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Contemplating a deal? Carefully consider acquired revenue contracts with customers
Observations from the front lines: Accounting Standards Update
In October 2021, Accounting Standards Update (ASU) 2021-08 was issued to improve the accounting for acquired revenue contracts with customers in a business combination. This new guidance requires companies to apply the revenue recognition standard (ASC 606) to recognize and measure contract assets and contract liabilities from contracts with customers acquired in a business combination, creating an exception to the general fair value measurement principles of ASC 805 and an additional difference to purchase accounting between US generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRSs).
The new guidance should be applied prospectively to business combinations occurring on or after the effective date of the amendments and is effective for calendar year public business entities in 2023 and all other calendar year entities in 2024, including interim periods within those years. Early adoption is permitted, including in interim periods, for any financial statements that have not yet been issued. An entity that early adopts in an interim period should apply the amendments (1) retrospectively to all business combinations for which the acquisition date occurs on or after the beginning of the fiscal year that includes the interim period of early application and (2) prospectively to all business combinations that occur on or after the date of initial application.
Generally, application of the new guidance is expected to result in revenue recorded by an accounting acquirer in post-close periods more closely aligning with the acquiree’s revenue recognition before the acquisition. This eliminates the typical effect of “disappearing revenue” often observed in business combinations from deferred revenue “haircuts” to fair value.
Why it matters
For companies considering deals now or in the near term, applying this new guidance could have a substantial impact on a variety of deal-specific considerations. Early preparation could be key to effective and efficient adoption of the ASU, including for the benefit of investors, lenders, regulators and other key stakeholders. It’s critical that companies revisit their existing acquisition playbooks to incorporate specific procedures and processes to assess the impact of these changes, given the potentially significant impact to acquisition accounting, deals modeling and post-close accounting.
“It is critical that companies revisit their existing acquisition playbooks to incorporate specific procedures and processes to assess the impact of these changes.”
Deal specific considerations
- Forecasting and projection models
- Overall impact
- Due diligence assessments
- Cross-border transactions
- Working capital impact
Forecasting and projection models
Buyers and sellers alike may need to revisit revenue projection models and forecasts relevant to their deal early in the transaction. Coordinating effectively with accounting advisory and financial diligence professionals could help in early identification of potential adjustments to such models.
Overall impact
Impact on financial covenants, debt agreements and compensation arrangements
This change in measurement basis for contract assets and contract liabilities that are acquired in business combinations could have upstream and downstream impact on provisions in a variety of other agreements negotiated or assessed as part of deals.
For example, a contingent consideration arrangement such as an earnout agreement may create an obligation of the acquirer to transfer additional assets or equity interests to the selling shareholders if future events occur or conditions are met. Future events or conditions may include the achievement of specific financial performance metrics, such as revenues or EBITDA.
Buyers and sellers should determine upfront if these impacts should be considered as part of the overall purchase price consideration.
Due diligence assessments
Financial due diligence and ASC 606 assessments
Applying ASC 606 at the acquisition date may not always be as simple as carrying over the acquiree’s recorded amounts. Because the assessment is of such significance (e.g., could result in material quality of earning adjustments), it will often require a full-scope review of contract assets and contract liabilities in buy-side transactions to obtain a full financial picture of the target.
Cross-border transactions
Because IFRS 3, the international business combination standard, does not include similar updated guidance, additional accounting complexities may arise in transactions, such as when a foreign subsidiary of a US parent acquires a business and recognizes the transaction in its statutory financial statements under IFRS or local GAAP, while the US parent must recognize the transaction in its consolidated financial statements under US GAAP.
Working capital impact
Changes in the measurement of acquired contract assets or liabilities could have an impact on post-close net working capital (NWC). Parties to a business combination will need to carefully assess this impact to post-acquisition NWC, including considering the impact to key liquidity ratios such as the current ratio and quick ratio relevant to deals.
Impact on financial metrics
- EBITDA and other profitability metrics
- Current liabilities
- Increased revenue
EBITDA and other profitability metrics
Generally, acquirers will see an increase in assumed contract liabilities in business combinations, which will commonly result in an increase in the subsequent revenue recognized by acquirers, post close, as compared to the current accounting model.
The increase in revenue will impact various profitability metrics (such as gross profit and EBITDA) as well as valuation multiples (such as price/earnings and enterprise value/EBITDA ratios), with potential impact on business purchase prices.
This may also reduce back-end reporting efforts under the current standard to reverse the effects of fair value measurement for non-GAAP or supplemental financial information disclosures.
Current liabilities
More assumed current liabilities and direct impact on net working capital
The typical increase in contract liabilities may reduce net working capital and related liquidity ratios (such as current ratio).
Increased revenue
Increased revenue driving improved interest/debt coverage ratios
Improved ratios may better illustrate the ability to meet interest obligations and indicate solvency to stakeholders.
Other relevant considerations
- Goodwill and impairment testing
- Accounting policy alignment
- Data and systems integration
- Plan for SOX impact
Goodwill and impairment testing
Goodwill and subsequent impairment testing
The amount of identifiable net assets recorded in acquisition accounting will likely be lower (due to the higher amount of contract liabilities), resulting in a higher goodwill balance.
As those contract liabilities are recognized into revenue post-acquisition, the carrying value of reporting units could increase, which could create challenges for subsequent goodwill impairment tests under ASC 350. Refer to our insights for more information regarding complexity with respect to the goodwill impairment testing model.
Accounting policy alignment
Accounting policy alignment and assessment of acquiree’s accounting conclusions
Absent justification for different accounting policies, an acquiree’s policies should generally be conformed to those accounting policies of the acquirer. While the extent of effort needed to align policies may vary by deal, the new guidance could add an additional layer of complexity (and costs). Acquirers will need to obtain in-depth understanding of the acquiree's accounting policies and must carefully assess the accuracy of the acquiree’s accounting conclusions, which could prove to be cumbersome.
Moreover, an acquirer and acquiree may assess measures of progress differently, such as in cost-to-cost arrangements in which one company's cost structure and assessment of a remaining post-acquisition performance obligation may differ from the other's. Such differences in estimates could lead to disagreements on the contract assets or liabilities to record, with a direct impact on goodwill, net working capital and even pursuit of the deal itself.
Data and systems integration
Data reliability, availability and systems integration
Successful post-deal integration often relies not only on effective change management strategy, cultural alignment and the realization of expected synergies. It also relies on complete seller-to-buyer information transfer, data availability and reliability, and knowledge sharing. These will continue to be particularly important upon adoption of ASU 2021-08, as Topic 606 assessments and estimates made at the acquisition date may need subsequent analysis and review for completely and accurately recording post-acquisition results. Any limited data availability relevant to acquired customer contracts could push more buyers to seek adjustments to the scope or specifics of transitional service agreements (TSAs).
Plan for SOX impact
Plan for SOX/business process impact
Acquirers may need updated or new financial processes and controls to apply the Topic 606 approach at the acquisition date.
How PwC can help
PwC has deep expertise with a range of accounting standard changes, the implications they have on executing a deal and on successful post-deal integration, and how to help companies overcome the various related challenges. Examples of how we can help include:
- Performing due diligence over the transaction to help assess if the transaction is the right strategic move for your business
- Determining the impact that ASU No. 2021-08 adoption has on a target or the acquirer, including detailed assessments for potential early adoption impact
- Accounting support for your acquisition close including alignment of accounting standards
- Advising on your post-integration controls, business processes and technologies to enhance efficiency across your company
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