Clearer Definition of a Business Called Boon for CFOs

FASB wants to narrow the definition of a business, making it easier for companies to report that they’re merely acquiring an asset.
David KatzDecember 2, 2015

Responding to complaints that companies are being driven to overly cautious M&A accounting, the Financial Accounting Standards Board last week drew what it thinks is a clearer line between what a business is and what assets are.

Thinkstock MergerAlthough it affects accounting for acquisitions, asset disposals, goodwill impairment, mergers, and other areas, “many stakeholders have said that the current definition of a business is applied too broadly, requiring many transactions to be treated as businesses when they should be treated as assets,” according to a Nov. 23 FASB news release.

Such critics “noted that analyzing such transactions is costly and complex,” the board reported. Its proposal seeks to narrow a gray area of accounting by clearly stating that for an acquisition to be treated as a business, it must own the resources and processes needed to produce results like revenues, products, or services. Under current rules, the possibility exists that if an acquisition merely has the ability to buy a needed resource or system on the market, it can be dubbed a business.

By clarifying the difference between the definition of a business and that of an asset, the proposal would make it easier for CFOs to report that their companies are acquiring an asset rather than a business, according to Georgia Tech accounting professor Charles Mulford. And that could be a big boon for their companies in terms of saved time and expense.

The currently large gray area in determining the difference between acquiring an asset like a single business or a plant and a business that tends to combine such assets to produce a result has spawned “a predilection to going with calling [an acquisition] a business,” he says. “You don’t want to be wrong, so there was a tendency to call acquisitions businesses that might have been more easily just been characterized as an asset.”

The proposed update, currently in a public comment period until January 22, 2016, is “really just a result of the feedback of how difficult the definition is to apply. People were getting outcomes that didn’t make intuitive sense,” according to Nick Burgmeier, a FASB practice fellow.

Under the revisions proposed by the board, however, CFOs could “more quickly and easily determine that an acquisition is an asset as opposed to a business,” Mulford adds.

While outcomes may vary, classifying an acquisition as an asset rather than a business can be very advantageous to an acquiring company. In the case of buying a long-term asset, a company can simply capitalize the cost associated with the acquisition, meaning that it has the option to delay its recognition of the expense. When companies acquire businesses, they must recognize the costs immediately.

Thus, for example, if a company pays its investment bankers a fee to buy a business, it must book that expense immediately. But if a company incurs a transaction cost to buy an asset with a lengthy lifespan, it can spread out the cost for years – thereby maximizing its current profits.

Further, the acquisition of a business, unlike the purchase of an asset, requires such things as an appraisal of the business and a determination of how much goodwill is being acquired, according to Mulford, who noted that most acquirers aren’t eager to acquire goodwill. That’s partly because shareholders may be uneasy about paying a premium for such an intangible asset.

Despite those disadvantages in reporting transactions as business acquisitions, too many companies have done so because they fear the current definition of a business is so broad as to leave them open to accounting misstatements if they classify an acquisition as the purchase of an asset, experts say.

Inputs and Outputs

Under the current definition, a business is an entity that at the minimum consists of “inputs” and “processes” and may create “outputs.” The definitions of these terms depend on each other. FASB defines an input, for instance, as “[a]ny economic resource that creates, or has the ability to create, outputs when one or more processes are applied to it.”

Examples of inputs include “long-lived assets (including intangible assets or rights to use long-lived assets), intellectual property, the ability to obtain access to necessary materials or rights, and employees.”

What, then, is a process? “Any system, standard, protocol, convention, or rule that when applied to an input or inputs, creates or has the ability to create outputs.” They include “strategic management processes, operational processes, and resource management processes.” On the other hand, they don’t include “[a]ccounting, billing, payroll, and other administrative systems.”

In short, a business is a place where a process acts upon an input to spawn an economic result called an output. Outputs can include goods and services to customers, revenues, or investment income. Interestingly, an acquisition doesn’t have to actually produce outputs to be considered a business, as long as it has the ability to produce them.

In fact, under the current definition, an acquisition doesn’t even need to own all its inputs or processes to be deemed a business rather than an asset. It can be considered a business if there’s a market for the inputs and processes it lacks. If there’s software out there that could theoretically turn an acquisition into an entity that produces revenue, for example, then the acquisition can be considered a business.

In a sense, when it comes to the economy’s ability to supplying the missing pieces required to make an entity business, anything goes. The problem with the current guidance is thus that it doesn’t “specify the minimum inputs and processes required for [an acquisition] to meet the definition of a business,” according to FASB. “That lack of clarity has led to broad interpretations of the definition of a business.”

To narrow the possible interpretations, FASB would “remove the evaluation of whether a market participant could replace any missing elements,” according to the proposed update. The proposed amendments would also require that to be considered a business, an entity must at least include “an input and a substantive process that together contribute to the ability to create outputs.”

“The difference now,” explains FASB’s Burgmeier, “is that the board decided that at a minimum an entity needs to acquire an input and a substantive process that together contribute to the ability to create outputs. So you have to have acquired both the input and the process, and the process needs to be substantive, in order for that acquired set to be considered a business.”

What makes a process “substantive”? Among the things that FASB proposes companies need to consider in answering that question are whether the acquired workforce can develop intellectual property that could be used to create goods or services; turn its resources into outputs; or has access to materials or rights that could help drive the creation of future outputs. Examples of elements that could make a process substantive could include technology, mineral interests, real estate, or in-process research and development.

Georgia Tech’s Mulford boils the proposed FASB definition into something much simpler. “A business is a collection of assets, and it has a dedicated workforce [and] the processes to add value to the input resources,” he says. “When you’re talking about simply buying an asset, that’s not buying a business, because a business is a collection of things.”