A recent accounting standards update helps entities evaluate whether transactions should be accounted for as acquisitions or disposals of assets or as businesses.
The Financial Accounting Standards Board’s Accounting Standards Update 2017-01 “Business Combinations (Topic 805): Clarifying the Definition of a Business,” states that a business has the following:
2. Processes applied to those inputs; and
3. The ability to create outputs, although outputs are not required for an entity to be considered a business.
In this update, to be a business a set of activities and assets must have at least one input and a substantive process that have the ability to create outputs to be considered a business. The prior U.S. GAAP definition required the evaluation of whether a market participant could replace missing inputs or processes to be a business. FASB developed the guidance in response to concerns that this definition of a business was too broad or challenging to apply.
The new guidance is significant for some companies. Those acquiring a business must expense transaction costs as incurred (debt issuance fees may be capitalized), record goodwill and contingent considerations and capitalize as indefinite-lived intangible assets any in-process research and development assets, or IPR&D, acquired. However, if acquiring an asset or assets, the transaction costs are capitalized as a component of the assets acquired, the contingencies are generally recognized when the contingency is resolved rather than at the transaction date, any IPR&D acquired would be expensed rather than capitalized unless it had an alternative future use, and the purchase price would be allocated.
Within the guidelines of the accounting standards update, there are two main thresholds to determine if an entity is a business:
“Substantially All” Threshold
Under the ASU, the first step is to determine if substantially all of the fair value of the gross assets being acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. If this threshold is met, the asset or set of assets acquired is not a business. The ASU provides guidance concerning the types of assets that can or cannot be combined into a single asset. The guidance includes tangible assets that are attached to and cannot be physically removed or separated from other tangible assets without incurring significant cost, such as a building from land.
If the “Substantially All” threshold is not met, and the set (of assets and activities) does not produce an output, the next step is to consider whether the set includes at least one input, one substantive process that contributes to the creation of an output, and an organized workforce. FASB narrowly defines outputs to be closely aligned with the outputs as described in the new revenue recognition guidance.
If the set does produce outputs, it will have inputs and a substantive process when it also has at least one of the following:
1. A skilled and experienced workforce that can continue to produce outputs;
2. A contract providing access to same;
3. A process or processes that cannot be replaced without significant cost or effort; or
4. A process or processes that is considered unique or scarce.
As with other fair value accounting standards, the determination of whether a particular set of assets and activities is a business should be determined from a market participant’s perspective (i.e., whether the set can be managed as a business by a market participant). The determination should be independent of whether the seller operated the set as a business or the buyer intends to operate the set as a business.
Valuation Considerations and Implications
The ASU guidance is likely to have a significant impact on real estate acquisitions. For example, an acquired building or multiple buildings, even those with leases in place, will not be considered a business if the set of assets acquired does not include one of the items discussed above (a workforce, a contract providing access to a workforce, a process that cannot be easily replaced, or a process that is unique or scarce).
ASU 2017-01 is effective for public business entities with fiscal years beginning after Dec. 15, 2017, and for all other entities for fiscal years beginning after Dec. 15, 2018. Early adoption is permitted.
The distinction between an asset purchase and a business combination can make a difference to a company’s financial reporting, with future impacts on the balance sheet (such as goodwill and in-process research and development) and the income statement (such as the depreciation and amortization effects of capitalizing transaction expenses) as well as impairment testing.