In its first accounting update of the new year, the Financial Accounting Standards Board (FASB) released guidance clarifying the definition of a business. Accounting Standards Update (ASU) 2017-01, Business Combinations (Topic 805) Clarifying the Definition (ASU 2017-01) seeks to narrow the circumstances where a set of assets and activities qualifies as a business. The changes are anticipated to result in more transactions being accounted for as asset acquisitions instead of business combinations.
Changes in ASU 2017-01 reflect the first phase of the business definition project. Phase two, which is expected to be issued soon, provides guidance related to partial sales or transfers of assets within ASC Subtopic 610-20. A third phase will delve into whether there are differences in the acquisition accounting and derecognition guidance for assets and businesses and whether those differences should be aligned.
Under current U.S. GAAP, a set of assets and activities that is a business contains up to three elements: inputs, processes and, usually, outputs. To be a business all of the inputs and processes necessary to operate the set of assets and activities are not required if the inputs and process used to produce outputs can be acquired, such as by integration into the buyer's existing inputs and processes. An "output" refers to the ability to provide a return in the form of dividends, lower costs or other economic benefits to investors or other owners. As a result of these provisions, the definition of a business has encompassed many transactions that many have argued would be more appropriately accounted for as asset acquisitions.
Under the current definition of a business, the purchase of rental real estate, ships or equipment may often be identified as acquisitions of a business. For example, the acquisition of a building that is under lease to a restaurant at the time of acquisition may be determined to be a business even if no employees, marketing, maintenance or other processes are obtained. In such a situation, inputs (land, building and lease) and outputs (lease revenue) are acquired. The lack of the acquisition of processes may not impact the analysis of whether a business was acquired because those processes may readily be replaced by a market participant.
Changes to the Existing Guidance
The revised guidance retains the concept that a business has inputs, processes applied to those inputs and, usually, outputs. ASU 2017-01 modifies the application guidance to further clarify the requirements that a set of assets and activities must meet to be a business. Changes to these requirements include:
- Introduction of a "screen" that is applied prior to evaluating other aspects of the definition of a business;
- Narrowing the definition of an output; and
- Introducing new requirements related to inputs and processes.
Screen: When an entity enters into a transaction where it acquires a set of assets and activities prior to evaluating the definition of a business, it will apply a "screen". The screen acts as a filter to prevent certain types of assets and activities from meeting the definition of a business. It applies to a set of assets and activities when substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar assets. The guidance further specifies that assets should be grouped based on their similarity in the nature of the assets and risks associated with managing the assets. Specifically targeting real estate entities, the revised definition states that tangible property that cannot be physically removed, such as land and building and the related in-place leases should be grouped for purposes of applying the screen.
In the example discussed above about the acquisition of a building that is leased to a restaurant, the screen would apply because the fair value of the land and building, combined with the in-place lease, represents substantially all of the fair value of the gross assets acquired.
Definition of an Output: The definition of an output was also modified to reduce the instances where a set of assets and activities will meet the definition of a business. Previously, outputs included economic benefits, such as the lowering of costs consistent with the purpose of a business. Under the revision, an output is defined as results that generate revenues or investment income.
Inputs and processes: Under the revision, an acquired set of assets and activities must include at least one input and a substantive process that together contribute to the ability to create an output in order to qualify as a business. In scenarios where outputs are included in the set of assets and activities, the mere existence of outputs prior to and subsequent to a transaction does not automatically result in a determination that a substantive process exists. Rather, an evaluation is performed to consider whether the processes acquired contribute significantly to the creation of the outputs.
As with the prior guidance, a set of assets and activities may be a business even when the set does not include outputs. ASU 2017-01 creates a framework for evaluating a set of assets and activities which have no outputs that is narrower than the existing requirements. A substantive process may only exist (i.e. a business may exist) in a transaction that does not include outputs if an organized workforce is acquired and that organized workforce engages in processes that are not ancillary or minor (ex. bookkeeping) that are applied to inputs that are being developed into outputs.
The changes to the definition of a business are expected to reduce the number of transactions that must be accounted for as a business combination under ASC Topic 805 Business Combinations (ASC Topic 805). Transactions that are no longer in the scope of ASC Topic 805 will not be accounted for under the acquisition method; instead, they will be accounted for as asset acquisitions.
Asset acquisitions are accounted for at historical cost instead of fair value. However, the revision to the definition will not eliminate the need to determine the fair value of assets acquired when these transactions cease to meet the definition of a business. In an asset acquisition, an entity is required to allocate the cost to the assets acquired based on those assets fair value. Therefore, in the example discussed above for the acquisition of a leased building, a reporting entity would determine the fair value of the building, land and in-place lease, and proportionately allocate the cost between those three assets based on the relative amounts of each asset's fair value.
Although fair value of the individual assets is determined for transactions under both models of accounting, differences in the accounting for asset acquisitions and business combination do exist. For instance, in the example involving the acquisition of a leased building, the nature of the lease as a direct-financing, sales-type, or operating lease is re-evaluated as of the date of acquisition, whereas in a business combination the lease type is retained from the date of the leases inception. Three of the most significant differences between an assets acquisition and a business combination are:
- In an asset acquisition goodwill or gain is not recognized;
- In an asset acquisition transaction costs are capitalized instead of expensed; and
- If an asset acquisition includes a workforce, the intangible asset of the workforce is allocated a portion of the cost, whereas in a business combination the workforce is subsumed into goodwill.
Lastly, the adoption of the new definition may impact other areas of U.S. GAAP that use the term "business." Perhaps most significantly, ASC Topic 810 Consolidations uses the definition of a business when determining whether relationships with a legal entity are in scope of the variable interest entity (VIE) model. Entities adopting the new guidance may need to re-evaluate their conclusions when the business scope exception was applied.
Effective Date and Transition
The guidance will be applied prospectively as of the adoption date. No additional disclosures will be required at adoption. Public business entities will apply ASU 2017-01 to annual and interim periods beginning after Dec. 15, 2017. Nonpublic business entities will apply the guidance for annual periods beginning after Dec. 15, 2018 and interim periods within annual periods beginning after Dec. 15, 2019.
Entities will have the option to early adopt the changes. Entities may apply the new definition to transactions that take place before the effective date (including prior to the issuance of ASU 2017-01), so long as the transaction has not already been recorded in financial statements that are issued or available for issuance.
For comments, questions or concerns about how the standard will affect your reporting, please contact Mark Winiarski of MHM's Professional Standards Group. Mark can be reached at firstname.lastname@example.org or 816.945.5614.
Published on January 16, 2017