilities that had been

recognized by the acquiree or the acquireron their pre-combination balance sheets donot necessarily qualify as deferred revenueliabilities in the acquirer’s post–businesscombination financial statements.Performance obligations and fair market val-ues impact the amount of deferred revenueliabilities that an acquirer would recognizein post–business combination accounting.As a result, the revenues of the combinedcompanies’ post–business combination maybe significantly lower than the total revenuesof the two companies if they would not havebeen merged. Furthermore, reacquired rightswill not only impact the amount of deferredrevenue liabilities and revenues during thepost–business combination period—theymay also impact the earnings throughadditional expenses or income, as illustrat-ed above. "

Josef Rashty, CPA, has had managerialpositions in several publicly held technol-ogy companies in the Silicon Valley regionof California. He can be reached atjrashty@sfsu.edu. John O'Shaughnessy,PhD, CPA (inactive) is an accounting pro-fessor at San Francisco State University.He can be reached at joshaun@sfsu.edu.

Performance obligations and fair market values impact the

amount of deferred revenue liabilities that an acquirer

would recognize in post–businesscombination accounting.