Earlier this year, the Financial Accounting Standards Board (FASB) updated its definition of a “business” for accounting purposes. The changes are significant because the new rules will classify many common transactions currently treated as business combinations as, instead, asset acquisitions. (See “Business combination vs. asset acquisition.”) For public companies, the revised definition takes effect for annual periods beginning after December 15, 2017, including interim periods within those periods, although the rules permit early adoption. For all other companies and organizations, the guidance is effective for annual periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019.
Inputs, processes and outputs
Currently, a set of assets and activities constitutes a “business” if it contains inputs, processes and, in most cases, outputs. Inputs are economic resources — such as fixed assets, intellectual property and employees — that create or have the ability to create outputs. Processes are systems, standards, protocols, conventions or rules applied to inputs to create outputs. They include an organized workforce with the necessary skills and experience.
Outputs, which result from the application of processes to inputs, provide or have the ability to provide returns in the form of dividends, lower costs or other economic benefits to investors or other owners. The FASB doesn’t require outputs, however, allowing start-ups that haven’t yet generated revenues to qualify as businesses.
The FASB decided to update the definition, as it felt that the current definition was too broad, causing many transactions to be accounted for as business combinations even though they’re more akin to asset acquisitions. For example, under the current definition, a transaction that includes no processes may qualify as a business if the buyer has the ability to generate outputs by combining acquired inputs with its own processes. Another concern is that, under the current definition of output, a single asset — such as a piece of equipment — could be considered a business if it’s expected to lower the buyer’s costs.
A new framework
The new definition is found in Accounting Standards Update (ASU) No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. It retains the concepts of inputs, processes and outputs, but tightens the requirements for qualifying as a business. The first step in evaluating whether a set is a business is to apply a “screen” designed to filter out certain transactions that are never characterized as businesses. The screen applies if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets. The updated standard provides detailed guidance on making this determination, as well as examples companies can review to help understand the new guidance.
If the screen doesn’t apply, the next step is to evaluate whether a set is a business under the new definition. 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 outputs. The buyer’s ability to replace missing inputs or processes with its own is no longer enough.
Determining whether a process is substantive depends on whether a set has outputs, with a stricter test applied to sets without outputs. Sets without outputs qualify only if they include an organized workforce — with the necessary skills and experience — that is critical to the ability to generate outputs. A workforce that performs ancillary or minor tasks, such as bookkeeping, isn’t enough.
Sets with outputs (that is, those that generate revenue before and after the transaction) qualify if they include any of the following:
- An organized workforce as described above,
- An acquired contract that provides access to such a workforce, or
- A process or processes that, when applied to an acquired input, significantly contribute to the ability to generate outputs that either can’t be replaced without significant cost, effort or delay, or are considered unique or scarce.
For example, in the real estate industry, an acquired contract for outsourced cleaning, security and maintenance isn’t enough to satisfy the new definition of business, because these services aren’t critical, unique, scarce or costly to replace. The result would be different, however, if the buyer also acquired the employees responsible for leasing, tenant management and other operational processes.
The updated standard also narrows the definition of an output. Economic benefits, such as lower costs, are no longer enough. The new rules limit outputs to revenues (for example, from providing goods or services to customers) and investment income.
If your company is involved in acquisitions, the new business definition may have a major impact on the way you account for certain transactions, particularly within the real estate, pharmaceutical and oil and gas industries. Familiarize yourself with the new rules and be prepared to make the decisions and judgments they require.