In early 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2017-01, Clarifying the Definition of a Business. This guidance has been effective for annual periods beginning after December 15, 2017 for public companies, and it will be effective for annual periods beginning after December 15, 2018 for all other entities.
True to its description, the new guidance technically does not change the definition of a business, which remains defined in the ASC Master Glossary as
“an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.”
The FASB clarification applies to the qualitative aspects of a business, requiring that its inputs and processes work together to create the ability to produce outputs (e.g. revenues, cash).
However, the most significant update to the determination of whether an acquired entity is a business or a set of assets is the new quantitative asset concentration “screen” test, which is expected to result in fewer transactions qualifying as business combinations and more transactions being treated as asset acquisitions.
Why the change?
The FASB thought too many transactions, especially those involving the acquisition of one asset or a group of similar assets, were being accounted for as business combinations—for example, a pharmaceutical or biotech company’s acquisition of in-process medicine or drug technologies. The new guidance makes it more difficult for an acquired (or divested) entity to meet the definition of a business.
What is changing?
- The new concentration screen test requires an acquirer to determine whether “significantly all” of the fair value of gross assets acquired is concentrated in a single asset or in a group of similar assets. If this is the case, the transaction cannot meet the definition of a business and must be recorded as an asset acquisition.
- Even when the quantitative concentration screen test (Step 1) does not automatically trigger asset acquisition treatment, the entity must meet the new and more stringent qualitative criteria (Step 2) to be considered a business.
How different is accounting for asset acquisitions versus business combinations?
- First and foremost, goodwill is not recognized in an asset acquisition. Instead, any excess of purchase consideration transferred over the fair value of net identifiable assets acquired is allocated to the long-term nonfinancial assets based on relative fair value. This results in certain recognized assets being measured on a company’s books at amounts higher than fair value, which in turn can result in near-term impairment charges. (Most financial assets and assets subject to recurring fair value impairment testing—such as indefinite-lived intangible assets— would not be allocated a portion of the excess consideration. Increasing the accounting basis of these assets at acquisition would likely lead to an impairment at the next testing date.)
- Also, while transaction costs are expensed in a business combination, they are capitalized in an asset acquisition, which also may push acquired asset carrying values above their fair values.
- In asset acquisitions, in-process research and development assets (IPR&D) are generally expensed at the acquisition date (not capitalized at fair value, as in business combinations).
- Other significant differences include accounting for contingencies, contingent consideration, and assembled workforce assets.
Is the impact limited to acquisition accounting?
No. The impact is much broader:
- In many instances, entities may be required to determine not only the fair value of net assets acquired but also of assets divested. (The accounting for divestitures varies depending on whether the disposal group represents a business.)
- The definition of a business is embedded in the authoritative guidance for other accounting topics, such as goodwill impairment testing and variable-interest entity determination. The new guidance could directly affect an entity’s ability to consolidate a subsidiary or result in an unexpected impairment charge.
What next steps should I take?
Plan ahead. If your company is contemplating an acquisition or divestiture, talk to your in-house valuation and accounting group or external valuation expert and accounting advisors about the impact of the new guidance.
The FASB’s clarification of the definition of a business transforms the traditional perspectives on accounting for acquisitions, divestitures, goodwill, and variable-interest entities. Companies should consider the sweeping impact of this change on its current accounting policies, disclosures, and forecasting methodologies.