EITF ABSTRACTS. Title: Accounting in a Business Combination for Deferred Revenue of an Acquiree

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1 EITF ABSTRACTS Issue No Title: Accounting in a Business Combination for Deferred Revenue of an Acquiree [Nullified by FAS 141(R)] Dates Discussed: April 18 19, 2001; January 23 24, 2002; March 20 21, 2002 References: FASB Statement No. 5, Accounting for Contingencies FASB Statement No. 13, Accounting for Leases FASB Statement No. 48, Revenue Recognition When Right of Return Exists FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises FASB Statement No. 66, Accounting for Sales of Real Estate FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities FASB Statement No. 141, Business Combinations FASB Statement No. 141 (revised 2007), Business Combinations FASB Statement No. 143, Accounting for Asset Retirement Obligations FASB Concepts Statement No. 6, Elements of Financial Statements FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements APB Opinion No. 10, Omnibus Opinion 1966 APB Opinion No. 16, Business Combinations AICPA Statement of Position 97-2, Software Revenue Recognition AICPA Statement of Position 00-2, Accounting by Producers or Distributors of Films ISSUE 1. Statement 141 requires that an acquiring enterprise allocate the cost of an entity acquired in a business combination to the individual assets acquired and liabilities assumed based on their estimated fair values at date of acquisition. In some cases, the Page 1

2 balance sheet of an acquired entity immediately before the acquisition date includes deferred revenue. 2. The issues are: Issue 1 Whether the deferred revenue of an acquired entity represents a liability that should be recognized by the acquiring entity when the business combination is recorded and, if so, how the amount assigned to that liability should be measured Issue 2 How the recognized liability should be presented in the acquiring entity s balance sheet Issue 3 Whether the amortization of an exclusivity arrangement that was acquired and recognized as an intangible asset in a business combination should be recognized as an expense or as a reduction of revenue. EITF DISCUSSION Issue 1 Whether the deferred revenue of an acquired entity represents a liability that should be recognized by the acquiring entity when the business combination is recorded and, if so, how the amount assigned to that liability should be measured. 3. The Task Force observed that under existing accounting principles, the acquired entity might have deferred recognition of revenue for a variety of reasons. The Task Force reached a consensus that the acquiring entity should recognize a liability related to the deferred revenue of an acquired entity only if that deferred revenue represents a legal Page 2

3 obligation 1 assumed by the acquiring entity (a legal performance obligation). [Note: This consensus has been nullified by Statement 141(R). See STATUS section.] 4. The Task Force noted that a legal obligation to provide goods, services, the right to use an asset(s), or some other consideration to a customer(s) would be examples of a legal performance obligation assumed by the acquiring entity. The Task Force also noted that an acquired entity might have deferred recognition of revenue because it is (or may be) obligated to grant the customer future concessions, as would be the case under a general right of return under Statement 48 or a price protection provision. The Task Force noted that the acquiring entity should recognize a liability if it has assumed a legal obligation to provide such concessions. [Note: See STATUS section.] 5. The Task Force noted that there are circumstances in which the deferred revenue of an acquired entity does not represent a legal performance obligation and, therefore, should not be recognized by the acquiring entity as a liability when the business combination is recorded. Examples of such circumstances are included in Exhibit 01-3A (Examples 1 4). 6. The Task Force observed that in accordance with Statement 141, when the acquirer recognizes a legal performance obligation related to a revenue arrangement of an acquired entity, the amount assigned to that liability should be based on its fair value at the date of acquisition. [Note: See STATUS section.] Issue 2 How the recognized liability should be presented in the acquiring entity s balance sheet. 1 The Task Force observed that a legal obligation could arise from contractual provisions or from consumer rights in the relevant legal jurisdiction. Page 3

4 7. The Task Force observed that a revenue arrangement acquired in a business combination might give rise to recognition by the acquiring entity of both an asset and a liability. For example, a single revenue arrangement may result in the assumption of a legal obligation to provide goods or services and the acquisition of a customer-related intangible asset. The Task Force observed that the liability recognized for the assumed legal obligation for performance and the related asset acquired should not be reported net on the balance sheet; that is, the asset and the liability should be recognized separately. An example of balance sheet presentation is included in Exhibit 01-3A (Example 5). [Note: See STATUS section.] Issue 3 Whether the amortization of an exclusivity arrangement that was acquired and recognized as an intangible asset in a business combination should be recognized as an expense or as a reduction of revenue. 8. The Task Force discussed the following fact pattern: Supplier A is willing to pay an upfront fee to Company B in return for the right to be the exclusive supplier of Product A. If that arrangement were entered directly, Supplier A would be required by Issue No. 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor s Products), to recognize the upfront fee as a reduction of revenue. Supplier A has agreed to acquire Supplier Z, a much smaller entity in the same line of business that also sells Product A. Shortly before the acquisition date, Supplier Z pays an upfront fee to serve as the sole supplier of Product A to Company B on terms similar to those that would have been offered by Supplier A. As a result of its acquisition of Supplier Z, Supplier A, in effect, will become the exclusive Page 4

5 supplier of Product A to Company B. Supplier A would recognize the fair value of that exclusivity arrangement as an intangible asset when the business combination is recorded. 9. The Task Force reached a consensus that the income statement characterization model in Issue 01-9 applies to the amortization of an exclusivity arrangement acquired in a business combination only if the exclusivity arrangement negotiated by the acquiree was not negotiated independently of the acquirer. [Note: This consensus has been nullified by Statement 141(R). See STATUS section.] Otherwise, amortization of an exclusivity arrangement acquired in a business combination should be characterized as an expense. For the above fact pattern, the Task Force agreed that the exclusivity arrangement was not negotiated independently by the acquiree; therefore, the acquirer s consolidated income statement characterization of the amortization of that arrangement should be governed by the model in Issue That income statement characterization likely would be a reduction of revenue. 10. The Task Force decided to discontinue further discussion of this Issue because it is within the scope of the FASB agenda project, Business Combinations: Purchase Method Procedures. STATUS 11. Statement 141(R), which was issued in December 2007, replaces Statement 141 and nullifies this Issue. However, this Issue still applies to mergers and acquisitions by notfor-profit organizations, which will be further considered as part of a separate FASB project that was exposed for comment in proposed Statements, Not-for-Profit Page 5

6 Organizations: Mergers and Acquisitions, and Not-for-Profit Organizations: Goodwill and Other Intangible Assets Acquired in a Merger or Acquisition. Statement 141(R) is effective for business combinations with an acquisition date on or after the beginning of the first annual reporting period beginning on or after 12/15/ No further EITF discussion is planned. Page 6

7 Exhibit 01-3A EXAMPLES OF CIRCUMSTANCES THAT WOULD NOT RESULT IN RECOGNITION OF A LEGAL PERFORMANCE OBLIGATION FOR THE ACQUIRER IN A BUSINESS COMBINATION 2 Example 1 Revenue deferred because collectibility is not reasonably assured Company A has delivered all services under an arrangement with a customer in exchange for a promissory note. As of the date Company A was acquired by Company B in a business combination, it had deferred recognition of revenue because collectibility of the note was not reasonably assured. Analysis: The deferred revenue does not represent a legal performance obligation assumed by Company B. As a result, Company B would not record a liability related to this revenue arrangement when the business combination is recorded. However, Company B would initially record the promissory note at its fair value, which would reflect an assessment of the note s collectibility. Example 2 Real estate sale with a note subject to future subordination Company C is in the business of selling property. Company C sells a property with a carrying amount of $50 for $100 of consideration consisting of $5 cash and a $95 note from the seller. The note received is subject to future subordination as described in paragraph 17 of Statement 66. In that case, paragraph 24 of Statement 66 requires Company C to use the cost recovery method. Under that method, Company C recognizes cash received ($5), the note receivable ($95), a deferred gain ($50), and derecognizes the 2 For entities subject to specialized accounting literature, the general requirements for revenue recognition described in these examples may not directly apply. For example, for entities subject to SOP 97-2, collectibility must be probable for revenue recognition to be appropriate. Page 7

8 property sold ($50). Paragraph 63 of Statement 66 requires that the deferred gain be recognized as revenue on the cash basis after the cost of the property sold is recovered (when the note receivable has a carrying amount of $50). Immediately after this transaction occurs, Company D acquires Company C in a business combination. Analysis: Company D has not assumed a legal obligation, so it would not record any deferred gain at the acquisition date. Company D would initially record the note at its fair value, which would reflect an assessment of the note s collectibility. Example 3 Sale-operating leaseback Company E enters into a sale-operating leaseback of nonintegral equipment with Bank F. Company E will continue to use the equipment in its operations. Company E follows paragraph 33 of Statement 13 and derecognizes the equipment, recognizes the cash received, and records a deferred gain, which it will amortize into income over the lease term. Subsequently, Company G acquires Company E in a business combination. Analysis: Company G has not assumed a legal obligation related to the deferred gain recorded by Company E. However, Company G may have acquired an asset (or assumed an obligation) relating to the operating lease commitment if it is favorable (unfavorable) relative to current leasing rates and would record the operating lease commitment at fair value, which would reflect an assessment of collectibility. Example 4 Software revenue extended payment terms Vendor H offers certain customers financing for the purchased software license in the form of a five-year note receivable provided by the customer at the inception of the arrangement. Paragraph 28 of SOP 97-2 indicates that if payment of a significant portion Page 8

9 of a software license is not due until after expiration of the license or more than 12 months after delivery, the licensing fee should be presumed not to be fixed or determinable. As a result of the extended payment terms, Vendor H initially defers all revenue on the arrangement because Vendor H cannot overcome the presumption in paragraph 28 of SOP Subsequently, Company I acquires Vendor H in a business combination. Analysis: If the sole reason Vendor H needed to defer revenue was because it failed to meet the criteria in paragraph 28 of SOP 97-2, Company I has not assumed a legal performance obligation. Example 5 EXAMPLE OF BALANCE SHEET PRESENTATION Company A owns a building having a 30-year remaining life. The building is fully leased to a single tenant under an operating lease with a three-year remaining life. That lease was fully prepaid at inception. Company B purchases Company A in a business combination. At the acquisition date, the fair value of the assumed lease obligation is estimated to be $1.5 million. Absent that lease commitment, the building has a fair value of $30 million. This example assumes that no other tangible or intangible assets were acquired in this transaction. 3 Paragraph 28 of SOP 97-2 requires deferral of revenue in many arrangements having extended payment terms because a product s continuing value may be reduced due to the subsequent introduction of enhanced products by the vendor or its competitors, the possibility that the vendor still may provide a refund or concession to a creditworthy customer to liquidate outstanding amounts due under the original terms of the arrangement increases as payment terms become longer (emphasis added). Page 9

10 Analysis: Company B would separately recognize the acquired building as a balance sheet asset in the amount of $30 million and a liability in the amount of $1.5 million representing the fair value of the assumed lease obligation. Page 10

11 Suggested Index Entries for Issue No. 01-3, Deferred Revenue of an Acquiree in a Business Combination BUSINESS COMBINATIONS Purchase Method.. Deferred Revenue of an Acquiree in a Business Combination 01-3 REVENUE RECOGNITION Deferred Revenue of an Acquiree in a Business Combination 01-3 Page 11