The change to the Financial Accounting Standards Board’s (FASB) definition of a business, made earlier this year in an Accounting Standards Update (ASU),* will likely lead to more acquisitions being accounted for as asset acquisitions rather than business combinations. This is significant, since the definition of a business affects many areas of accounting, including acquisitions, disposals, goodwill and consolidation. The impact of this change will be felt across many industries, and the complexities involved warrant some thorough analyses.
Why the change?
Accounting professionals communicated to the FASB that the definition was too broad and that too many transactions were being recorded as business combinations that were in essence asset acquisitions. In addition, they felt the current definition was too difficult and costly to implement, since asset acquisitions have fewer reporting and other requirements.
Why does it matter?
The accounting for business combinations and asset acquisitions has many differences. For instance:
• Transaction costs are expensed in a business combination but capitalized in an asset acquisition.
• In a business combination, in-process research and development costs are capitalized as an indefinite-lived asset; these costs are expensed in an asset acquisition, unless they have an alternative future life.
• Goodwill can only come about in a business combination.
There are many other substantive differences, which is why the FASB’s decision to change the definition is so important.
What are the key considerations in determining whether an acquisition is an asset or a business?
The new guidance provides “screens” to determine if a set of transferred assets and activities (set) would not be considered a business.
Single Asset
If an entity determines that substantially all the fair value of the gross assets acquired is concentrated in a single asset or group of assets, it’s not a business.
The ASU notes that a “single identifiable asset includes any individual asset or group of assets that could be recognized and measured as a single asset in a business combination.” In some instances, determining whether assets are similar will require significant judgment. The ASU notes, “When evaluating whether assets are similar, an entity should consider the nature of each single identifiable asset and the risks associated with managing and creating outputs from the assets (that is, the risk characteristics).” The ASU uses the example of an entity acquiring multiple versions of the same asset as satisfying this requirement, specifically referring to certain transactions in the real estate industry.
Substantive Process
The new guidance also notes that an asset can’t be a business unless it includes an input and a substantive process that create the ability to produce output — while narrowing the definition of output. This new definition of an output is now consistent with the description in the revenue recognition guidance.
The ASU lists criteria to be considered in determining whether sets with or without outputs include a substantive process. Because outputs are an important part of a business, the standard notes that when they are missing, it’s more difficult to determine that a substantive process is present. A substantive process is something that allows inputs to be created into outputs. The standard includes examples of what should be considered a substantive process. The ASU defines output as the “results of inputs and processes applied to those inputs that provide goods or services to customers, investment income or other revenues.”
What about the SEC’s definition of a business?
An important distinction to keep in mind is that the FASB’s definition of a business does not affect the SEC’s definition of a business. There is a presumption in the SEC’s analysis that a separate entity, subsidiary or division is a business. As noted in the SEC’s staff training manual, “The staff’s analysis of whether an acquisition is of a business, rather than of assets, focuses primarily on whether the nature of the revenue producing activity previously associated with the acquired assets will remain generally the same after the acquisition.” This is a distinction worth remembering because the SEC’s definition is used to determine whether historical financial statements and pro forma financial information are required in certain SEC filings.
With the new ASU, we may see more acquisitions not meeting the definition of a business under US GAAP but meeting the SEC’s definition of a business. This is especially relevant in the case of an Initial Public Offering because registrants will need to consider all businesses acquired during the last two or three years, depending on the registrant's filing status.
What are the important dates?
For public companies, this new guidance is effective for financial statements issued for fiscal years beginning after December 15, 2017 and interim periods within those years. For others, it becomes effective for financial statements issued for fiscal periods beginning after December 15, 2018 and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted.
Parting thoughts…
The rules are complex, so don’t wait to start your analyses. You may be able to reduce your reporting requirements, so opting for early adoption could save you time and money. If you need assistance, don’t hesitate to contact me at csmith@friedmanllp.com or reach out to your Friedman advisor.
*Accounting Standards Update (ASU) 2011-01