The FASB’s new definition of a business is effective on January 1, 2018. The definition of a business may affect many areas of accounting, including acquisitions, disposals, goodwill impairment, and consolidation. According to feedback received by the FASB, the previous guidance was thought to be applied too broadly, which resulted in too many transactions qualifying as business combinations.
As a result of the new definition, more acquisitions are expected to be considered “asset acquisitions” rather than “business combinations.” While there are many implications of this change to users of the financial statements, we discuss four that will have a more significant impact.
Using the new definition, more acquisitions in certain industries, such as real estate and pharmaceuticals, will be asset acquisitions. As a result, acquisition costs will be capitalized as part of the assets acquired, rather than being expensed as is the case with business combinations. For acquisitive companies that are suddenly buying assets instead of businesses, this could mean a substantial benefit to net income in the short term. However, over the long term, depreciation and amortization expense would increase as a result of the higher asset base. Regardless, net income will be less volatile going forward, which should allow for better trend analysis and less reliance on non-GAAP measures.
For business combinations, GAAP allows for a measurement period of up to a year to make adjustments to the initial acquisition accounting for information that was unknown at the time of acquisition. The cumulative impact of the adjustment is recognized in the reporting period in which the adjustment is identified within the respective line items affected. No such measurement period guidance exists for asset acquisitions, as the accounting for these acquisitions is thought to be inherently less complex. Despite the perceived lack of complexity, it can often be challenging to complete the accounting for certain asset acquisitions, especially if a deal closes near a period end. Any subsequent adjustments to the accounting for asset acquisitions will be considered errors. To minimize the occurrence of errors, we recommend that companies involve consultants (to the extent they are needed) earlier in the deal process to ensure quick completion of the accounting after close. However, this may have the unintended consequence of increased “dead deal costs” as earlier involvement may lead to incurring costs on deals that do not actually close.
The new definition of a business introduces a “screen test” that is a quantitative threshold for defining asset acquisitions. If substantially all of the acquisition is made up of one asset or several similar assets, then the acquisition is an asset acquisition. “Substantially all” is commonly considered to be approximately 90%. While it is not a bright line, if it meets or exceeds the threshold it’s an asset acquisition. Otherwise, the analysis must continue through the “full model.” This means that the structure of the transaction will be important in determining the accounting result. Three types of scenarios that are more likely to result in asset acquisitions under the new guidance are:
The definition of a business can also impact disposition accounting. When a business is disposed of, any related goodwill is derecognized. However, as more disposal transactions are expected to be of assets after adoption of the new definition, goodwill that arose upon the acquisition of a business would remain. This may have the immediate impact of increasing the gain on sale, as the carrying value of the asset being derecognized would be less than it would have been as a business with goodwill. However, this may also increase the likelihood of goodwill impairment in the future. When the assets are derecognized, headroom related to the goodwill impairment test will likely decrease.
The revised definition of a business is new, and there is no certainty as to how the marketplace will react to it. The discussion above is not a comprehensive list of the implications of the revised definition, but rather four that users may find impactful. In addition, the FASB has an ongoing project related to addressing certain differences in the accounting between asset and business acquisitions that may ultimately eliminate some of the differences between the two frameworks.