Clarifying the definition of a business

New accounting guidance is likely to have a significant impact on real estate acquisitions

The Financial Accounting Standards Board (FASB) recently issued Accounting Standards Update (ASU) 2017-01 Business Combinations (Topic 805): Clarifying the Definition of a Business to help entities evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or as businesses. The new guidance is a response to concerns that the prior Generally Accepted Accounting Principles (GAAP) definition of business was too broad or challenging to apply.

The ASU states that a business has the following:

  1. Inputs
  2. Processes applied to those inputs
  3. The ability to create outputs, although outputs are not required

New Guidance, Implications and Timing

Within the ASU guidelines, there are two main thresholds to determine if an entity is a business:

  1. Substantially All: The first step is to determine if substantially all of the fair value of the gross assets being acquired is concentrated in a single identifiable asset or a group of similar identifiable assets.
  2. Processes Required: If the “Substantially All” threshold is not met and the set of assets and activities does not produce an output, the next step is to consider whether the set includes at least one input, one substantive process that contributes to the creation of an output and an organized workforce.

For full detail on the thresholds, read more here.

The guidance is likely to have a significant impact on real estate acquisitions. For example, an acquired building or multiple buildings, even those with leases in place, will not be considered a business if the set of assets acquired does not include a workforce, contract providing access to a workforce, process that cannot be easily replaced or a process that is unique or scarce.

ASU 2017-01 is effective for public business entities with fiscal years beginning after December 15, 2017, and for all other entities for fiscal years beginning after December 15, 2018. Early adoption is permitted.

Valuation Considerations and Impacts

The distinction between an asset purchase and a business combination can make a difference to a company’s financial reporting, with future impacts on the balance sheet (goodwill, IPR&D) and the income statement (depreciation/amortization effects of capitalizing transaction expenses) as well as impairment testing.

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