Applying the “duck test,” most folks in business can spot a business when they see one. If it looks like a business, quacks like a business, swims like a business … Alas, nothing in U.S. Generally Accepted Accounting Principles is left to such logic.
Something as seemingly simple as identifying a business presents a new compliance imperative for public companies, which need to be sure their accounting for business transactions going forward reflects a new definition in GAAP.
As a result of a 2007 standard on how to account for business combinations such as mergers or acquisitions, GAAP contains a precise definition of a “business,” which speaks of inputs, processes, and the ability to produce outputs. In the course of a 2013 review of the standard, the Financial Accounting Standards Board heard some flack that the definition was a little off.
“Stakeholders believed that the definition of a business was being interpreted too broadly,” says Daryl Buck, national managing partner at Grant Thornton who recently exited FASB as a board member when his term expired. Applying the strict words of the definition, companies felt like they were forced to treat some asset acquisitions as business combinations.
How can an asset look like a business, or vice versa? Consider some of the common conundrums. In the real estate sector, when a commercial building full of leasing tenants changes hands, is it an asset or a business?
Applying the existing GAAP definition, it’s often classified as a business because the building is an input, the leasing of space is a process, and the cash flow is an output. Similar scenarios emerge with the sale of a product line or a brand name, or the sale of in-process research and development for a promising new technology, or even the sale of a portfolio of loans in some cases.
The distinction is important because the accounting for a business combination is not the same as the accounting for the purchase of an asset, says Brian Marshall, a partner at audit firm RSM. “There are quite a few things that differ,” he says.
With a business combination, companies must establish fair values for assets and liabilities and must book goodwill, an intangible asset that requires a great deal of additional accounting maintenance in future periods. Costs incurred to complete the transaction must be expensed through the income statement immediately, creating an upfront hit to earnings.
An asset purchase is much simpler. Companies generally book the transaction at the price they paid for it, and they can build in any acquisition costs so they will be depreciated with the value of the asset over time.
“Now this guidance has multiple layers. When you’re in that gray space, it’s going to require a lot more analysis.”
Mark Winiarski, Shareholder, Mayer Hoffman McCann
To help companies more clearly sort out assets from businesses so the accounting makes sense, FASB recently issued a new standard, Accounting Standards Update No. 2017-01. The new guidance clarifies the definition of a business and applies a “screen” meant to weed out asset acquisitions, says Scott Lehman, a partner at Crowe Horwath. The screen says if a significant portion of the fair value of an acquisition is focused on a single asset or a group of similar assets, then it’s an asset and not a business.
The guidance logically will lead to fewer transactions being accounted for as business combinations, but it doesn’t mean the analysis will be any simpler. “Ironically, it will make it more complex,” says Mark Winiarski, a shareholder at audit firm Mayer Hoffman McCann. Under the existing definition, “it’s relatively easy to conclude whether a business exists,” he says. “Now this guidance has multiple layers. When you’re in that gray space, it’s going to require a lot more analysis.” Marshall agrees the standard is going to require more judgment in some cases.
Not all accounting experts are expecting upheaval, however. “I think the intention is that it will be simpler,” says Beth Paul, a partner at PwC. “With any new standard, there’s always a period of interpretation and adjustment as people get familiar with where the new lines are.”
The implications of the new definition will extend beyond the upfront questions associated with acquisitions. Companies will need to refer to the standard when they are disposing of assets as well, says Paul, and when considering consolidations and reorganizations of entities under common control.
PWC ON THE NEW DEFINITION
Below is an excerpt from PwC’s briefing on FASB’s new definition of a business.
When substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business. This introduces an initial required screen that, if met, eliminates the need for further assessment.
To be considered a business, an acquisition would have to include an input and a substantive process that together significantly contribute to the ability to create outputs. The new guidance provides a framework to evaluate when an input and a substantive process are present (including for early stage companies that have not generated outputs). To be a business without outputs, there will now need to be an organized workforce. The Board noted that outputs are a key element of a business and included more stringent criteria for sets without outputs.
Finally, the new guidance narrows the definition of the term “outputs” to be consistent with how it is described in Topic 606, Revenue from Contracts with Customers. Under the final definition, an output is the result of inputs and substantive processes that provide goods or services to customers, other revenue, or investment income, such as dividends and interest.
For public business entities with a calendar year end, the standard is effective in 2018. All other entities have an additional year. Early adoption is permitted.
The amendments can be applied to transactions occurring before the guidance was issued (January 5, 2017) as long as the applicable financial statements have not been issued. For example, a public company with a calendar year-end can apply the new guidance to transactions that occurred after its third quarter, but before filing of its 2016 Form 10-K.
Why is this important?
The changes to the definition of a business will likely result in more acquisitions being accounted for as asset acquisitions across all industries, particularly real estate, pharmaceutical, and oil and gas. Application of the changes would also affect accounting for disposal transactions. Refer to Table 9-1 in PwC’s Business combinations and noncontrolling interests guide on CFODirect.com for a summary of the accounting differences between the acquisition of a business versus an asset.
FASB’s updated definition does not impact the SEC definition of a business used to determine whether historical financial statements and pro forma information is required in certain SEC filings.
The good news, says Winiarski, is that the new standard will not require companies to make wholesale changes to internal controls. “Most companies would have a process in place to identify when they have a business combination,” he says. “That’s still going to apply. You just need to get up to speed on the requirements under the new guidance and make sure you update your memos.”
Companies can expect some differences in the accounting for asset acquisitions if the transaction includes any kind of workforce, says Paul. Under current guidance, the presence of a workforce typically is a strong indicator of a business, and the value of a workforce is typically accounted for under goodwill. Now companies may be faced with workforce valuation questions they’ve not traditionally faced, she says. “Those are things people will be thinking about,” she says.
Julie Valpey, a partner at BDO USA, offers another caution regarding implications of the new definition in GAAP. FASB’s new standard has no effect on the definition the Securities and Exchange Commission observes, she says.
The SEC’s Regulation S-X prescribes what companies must provide in their financial statements, and Rule 3-05 within that regulation addresses the inclusion of any acquired business. The rule generally lays out requirements for financial statements, registration statements, and proxy statements when a company completes a business acquisition.
“A lot of companies particularly in the real estate sector, thought this would be a huge relief in their SEC reporting requirements,” says Valpey. “But the SEC has its own definition of a business, and that definition has not changed. If companies conclude they don’t have a business combination under the new guidance, they still have to consider the SEC’s definition and whether they will have to provide financial statements under S-X 3-05.”
The new definition takes effect for public companies in 2018, but companies are allowed to adopt it early if they wish.