ASU-2017-01 -- FASB Clarifies Definition of a Business

The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation. Many stakeholders provided feedback that the definition of a business in ASC 805, Business Combinations, is applied too broadly, resulting in many transactions being recorded as business acquisitions rather than more appropriately in asset acquisitions.

In response, the FASB recently issued ASU 2017-01 to clarify the definition of a business. ASU 2017-01 adds guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses.

ASC 805 Definition

Under ASC 805, a business is defined as having a set of assets along with 3 elements or activities—inputs, processes, and outputs. However, confusion occurs when a business does not always have outputs. In addition, all the inputs and processes that a seller uses in operating a set are not required if market participants can acquire the set and continue to produce outputs, for example, by integrating the acquired set with their own inputs and processes. As a result, this definition of a business under ASC 805 led some transactions to be accounted for as a business combination.

ASU 2017-01 Definition and Testing

The new ASU has refined the definition of a business. Now, to be considered a business, an acquisition would have to include an input and a substantive process that together significantly contributes to the ability to create outputs. The ASU creates an initial screening test to reduce the number of transactions that an entity must evaluate to determine whether they are business combinations or asset acquisitions. The steps are:

Step 1. Initial screening. Are substantially all of the entity’s fair value of the gross assets acquired (or disposed of) concentrated in a single identifiable asset or group of similar identifiable assets? If so, the set is not a business. However, if the set is considered a business, proceed to Step 2.

Step 2. Does the entity’s input and substantive process together significantly contribute to the ability to create output? The ASU provides a framework to assist entities in the evaluation of whether both an input and a substantive process are present (including for early stage companies that have not generated outputs) and it removes the evaluation of whether a market participant could replace the missing elements. Further to be a business without outputs, there will now need to be an organized workforce and an input that the workforce could develop or convert into an output.

Significance of the New ASU

An entity uses the new ASU 2017-01 definition of a business to determine whether to account for a transaction as an asset acquisition or a business combination. This distinction is important because the accounting for an asset acquisition significantly differs in certain respects from the accounting for a business combination. For example, the acquirer’s transaction costs are capitalized in an asset acquisition but are expensed in a business combination. Another difference is that in a business combination, the assets acquired are recognized at fair value and goodwill is recognized; in an asset acquisition, however, the cost of the acquisition is allocated to the assets acquired on a relative fair value basis and no goodwill is recognized.

Effective Date and Transition of ASU 2017-01

The amendments are effective prospectively for public business entities for annual periods beginning after December 15, 2017, including interim periods within those periods. All other entities for annual should apply the amendments to annual periods beginning after December 15, 2018, and interim periods within annual periods beginning December 15, 2019.