On January 5, 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-01, which clarifies the definition of a business and amends US generally accepted accounting principles (GAAP) ASC Topic 805, Business Combinations.
The main objective of this new standard is to help financial statement preparers evaluate whether a set of transferred assets and activities (either acquired or disposed of) is a business. Effective dates, which we list below, vary according to business entity type, and early adoption is permitted for all entities.
The revised definition of a business is generally expected to reduce the number of transactions that qualify for business combination accounting (as compared to current GAAP). This is particularly relevant in certain industries, such as real estate, life sciences, and others where the substantial value of an acquired set of assets and activities is often attributable to a single identifiable asset or group of similar identifiable assets.
The definition of a business affects acquisitions, disposals, goodwill, and consolidation, among other areas of accounting. Whether a transaction is accounted for as an acquisition (or disposal) of assets versus an acquisition (or disposal) of a business has significant accounting ramifications.
Under the FASB’s current guidance, an integrated set of assets and activities, referred to as a set in the standard, generally meets the definition of a business if it consists of three elements—inputs, processes, and outputs. However, while a business generally has outputs, the absence of outputs doesn’t preclude a set from being a business. ASC 805 states that not all inputs and processes needed to operate a set are required if the missing elements could be acquired by a market participant. However, it doesn’t specify the minimum inputs and processes required for a set to meet the definition of a business.
Many believe that this lack of clarity in the current definition of a business caused it to be applied too broadly to transactions that seemed like asset acquisitions but under the guidance were treated as business combinations.
The ASU amendments are intended to address these concerns by:
- More clearly outlining the requirements for a set to be considered a business
- Establishing a practical framework to determine when a set is a business
Following are the key provisions of the amendments.
“Substantially All” Screen
Under the revised guidance, a new screen is added where an entity must first determine if substantially all of the fair value of the gross assets acquired is concentrated in either a single identifiable asset or a group of similar identifiable assets. The set isn’t a business if this screen is met. The ASU provides guidance for determining which assets can be combined and considered either a single identifiable asset or a group of similar identifiable assets.
Requirement for an Input and a Substantive Process
To be considered a business—if the “substantially all” screen described above isn’t met— the set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create outputs.
When a set doesn’t have outputs, an acquired process is substantive if it includes both:
- Employees that form an organized workforce
- An input that the workforce could develop or convert into outputs
The organized workforce must have the necessary skills, knowledge, or experience to perform an acquired process (or group of processes) that when applied to an acquired input is critical to the ability to develop or convert that acquired input into outputs.
When a set has outputs, it will have a substantive process if it includes any of the following, according to the update:
- Employees that form an organized workforce, or an acquired contract that provides access to an organized workforce, that has the necessary skills, knowledge, or experience to perform an acquired process that when applied to an acquired input is critical to the ability to continue producing outputs.
- An acquired process that when applied to an acquired input significantly contributes to the ability to continue producing outputs and can’t be replaced without significant cost, effort, or delay in the ability to continue producing outputs or such acquired process is considered unique or scarce.
When a set has outputs, continuation of revenue doesn’t on its own mean that both an input and a substantive process have been acquired. Entities will need to evaluate whether the acquired set includes both an input and a substantive process using the criteria described above.
Revised Definition of Output
The ASU revises the definition of output as, “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.” This new definition changes two things:
- Narrows the types of returns to investors or other owners, members, or participants that are considered outputs
- More closely aligns with how outputs are described in ASC 606, Revenues from Contracts with Customers.
Effective Dates and Transition
For public business entities, the ASU is effective for annual periods beginning after December 15, 2017 (and interim periods within those periods). For all other entities, it’s effective for annual periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019.
The ASU amendments should be applied prospectively to any transactions occurring during the period of adoption. Early adoption is permitted for transactions not yet reflected in financial statements that have been issued or made available for issuance.
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