Category: Articles

With GAAP-complying companies having to adopt ASC 842 by the end of 2022, understanding the treatment of acquired leases through acquisitions is a relevant accounting consideration for companies.

This publication examines the relationship of Accounting Standards Codification 842, Leases (“ASC 842”) to Accounting Standards Codification 805, Business Combinations (“ASC 805”). This post and the underlying in-depth publication are not an extensive analysis of ASC 842, but rather a discussion of key components relating to acquired leases, whether it be leases acquired in a transaction accounted for as a business combination or in a transaction accounted for as an asset acquisition.

Acquirers of any lease, regardless of whether the acquirer of the acquired lease is in a lessor or lessee position, must treat the acquired lease as if it were a new lease as of the acquisition date. As such, acquirers must assess any differences between initial assessment of a lease under ASC 842, versus when a lease is acquired pursuant to a transaction accounted for under ASC 805. Specific differences are discussed in more depth within the publication and summarized in part below.

Typically, under ASC 805 acquired assets and liabilities through business combinations are recognized at fair value on the acquisition date following the measurement provisions of Accounting Standards Codification 820, Fair Value Measurement (“ASC 820”). Leases under ASC 842 are an exception to the requirement to recognize assets and liabilities acquired at fair value. As previously mentioned and as analyzed further in this discussion, acquired leases are recognized and measured as new leases as of the acquisition date. Lease classification can be reassessed, but if the lease was previously recognized under ASC 842 and is not modified through the acquisition, the lease is not required to be reclassified.

Leases acquired through asset acquisitions are generally recognized and measured similarly to how they are under business combinations with the exception of carrying over the lease classification. Lessors must reassess lease classification and lessee requirements to reassess classification are broadened to include more factors that would trigger reassessment (i.e., renewal and purchase options) when compared to the treatment under business combinations, as discussed below.

Download Full Report (PDF)

1. Lease classification in relation to a business combination

Provided that a lease was previously measured under ASC 842, then in accordance with ASC 842-10-55-11, leases acquired in a business combination should retain their previous lease classification unless there is a lease modification, and that modification is not accounted for as a separate contract (granting a lessee additional right-of-use assets (“ROU”) not included in the original contract and lease payments increase commensurate with the standalone price for the additional ROU).

Any of the following are lease modifications that are not accounted for as a separate contract and therefore represent a need for reassessment of the lease classification:

• Grants the lessee an additional ROU not included in the original contract
• Extends or reduces the term of an existing lease, other than through the exercise of a contractual option to extend (“renewal option”) or terminate the lease
• Fully or partially terminates an existing lease
• Changes the consideration of the contract only

Our observation: Acquirers and acquirees often have different business purposes for leases and other assets and liabilities, especially relating to the exercise of renewal options and purchase options. In practice, these differences in how the lease is intended to unfold are not considered to be a lease modification that would require a change in classification under ASC 842 in relation to ASC 805, as long as they represent rights that were present in the acquired lease. Rather, such rights are viewed as lessee elections for items already present in the lease contract and reflect more of the lessee’s intention rather than a modification of the lease. This conclusion is in line with the reassessment criteria above, especially when referring to the ‘exercise of a contractual option to extend’.

Further, acquirers often are uncertain whether some lease modifications will be made at the time of the acquisition. For modifications that are contemplated at the acquisition date but not put into place at that date, no impact is reflected as of the acquisition date and no classification reassessment is considered. Any reassessment of classification should be assessed when the modification is effective.

If the acquiree has not yet adopted ASC 842, whether it has accounted for leases under Accounting Standards Codification 840, Leases (“ASC 840”), International Financial Reporting Standards (“IFRS”) or other GAAP (non-US GAAP), reassessment of the classification of the acquired lease(s) must occur as of the acquisition date.

For leases where the acquiree is a lessee, the acquirer may elect an accounting policy election by class of underlying asset, which is applicable to all of the acquirer’s acquisitions, not to recognize assets or liabilities at the acquisition date for leases that, at the acquisition date, have a remaining lease term of twelve months or less. These acquired leases are considered short-term leases and the related lease expense is recognized on a straight-line basis over the remaining term.

2. Lease recognition and measurement in relation to a business combination

Acquired leases are accounted for in accordance with ASC 842, but certain aspects that are related to those leases are accounted for under other GAAP as described in ASC 805 for fair value measurement (ASC 820). The following table illustrates some of the key areas of recognition and measurement differences between assets and liabilities related to leases.

Acquiree as a:	Directly associated to leases Recognized & measured under ASC 842	Lease-related but outside scope of ASC 842 Recognized & measured under ASC 820
Lessee either finance or operating	Assets Right-use-asset Liabilities Lease liability Other considerations of note Can designate an accounting policy election by class for leases with a remaining life of 12 months or less	Assets Leasehold improvements In-place lease value Other identifiable intangible assets associated to leases (i.e., building naming rights)
Lessor operating	None	Assets Favorable lease terms relative to market Leased asset (includes lessor-owned tenant improvements) In-place lease value Customer relationship intangible asset Other identifiable intangible assets Property, plant, and equipment Liabilities Unfavorable lease terms relative to market
Lessor sales-type or direct finance	Assets Net investment in lease (sum of lease receivable & unguaranteed residual asset)	Assets In-place lease value Customer relationship intangible asset Other identifiable intangible assets

Other assets that are not directly included in the lease calculations but are still related to the lease are accounted for as indicated in the table above. These other assets can include various identifiable intangible assets (i.e., in-place lease intangibles, other intangible rights) that can be recognized related to acquired leases and are measured under ASC 820.

3. Lessee and lessor accounting – initial measurement upon acquisition

ASC 842 defines lease accounting relating to lessors and lessees. The various lease classifications under ASC 842 are as follows:

Lease holder type	Lease classification
Lessee	Finance or operating
Lessor	Operating, sales-type or direct finance

 

Lessee Accounting

For lessee accounting, under ASC 805-20-30 24, an acquirer must measure, or assess, any acquired lease as if the lease is a new lease as of the acquisition date, outside of its classification (see requirements above). If an acquirer acquires a lessee position that is either an operating or finance lease, the acquirer must first determine the lease’s lease liability at present value of the remaining lease payments. Measuring the acquired lease requires reassessment of all of the following:

• The lease term
• Any lessee options to purchase the underlying asset
• Lease payments (e.g., amounts probable of being owed by the lessee under a residual value guarantee)
• The discount rate for the lease

Our observation: One of the most difficult aspects of determining the present value of the lease liability is the conclusion of the discount rate, which is frequently determined by the incremental borrowing rate (“IBR”). This determination can be a judgmental area due to approach and information available. In addition to understanding the term of the lease, understanding the historical borrowing rates for the acquiring entity, if any, the acquisition date credit rating of the acquiring entity (or a near-term evaluation of the credit rating), along with input from the acquiring entity’s external auditors can greatly help this process. Additionally, performing sensitivity analyses around the selected rate can provide context for the selected rate and whether additional work is required for the rate to be more precise.

Lessor Accounting

For lessor accounting, the type of lease matters as operating leases are treated differently than sales-type or direct finance leases.

Similar to operating leases for lessees, an acquirer of operating leases in the lessor position determines if the terms of the leases have favorable or unfavorable market terms when compared to the same or similar items at the acquisition date. The acquirer recognizes an intangible asset if the terms are favorable or a liability if the terms are unfavorable relative to market terms and both are recognized under ASC 820 fair value guidance as indicated by ASC 805.

Both acquired lessor sales-type and direct finance leases are measured in the same manner. According to ASC 805-20-30-25, the acquirer measures its net investment in the lease as the sum of both of the following, which equal the fair value of the underlying asset at the acquisition date:

1. The lease receivable at the present value as if the acquired lease were a new lease at the acquisition date, discounted using the rate implicit in the lease, by using the following:
   1. The remaining lease payments
   2. The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor
2. The unguaranteed residual asset as the difference between the fair value of the underlying asset at the acquisition date and the carrying amount of the lease receivable, as determined in accordance with (a) above, at that date

Download Full Report (PDF)

Effectus Group’s team of highly skilled advisors, with extensive experience in assessing acquired leases as part of business combinations or asset acquisitions, is here to help navigate these areas and other related topics.

Notification to reader

© 2023 | All rights reserved | Effectus Group, LLC.

This publication contains information that is intended for general guidance purposes only and should not be used as a replacement for thorough research and professional judgement, especially in connection with specific and distinct circumstances to any person or entity. No express or implied representation or warranty is given with regards to the accuracy or completeness of the information contained herein. Effectus Group, LLC has endeavored to provide the most recent information but does not guarantee that the information will be accurate at the date of receipt or that the information will be accurate in the future. The information herein should not be interpreted as legal, tax, accounting, or any other professional service or advice and as such Effectus Group, LLC cannot accept any responsibility for loss resulting from any person acting or abstaining from action resulting from any information in this publication.

The FASB Accounting Standards Codification® material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856.

In the merger and acquisition landscape, transactions often include a variety of types of consideration transferred from the buyer, or acquirer, to the seller, including cash and the acquirer’s equity instruments. The buyer and seller may also agree to have a portion of the purchase price become payable if certain contingencies, milestones, or metrics are met in the post-acquisition period. These arrangements are typically referred to as contingent consideration arrangements, or earnouts, in practice.

Earnouts can be a useful component of the transaction structure when the buyer and seller have differing views on the target company’s valuation and the total consideration to be transferred to acquire the target company or the target’s assets. In these instances, earnouts can be used to bridge a “valuation gap”. Valuation gaps may arise during the negotiations on the value of the target company or its assets, often because of information asymmetry or differing expectations in the growth or profitability profile of the target company. In these cases, incorporating contingent consideration provisions and payments in lieu of the purchase price being paid entirely on the closing date can reduce the risk of the transaction for the acquirer, and can enable the seller to achieve its total desired purchase price if the earnout requirements are met in the post-closing period.

Pursuant to Accounting Standards Codification 805, Business Combinations (“ASC 805”) consideration transferred, including contingent consideration, is measured at fair value on the acquisition date when a transaction is accounted for as a business combination. The accounting for these arrangements can be highly complex and may require a significant degree of judgment. For financial reporting purposes, topics that management may consider when structuring, negotiating and accounting for these types of arrangements include, but are not limited to the following:

• Is the settlement in cash or the acquirer’s equity instruments?
• Is the payment or settlement contingent on continuing employment of sellers who became employees of the acquirer or the combined entity post-acquisition?
• Are there other provisions and terms that may indicate that the substance of the arrangement is compensatory?
• Does the acquirer have internal capabilities and expertise to determine the fair value of these types of instruments?

This summary discussion and the in-depth report examines the concepts that an acquirer should consider when assessing the appropriate accounting for contingent consideration in business combinations, including classification, measurement and recognition, and factors that impact whether arrangements represent consideration transferred in the business combination under GAAP or compensation to sellers for future services to be rendered. Additionally, the in-depth report presents data related to contingent consideration in business combinations from recent SEC filings as well as examples of common types of arrangements included in business combinations, and the appropriate classification and measurement and recognition conclusions.

1. Classification Considerations

Often times, purchase agreements include a clause that offers contingent payments to selling shareholders who will remain as employees of the acquiree or the combined entity, with the contingent payment tied to continuing employment of specified selling shareholders. In such cases, the contingent payments to be made to the selling shareholders are more appropriately accounted for as compensation for services to be provided subsequent to the acquisition date, as opposed to a component of the consideration transferred to sellers of the acquired entity. Prior to assessing the accounting for contingent consideration arrangements in a business combination, the acquirer should first ensure that the arrangement meets the criteria to be accounted for as contingent consideration instead of compensation for future services to be rendered.

Once it has been concluded that an arrangement meets the criteria to be accounted for as contingent consideration, ASC 805-30-25-6 indicates that a contingent consideration arrangement should be classified as either a liability (or an asset) or as equity in accordance with ASC Subtopics 480-10 (Distinguishing Liabilities from Equity – Overall) and ASC 815-40 (Derivatives and Hedging – Contracts in Entity’s Own Equity), or other applicable generally accepted accounting principles (GAAP). In this assessment, the settlement form and which party controls the choice of settlement form, if applicable, is important to understand. Arrangements solely settleable in cash and arrangements settleable in cash or shares, at the election of the seller(s), are liability-classified arrangements. In contrast, arrangements solely settleable in shares or settleable in cash or shares, at the election of the acquirer, may qualify for equity classification if certain conditions are met. When the arrangement is compensation for future services, the acquirer should look to other GAAP, such as Accounting Standards Codification 718, Compensation—Stock Compensation (“ASC 718”), for the appropriate classification.

2. Measurement and Recognition Considerations

After determining the appropriate classification of the earnout arrangement, the acquirer must then address the initial measurement and recognition upon the transaction closing. Regardless of the balance sheet classification, contingent consideration is initially measured at fair value in accordance with ASC 805-30-30-7. As previously observed, management teams should also ensure that the earnout arrangement is not accounted for as a separate transaction from the business combination, such as compensation under ASC 718, when assessing the appropriate measurement and recognition basis. When the substance and the nature of the arrangement is compensatory, the acquirer should look to other GAAP for the measurement and recognition basis.

Once the contingent consideration arrangement has been initially measured at the acquisition date, the acquirer must also understand how to account for subsequent changes in the value of such arrangements. Examples of events that would result in changes in the fair value include meeting an earnings target, reaching a milestone on a research and development project, or management determining that it would be unlikely that the applicable earnout targets will be met. Except for measurement period adjustments, which arise from additional information about facts and circumstances that existed at the acquisition date that the acquirer obtained after that date, all other subsequent adjustments to the fair value of the contingent consideration arrangement will be treated as follows:

• If the contingent consideration arrangement is initially required to be classified as a liability (or an asset), then the arrangement will be subsequently remeasured at fair value, with any changes in fair value from the previous value recorded in earnings (as a component of operations) pursuant to ASC 805-30-35-1(b).
• If the contingent consideration arrangement is initially classified as equity, then the initial fair value of the equity-classified instrument is not subsequently revalued at the period-end date, unless the arrangement does not meet the equity classification conditions in subsequent periods, pursuant to ASC 805-30-35-1(a).

Regardless of the classification, the acquirer should consider whether facts and circumstances in subsequent periods would have resulted in the reclassification of the arrangement(s). If so, the arrangement may have to be reclassified from a liability to equity or vice versa.

Our observation: Acquirers and management teams should be aware of the accounting implications of the various structures for contingent consideration arrangements since there is a natural tension between buyers and sellers related to who bears downside risks associated with the form of earnout consideration.

While contingent consideration arrangements settled in cash will be classified as a liability, subject to be measured at fair value in subsequent periods, contingent consideration arrangements settleable in the acquirer’s equity instruments may meet the conditions to be equity classified in the acquirer’s financial statements. However, the acquirer should not presume that such equity-settled contingent consideration arrangements will always be equity-classified for accounting purposes. This determination may have significant accounting implications in the post-closing period, including potential volatility in the acquirer’s post-acquisition earnings, as a result of the requirement for entities to measure liability-classified contingent consideration arrangements at fair value in subsequent periods with changes in fair value recognized in earnings.

Download Full Report (PDF)

The current accounting guidance with respect to the recognition and measurement of contingent consideration in business combinations contains various complexities and nuances, and improper interpretation of such guidance may result in significant financial reporting consequences and other downstream impacts. It is important to understand the implications of different contingent consideration structures, including how such structures will impact the initial recognition and measurement, the subsequent measurement, and the settlement of the arrangement.

Effectus Group’s team of highly skilled advisors, with extensive experience in the area of complex contingent consideration arrangements in business combinations, is here to help navigate this topic.

Notification to reader

© 2023 | All rights reserved | Effectus Group, LLC.

This publication contains information that is intended for general guidance purposes only and should not be used as a replacement for thorough research and professional judgement, especially in connection with specific and distinct circumstances to any person or entity. No express or implied representation or warranty is given with regards to the accuracy or completeness of the information contained herein. Effectus Group, LLC has endeavored to provide the most recent information but does not guarantee that the information will be accurate at the date of receipt or that the information will be accurate in the future. The information herein should not be interpreted as legal, tax, accounting, or any other professional service or advice and as such Effectus Group, LLC cannot accept any responsibility for loss resulting from any person acting or abstaining from action resulting from any information in this publication.

The FASB Accounting Standards Codification® material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856.

In October 2021, the FASB issued ASU 2021-08 on treatment for acquired contract assets and assumed contract liabilities for transactions within the scope of ASC 805, Business Combinations. The ASU significantly changes an acquirer’s measurement and recognition of acquired contract assets and assumed contract liabilities when compared to the legacy ASC 805 measurement and recognition model for such assets and liabilities.

Under the legacy ASC 805 guidance, the general measurement principle in ASC 805-20-30-1 explains that an acquirer must initially measure all assets acquired and liabilities assumed, with limited exceptions, at their acquisition date fair values in accordance with ASC 820, Fair Value Measurement. Accordingly, legacy U.S GAAP required contract assets and contract liabilities to be measured at fair value prior to the adoption of ASU 2021-08.

In contrast, ASU 2021-08 provides a recognition and measurement exception from fair value for contract assets and contract liabilities. As such, contract assets and contract liabilities are to be recognized and measured by the acquirer on the acquisition date in accordance with ASC 606, Revenue from Contracts with Customers, instead of being measured at the acquisition-date fair value. The new guidance may result in the acquirer recognizing contract assets and contract liabilities at the same amounts as recorded by the acquiree, contingent on certain qualifications, including an acquiree’s historical revenue recognition policies having been consistent with principles of ASC 606.

The potential benefits of adopting ASU 2021-08 include:

• The complexity and effort required in accounting for acquired customer contracts may be reduced.
• The acquirer will generally record more revenue in the post acquisition period.
• Consistent application of GAAP for acquired revenue contracts and arrangements, resulting in better comparability across periodic reporting.
• Less complexity in reporting and disclosing the impact of the acquisition to users of financial information and other stakeholders.

Our observation: While the adoption of ASU 2021-08 may significantly reduce complexity and effort required by the acquirer in accounting for acquired contract assets and assumed contract liabilities in certain transactions, the new standard may also add complexity and effort required by the acquirer. The complexity and effort required to determine the appropriate acquisition date contract asset and contract liability balances may be significant for private company acquisitions, especially if those companies have experienced significant growth in periods leading up to the acquisition, have limited documentation on formal revenue recognition policies, or have not been previously audited.

This summary discussion and the in-depth report examines the differences in the acquirer’s accounting models for acquired contact assets and assumed contract liabilities in a business combination between the legacy ASC 805 accounting framework and the updated accounting framework pursuant to ASU 2021-08.

Download Full Report (PDF) >

1. Legacy accounting framework (prior to adoption of ASU 2021-08)

Under the legacy business combination guidance, contract assets and contract liabilities (i.e., deferred revenue) acquired in a business combination are recorded by the acquirer at fair value. An assumed obligation related to deferred revenue is measured at fair value at the date of acquisition, pursuant to the guidance in ASC 820. The requirement to measure deferred revenue based on an identification of legal obligations and at fair value typically results in a deferred revenue “haircut” resulting in the acquirer recording a lower deferred revenue balance than the acquiree’s preacquisition book value.

For instance, assume an acquiree had a deferred revenue balance of $100 for an arrangement where the customer had prepaid an annual subscription fee of $120. Assuming the underlying performance obligation is a stand-ready obligation that will be satisfied continuously during the 12-month term of the contract, the revenue for the related arrangement is recognized ratably over the 12-month subscription term under ASC 606. The acquiree is acquired with 10 months remaining in the contract term and the fair value of the deferred revenue balance is determined to be $50 at that time, representing a 50% reduction, or “haircut” from the acquiree’s preacquisition book value. In the post acquisition period, the acquirer would recognize $50 ratably over the remaining 10-month period, not the $100 which the acquiree would have recognized on a stand-alone basis prior to the acquisition, as a result of the requirement to measure contract liabilities at fair value under legacy ASC 805.

2. Updated accounting framework (after adoption of ASU 2021-08)

ASU 2021-08 provides an exception to the historical treatment of the general recognition and measurement principles under ASC 805 for contract assets and contract liabilities related to acquired customer contracts in a business combination. As such, acquired contract assets and assumed contract liabilities are not required to be measured at fair value after the adoption of the new standard. Instead, these will be measured and recognized pursuant to the principles of ASC 606.

The measurement of acquired contract assets and assumed contract liabilities under the ASU is premised on the notion that the accounting by the acquirer should be performed as if the acquirer had originated the contract with the customer. An acquirer may, however, assess and refer to an acquiree’s historical accounting for acquired customer contracts in determining the measurement and recognition of contract assets and contract liabilities. For instance, an acquiree would have recognized a contract liability for the remaining, unsatisfied performance obligations in accordance with ASC 606 when a revenue contract was paid fully upfront before an acquisition. This assessment by an acquirer may result in an acquirer recognizing contract assets and contract liabilities at the same amounts as historically recorded by an acquiree, and no further fair value assessment is needed under ASC 820.

For instance, assume an acquiree had a deferred revenue balance of $100 for an arrangement where the customer had prepaid an annual subscription fee of $120 and 10 months were remaining in the contract term. Assuming the underlying performance obligation is a stand-ready obligation that will be satisfied continuously during the 12-month term, the revenue for the related arrangement is recognized ratably over the 12-month subscription term under ASC 606. As part of the acquirer’s assessment of the acquiree’s historical accounting policies and practices, acquirer did not observe deviations from the principles of ASC 606, differences in estimates, or errors in acquiree’s historical application of ASC 606. Therefore, the acquirer would recognize a deferred revenue balance of $100 as part of the acquisition accounting. In the post acquisition period, the acquirer would recognize $100 ratably over the remaining 10-month period, which is same method of recognition for the $100 that the acquiree would have recognized prior to the acquisition.

In the basis of conclusions to ASU 2021-08, the FASB indicated that the differences between contract assets and contract liabilities recorded by an acquirer and those recorded by the acquiree before the acquisition generally would result from:

• Differences in the acquirer’s and acquiree’s revenue recognition accounting policies and the resulting change to the acquiree’s policies.
• Differences in estimates derived in applying the principles of ASC 606 between the acquirer and acquiree.
• Errors in the application of the principles of ASC 606 by the acquiree.

The ASU provides for two practical expedients for the acquirer’s measurement and recognition of acquired contract assets and assumed contract liabilities:

• The acquirer would apply ASC 606 for the acquiree’s revenue contracts that were modified during the pre-acquisition period using the latest modified terms of the contract as of the acquisition date to determine performance obligations and the transaction price.
• The acquirer is permitted to determine the standalone selling prices at the acquisition date, rather than at the contract inception date as otherwise required by ASC 606.

3. Scope and adoption dates

The ASU applies to contract assets and contract liabilities, as defined in ASC 606, from contracts with customers and other contracts to which the provisions of ASC 606 apply. The scope of the ASU excludes the following assets and liabilities relating to acquired customer contracts:

• Receivables under ASC 310, Receivables and ASC Subtopic 326-20, Financial Instruments—Credit Losses—Measured at Amortized Cost.
• Contract-based intangible assets and liabilities, such as customer relationships, backlogs, and contracts with off-market terms.
• Deferred costs in the scope of ASC Subtopic 340-40, Other Assets and Deferred Costs—Contracts with Customers.
• Other assets and liabilities that may be recognized under ASC 606. Examples of these may include refund liabilities or upfront payments to customers.

In the basis of conclusions to the ASU, the FASB further indicated that intangible assets associated with off-market terms in acquired customer contracts may also impact the subsequent revenue recognition by the acquirer even if intangible assets arising out of customer contracts are not directly within the scope of the ASU. In certain circumstances, an acquirer should recognize the amortization expense for such intangible assets as a reduction in revenue.

The effective dates and transition methods are as follows:

Issuer Type	Effective date and Transition Methods
Public business entities (PBEs)	Fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The amendments included in the new standard should be applied prospectively to business combinations occurring on or after the effective date of the new standard. Early adoption of the amendments is permitted, including adoption in an interim period. 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.
Other entities	Fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. The transition methods for non-PBEs are the same transition methods for PBEs.