FASB Proposes Update to Definition of Business

Transcription

1 FASB Proposes Update to Definition of On November 23, 2015, the Financial Accounting Standards Board (FASB) issued a proposal narrowing the definition of a business. This definition is significant because it determines which accounting model to use on an acquisition and disposal of a business or a group of nonfinancial assets; financial assets are covered by other specific guidance. The updated definition also is necessary to clarify the scope of sales of nonfinancial assets with noncustomers for the new revenue recognition standard (Accounting Standards Update (ASU) ). In addition, the changes will more closely align existing practice under generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). This is the first phase of a broader project. The second phase will focus on in-substance nonfinancial assets, partial sales and retained interests. The third phase will focus on alignment of measurement and recognition guidance for assets versus businesses. Comments to the first proposal are due by January 22, The effective date will be determined after feedback is reviewed. Project Timeline EITF 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a FAS 141(R), Combinations (codified as ASC 805) 2013 definition project added 2015 Exposure draft Definition 2016 Final standard? 2017??? Effective date? Phase 2 In-substance financial assets, partial sales & retained interests Phase 3 Alignment of meausurement and recognition guidance for asset vs. business Background Economically there is little difference between purchasing (or selling) an asset versus a business, but there is a substantial difference in the accounting, noted in the following table. The current definition of a business is very broad and seen by financial statement preparers as difficult and costly to apply. The definition is especially challenging for the pharmaceutical, real estate and extractive industries (oil, gas and mining).

2 FASB Proposes Update to Definition of Not recognized until the contingency is resolved Expensed as incurred unless it has an alternative future use Capitalized Allocated cost on a relative fair value basis Not applicable Not applicable Current Accounting for Acquisitions or Dispositions Contingent Consideration In-Process Research & Development Acquisition Related Costs Recognized at acquisition date fair value, while changes in estimates are trued up through earnings after the acquisition date Capitalized at fair value and accounted for as an indefinite-lived intangible asset until completion or abandonment of the project (expensed as incurred after the acquisition date) Expensed Initial Measurement Goodwill Bargain Purchase Price Measured at fair value Recognized as an asset and reassessed for impairment Recognized immediately in earnings as a gain For real estate entities, current GAAP is inconsistent. Commercial property acquisitions generally are business combinations, but dispositions are treated as sales of real estate assets, as noted in the table below: Real Estate Sales of Real Estate ASC , Real Estate Sales Continuing involvement model Acquisitions of Real Estate ASC 805, Combinations Control model 2

3 FASB Proposes Update to Definition of FASB first tackled this issue in 1998 with the release of Emerging Issues Task Force (EITF) Issue No. 98-3, Determining whether a Nonmonetary Transaction Involves Receipt of Productive Assets of a. This guidance established a narrow definition, requiring substantially all of the inputs and processes used by the seller to be included in the set or requiring the set to have outputs to be a business. Stakeholders found this definition too restricting; in 2007, FASB broadened the scope in Statement 141(R), subsequently codified into Topic 805, Combinations. Topic 805 provides guidance on how to evaluate whether an acquired set of activities and assets is a business, including three elements of a business: inputs, processes and outputs. Definition Current (Topic 805) Proposed (Topic 805) Requires inputs and processes Market participants capable of replacing missing elements and continue to produce outputs Outputs defined broadly as ability to provide a return (dividends, lower costs or other economic benefit) Does not matter if all value is assigned to a single asset Requires an input and one or more substantive processes Eliminated Outputs defined as goods or services provided to customers, other revenues or investment income Single or similar assets threshold Proposed Definition Substantive Processes A business under the proposal must include, at a minimum, an input and a substantive process. The proposal includes a framework to determine whether a transferred set includes a substantive process. There is a separate assessment for transactions having outputs and those that don t. The criterion is more stringent when there is no current output. No Outputs (Early-Stage Company) Early-stage companies must include an organized workforce that has the necessary skills, knowledge or experience to perform a process critical to the ability to develop or convert inputs into outputs. In assessing whether an acquired workforce is performing a substantive process, an entity should consider the following: A process is not critical if, for example, it is considered ancillary or minor in the context of all processes required to create outputs Inputs the organized workforce could develop (or is developing) or convert into outputs could include: Current Outputs Intellectual property that could be developed into a good or service Resources that could be developed to create outputs Access to necessary materials or rights that enable the creation of future outputs When there is a continuation of revenue before and after the transaction, a set would have both an input and a substantive process when any of the following criteria are present: 3

4 FASB Proposes Update to Definition of An organized workforce that has the necessary skills, knowledge or experience to perform a process on inputs critical to continued production; a process is not critical if it s ancillary or minor in the context of all processes required to continue producing outputs The acquired process, when applied to inputs, contributes to the ability to continue producing outputs and cannot be replaced without significant cost, effort or delay in continued production The acquired process, when applied to inputs, contributes to the ability to continue producing outputs and is considered unique or scarce Because outputs are generated before and after the transaction, FASB concluded it s more likely that both an input and a substantive process have been acquired when compared with a set having no outputs. Therefore, not all of the criteria are required. Although FASB believes an organized workforce indicates a substantive process, an organized workforce is not required when outputs are present. An organized workforce might not be required if the set includes automated processes, e.g., acquired technology, infrastructure or specialized equipment, that contribute to the ability to continue producing outputs. Current practice varies on whether leases, customer contracts or other contractual revenue arrangements that result in the continuation of revenues are, in and of themselves, processes. Because contractual arrangements can vary significantly, rather than stating that such arrangements are not a process, FASB decided to specifically exclude assumed contractual revenue arrangements from the analysis of whether a substantive process has been acquired. FASB does not believe a set should be a business just because there is a contract that provides a continuing revenue stream. Appendix I illustrates the difference between the criteria. Single or Similar Assets Threshold The business definition in Issue 98-3 allowed for a transferred set of activities to be an asset if all but a de minimis amount (set at 3 percent) of the fair value was represented by a single tangible or identifiable intangible asset. This was not carried forward into Statement 141(R); the de minimis exception is not in the current definition. The proposal reintroduces a threshold to evaluate when a set is not a business. The threshold reduces the number of transactions evaluated under the new framework. The new threshold is based on whether or not the fair value of a single identifiable asset or group of similar identifiable assets represents substantially all of the fair value of the gross assets acquired. Unlike Issue 98-3, the threshold would not be limited to a single asset. An acquisition can be considered an asset if there are multiple versions of substantially the same asset type. An entity would compare the concentration of fair value in a single asset or group of similar assets with the gross assets acquired rather than with the total consideration paid or net assets. The existence of debt, e.g., a building with a mortgage, or other liabilities would not skew the analysis of whether the threshold has been met. Only tangible nonfinancial assets that are attached to and cannot be physically removed and used separately from other tangible nonfinancial assets without incurring significant cost or decline in utility or fair value should be considered a single asset. The proposal prohibits the following items from being combined: Tangible and intangible assets, e.g., real estate and in-place lease intangibles Identifiable intangible assets in different major intangible asset classes, e.g., customer-related intangibles, trademarks and in-process research and development, except for groups of identifiable intangible assets recognized and measured as a single identifiable asset, e.g., complementary intangible assets that have similar useful lives Financial and nonfinancial assets Different major classes of financial assets, e.g., cash, accounts receivable and marketable securities Different major classes of tangible nonfinancial assets, e.g., inventory, manufacturing equipment and automobiles, not meeting the substantially the same criterion 4

5 FASB Proposes Update to Definition of See Appendix II for an example of this assessment. Outputs GAAP s current output definition refers to the ability to provide a return in the form of dividends, lower costs or other economic benefits. This definition leads to a broad interpretation that does not appropriately distinguish between an asset and a business as many transactions can provide a return, e.g., the acquisition of a new machine could be expected to lower costs. The proposal narrows the definition of outputs by focusing the ability to generate goods or services provided to customers. Transition If adopted, the amendments would be applied on a prospective basis, which would require application to transactions occurring after the effective date. No additional transition disclosures would be required on transition. For additional information, contact your BKD advisor. Contributor Anne Coughlan Director acoughlan@bkd.com 5

6 FASB Proposes Update to Definition of Appendix I Acquisition of Corporate Office Building Employees Not Included A real estate investment trust (REIT) purchases all of the outstanding shares of Building Co. from seller. Building Co. holds a multitenant corporate office park with six 10-story office buildings leased to maximum occupancy. Seller manages its properties centrally and manages the operations of Building Co. with its own employees. As part of the transaction, REIT acquires the land, buildings and in-place leases and assumes vendor contracts for outsourced cleaning and security. Seller s employees who perform leasing (sales, underwriting, etc.), tenant management, financing and other strategic management processes are not included in the set. REIT plans to replace the property management and employees with its own internal resources. REIT first considers whether substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. Although the leases are at market value, REIT concludes the fair value of the in-place leases is significant and the fair value of the gross assets acquired is not concentrated in either the leases or the tangible assets. The set has continuing revenues through the in-place leases and, therefore, has outputs. As such, REIT must determine whether the set includes both an input and a substantive process that together contribute to the ability to create outputs. REIT reviews each of the following criteria: An organized workforce that has the necessary skills, knowledge or experience to perform a process on inputs critical to continued production; a process is not critical if it s ancillary or minor in the context of all processes required to continue producing outputs. The first criterion is not met because the cleaning and security contracts (the only process acquired) would be considered ancillary or minor in the context of all the processes required to create outputs in the real estate industry. While the cleaning and security outsourcing agreements may be considered to provide an organized workforce, the processes performed by those personnel would not be considered critical in the context of all the processes required to create outputs. The acquired process, when applies to inputs, contributes to the ability to continue producing outputs and cannot be replaced without significant cost, effort or delay in continued production. The second criterion is not met because the cleaning and security processes could be easily replaced with little cost, effort or delay in the ability to continue producing outputs. The acquired process, when applied to inputs, contributes to the ability to continue producting outputs and is considered unique or scarce. The final criterion is not met because the cleaning and security contracts are not considered unique or scarce; these types of arrangements are readily accessible in the marketplace. Because none of the criteria were met, REIT concludes the set does not include both an input and substantive processes that together contribute to the ability to create outputs and therefore is not considered a business. Acquisition of Corporate Office Building Employees Included Assume the same facts as above except that the set includes the employees responsible for leasing, tenant management and managing and supervising all operational processes, such as the cleaning and security vendors. The first criterion is met because the set includes an organized workforce that performs processes critical to the ability to continue producing outputs when applied to the acquired inputs in the set, such as the land, building and in-place leases, i.e., REIT concludes the leasing, tenant management and supervision of the operational processes are critical to the creation of outputs. Because only one or the three criteria must be met, REIT concludes the set includes both an input and substantive processes that together contribute to the ability to create outputs and therefore is a business. 6

7 FASB Proposes Update to Definition of Appendix II Acquisition of Single-Family Homes ABC acquires, renovates, leases, sells and manages single-family residential homes. ABC acquires a portfolio of 10 single-family homes, each of which has an at-market in-place lease. The only elements included in the acquired set are the 10 single-family homes and the 10 in-place leases. Each single-family home includes the land, building and property improvements. Each home has a different floor plan, square footage, lot and interior design. ABC first considers whether substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. ABC must determine whether each single-family home would be considered a single asset for purposes of this analysis. It concludes the land, building and property improvements can be considered a single asset because the building and property improvements are attached to the land and cannot be removed without incurring significant cost. However, the in-place lease is an intangible asset and cannot be combined with the tangible real estate as required under the guidance. ABC then considers whether the 10 tangible assets (the combined land, building and property improvements) are similar. While each home is different, the nature of the assets (all single-family homes) is similar. As such, ABC concludes the group of 10 single-family homes is a group of similar assets. Next, ABC compares the fair value of the group of similar tangible assets with the fair value of the total gross assets acquired (the homes plus the lease assets) and concludes that substantially all of the fair value of the gross assets acquired is concentrated in the group of similar tangible assets, i.e., the leases do not have significant fair value. As such, the set is not a business. 7