ASU 2017-01: Clarifying the Definition of a Business

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-01 to provide a clearer, more robust framework for defining a business. This update was a response to feedback that the previous definition was often applied too broadly, leading to incorrect classifications. This clarification is important because it directly impacts whether a transaction is accounted for as a business combination or as an asset acquisition, which have different accounting treatments. The standard aims to create more consistency in application and reduce the costs associated with this evaluation.

The Initial Screen Test

ASU 2017-01 introduced an initial screen test as a simplified first step to efficiently identify acquisitions that are not businesses. The core principle is to determine 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. If this is the case, the set of acquired assets is not considered a business, and the analysis concludes.

For this test, a single identifiable asset includes any individual asset or group of assets that could be recognized as one in a business combination, such as a building and the land it sits on. A group of similar identifiable assets would include tangible assets that are alike in nature, like a fleet of vehicles. The calculation of gross assets for this test excludes cash, deferred tax assets, and any goodwill created from deferred tax liabilities.

A practical example of passing this screen test is a real estate company purchasing a single commercial office building. In this scenario, the fair value is concentrated in one asset. Therefore, the transaction would be accounted for as an asset acquisition, not a business combination. This simplifies the subsequent accounting required.

The Business Definition Framework

When a transaction fails the initial screen test, the acquiring entity must proceed to a more detailed analysis using the business definition framework. The framework requires determining if the acquired set contains both an “input” and a “substantive process” that together contribute to the ability to create outputs. An input is any economic resource, such as tangible assets or employees, that creates or can create outputs when a process is applied to it.

The evaluation of whether a process is “substantive” depends on whether the acquired set has outputs at the time of acquisition. Outputs are the result of inputs and processes that provide goods or services to customers, generating income. If the acquired set is already generating outputs, a process is considered substantive if it is important to the continuation of producing those outputs, which can be demonstrated by an organized workforce or an acquired automated system.

The criteria are more stringent if the acquired set is not generating outputs, such as with a development-stage company. In this scenario, a process is deemed substantive if it is important to the development or conversion of an acquired input into an output. The acquired set must include an organized workforce that performs this process and the other inputs that the workforce needs to develop the outputs, such as intellectual property or specialized equipment.

Accounting Implications of the Classification

The classification of a transaction as either an asset acquisition or a business combination carries distinct accounting consequences. These differences affect how costs are recorded, how assets are valued on the balance sheet, and how future earnings are reported. The primary accounting differences include:

• Transaction Costs: In an asset acquisition, costs such as legal and advisory fees are capitalized, meaning they are added to the cost of the acquired assets. In a business combination, these costs are expensed as they are incurred, reducing net income in the period the transaction occurs.
• Goodwill: This intangible asset, representing the premium paid over the fair value of identifiable net assets, is only recognized in a business combination. It is not recorded in an asset acquisition; instead, any excess purchase price is allocated to the identifiable assets.
• Contingent Consideration: In a business combination, payments dependent on future events are recorded at fair value at the acquisition date, with subsequent changes in value impacting earnings. In an asset acquisition, such consideration is recorded only when the contingency is resolved and payment is required.
• Deferred Taxes: Acquired deferred taxes are handled differently, with more limitations on recognizing deferred tax assets in an asset acquisition compared to a business combination.