New guidance issued by the Financial Accounting Standards Board (FASB) in January 2017 revises the definition of a business. If you are wondering whether this will have any effect on your organization, the definition of a business affects many areas of accounting, including acquisitions, disposals, goodwill, and consolidation. The new standard will affect all entities that must determine whether they have acquired/sold a business.
This revision in the definition is anticipated to result in far fewer business combinations and more asset acquisitions.
Currently, there are three elements of a business: inputs, processes, and outputs. While outputs are usually present, they are not required to meet the current definition of a business. In addition, certain inputs and processes do not have to be part of what is acquired if the acquirer can obtain them independently or may already have them in an existing business. This integrated set of assets and activities is collectively referred to as a “set.”
The New Definition
The new definition retains the three elements of inputs, processes, and outputs forming a “set.”
These elements of a business are defined as follows:
Input – Any economic resource that creates or has the ability to contribute to the creation of outputs when one or more processes are applied to it, such as machinery and equipment, licenses, a source of supply, and employees.
Process – Any system, standard, protocol, convention, or rule that creates or has the ability to contribute to the creation of outputs when applied to an input or inputs, such as operational or strategic management processes.
Output – The result of inputs and processes applied to those inputs that provide goods or services to customers, investment income (such as dividends or interest), or other revenues.
To meet the definition, an integrated set of assets and activities requires two essential elements: inputs and processes applied to those inputs.
A business is not required to include all of the inputs or processes used by the seller. However, at a minimum, the set must include an input and a substantive process that together significantly contribute to the ability to create output.
Implementing the New Definition – Step 1
The new guidance provides a screen, or first step, to determine when a set is not a business. If substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not a business. The transaction is accounted for as the acquisition of an asset(s), and further analysis is not required. Guidance is provided to determine whether the single identifiable asset or similar assets criteria are met.
This first step will most likely reduce the number of transactions that will require business combination accounting.
The evaluation of whether assets are similar should include consideration of the nature of each asset and the risks associated with managing and creating outputs from the assets.
For example, a real estate management company that purchases five residential rental properties with in-place leases could consider the properties to be similar assets. However, three residential rental properties and two commercial rental properties with multiple tenants and cleaning and security contracts would not be considered similar assets. The management of and risks associated with the commercial properties are far different from those for the residential properties. Additional guidance provides that the following should not be considered similar assets:
- A tangible asset and an intangible asset
- A financial asset and a nonfinancial asset
- Different major classes of tangible assets, such as inventory and equipment
- Different major classes of financial assets, such as loans receivable and marketable securities
- Different major classes of intangible assets, such as customer lists and trademarks
- Assets within the same major class that have significantly different risk characteristics
Implementing the New Definition – Step 2
If the screen is not met, an additional evaluation is needed. The new guidance:
- Requires that to be considered a business, a set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output.
- Removes the evaluation of whether a market participant could replace missing elements.
The guidance provides a framework to use in evaluating whether both an input and a substantive process are present. The framework includes two sets of criteria to consider that depend on whether a set has outputs.
While outputs are not required to meet the definition of a business, such as in the acquisition of an early-stage company, outputs are a key element of a business; therefore, the new guidance includes more stringent criteria for sets without outputs.
- If a set does not have outputs, it can be considered a business only if it includes, among other things, employees who form an organized workforce.
- If a set does have outputs, it can be considered a business if it includes, among other things, employees who form an organized workforce or an acquired process, as defined in the standard.
The standard includes examples applying the screen and, when needed, the additional evaluation to various acquisitions in real estate, manufacturing, pharmaceuticals and research, television stations, distribution rights, intellectual property, and loan portfolio acquisitions.
Asset Acquisitions Versus Business Combinations
After determining whether a transaction qualifies as an asset or a business acquisition, a different accounting treatment will apply. While future changes by the FASB may occur, ASU 2017-01 did not change the accounting treatment or disclosure requirements for asset acquisitions or business combinations. A brief recap of the accounting, with considerably more effort required for accounting for business combinations than for asset acquisitions, follows.
Asset acquisitions that do not meet the definition of a business are generally accounted for as follows:
- Assets acquired are measured at cost.
- Cost is measured at either the cost to the acquiring entity, based on the fair value of the consideration given, or the fair value of the net assets acquired.
- When a group of assets is acquired, cost is allocated to individual assets and liabilities based on relative fair values.
- No goodwill is recognized.
- Separate disclosures of the transaction are not required.
Transactions meeting the definition of a business combination are accounted for as follows:
- Business combinations are accounted for using the acquisition method, which requires:
- Identifying the acquirer.
- Determining the acquisition date.
- Recognizing and measuring identifiable assets acquired, liabilities assumed, and noncontrolling interests at fair value.
- Recognizing and measuring goodwill or a gain from a bargain purchase.
- Disclosures that enable users to evaluate the nature and financial effect of a business combination are required, including:
- Name and description of the acquiree.
- Primary reasons for the combination and how control was obtained.
- A qualitative description of the factors that make up the recognized goodwill.
- The amounts recognized as of the acquisition date for each major class of assets acquired and liabilities assumed.
- Additional disclosures for contingencies and contingent consideration arrangements, bargain purchases, combinations achieved in stages, and combinations of less than 100%.
ASU 2017-01, Business Combinations, is effective for public companies for annual reporting periods beginning after December 15, 2017 (calendar year 2018) including interim periods within that reporting period.
All other entities will apply the new guidance to annual reporting periods beginning after December 15, 2018 (calendar year 2019) and interim reporting periods beginning after December 15, 2019.
The amendments should be applied prospectively on or after the effective date. No disclosures are required at transition. Early application generally is allowed for transactions that have not been reported in financial statements which have been issued or made available for issuance.