Picture this: Your company buys a shiny new office building to use in its eventual relocation from current headquarters. The former owner leased out most of the building to several different tenants, a nice cash flow bonus which will carry over under your company’s ownership until you renegotiate the contracts. Seems like a pretty straightforward purchase, right? Well, you may be left scratching your head when you find out your company needs to account for this transaction as a business combination! “Why, oh why, did this happen?” you might ask yourself aloud, alarming your office neighbors. Well, thanks to the incredibly broad definition of a “business” under ASC 805, of course! But, there’s a ray of hope. The FASB just released ASU 2017-01, which provides a more limited definition of what constitutes a business with a new framework for applying this definition.
Before I describe the biggest changes in ASU 2017-01, here’s a high-level rundown of what a business looks like:
- A business is still an integrated set of activities capable of providing a return.
- The integrated set of activities must include at least one input and one substantive process; together, both must significantly contribute to the creation of outputs.
- If the purchaser needs additional inputs or processes to create outputs, don’t worry about the ability of market participants to replace those inputs or processes. The new criteria for the integrated set make that evaluation unnecessary.
So far, it sounds pretty similar to the current guidance, right? Well, the FASB added two major changes to the current guidance to narrow the application of its definition of a business. The first change installs the “Screen” for the acquisition of single or similar assets, like the example of the new office building earlier. The second amendment provides a new framework, the “Machine”, for evaluating “screened” transactions depending on the presence of outputs before the acquisition.
If substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set does not qualify as a business. So, the purchase of that shiny new office building? It gets caught in the Screen and will not fall under the rules of ASC 805.
What if your company purchases several shiny new office buildings? Well, that depends on the risks associated with each building purchased. In this case, if all the buildings are the same type of office buildings, then the risks of managing outputs from these buildings may also be similar. If so, this purchase likely gets caught by the Screen and is not a business. What if your company buys office buildings and undeveloped land in the same transaction? Now, the risks of the assets could be different enough to cause the set to fall through the Screen into the Machine.
Once the acquired set of inputs and processes falls through the Screen, you need to pull a lever to determine which criteria you will evaluate the transaction against. Which lever you pull depends on one relatively straight forward question: Does the acquired set include outputs? Oh, and outputs under the new guidance means goods or services provided to a customer, investment income, or other revenue.
If the set has already generated revenues, pull the “Yes, it’s got outputs!” lever. If it doesn’t, pull the “No existing outputs here” lever.
The Yes Lever
In the eyes of the FASB, the generation of outputs by an integrated set prior to acquisition means it is more likely that this set includes both an input and a substantive process compared to sets that have not generated revenue. For that reason, it is easier to meet the new definition of a business, provided any one of the following conditions is present:
- Employees (as an organized workforce) have the ability to perform an acquired process which is critical to converting acquired inputs into outputs;
- An acquired contract that provides access to the organized workforce in point 1;
- The acquired process significantly contributes to the ability to produce outputs, and the process cannot be replaced without significant cost, effort or delay; or
- The acquired process significantly contributes to the ability to produce outputs, and the process is considered unique or scarce.
If none of these conditions are met, then the transaction is not a business combination!
The No Lever
An acquired set of inputs and processes may not already have outputs. This set will include an input and a substantive process only if:
- The set includes the organized workforce in the first condition (point 1) from the Yes Lever; and
- The set includes an input that the organized workforce can convert into output.
If both are met, then the integrated set qualifies as a business under the new guidance. Otherwise, it is treated as an asset acquisition.
With all this new information, the FASB decided to give a bit of breathing room until implementation and only deal with the changes to the financial statements prospectively. The ASU is effective for reporting periods beginning after December 15, 2017 for public companies, while nonpublic companies have an additional year (annual reporting periods beginning after December 15, 2018).