The FASB recently issued a Proposed Accounting Standards Update (ASU), Business Combinations — Clarifying the Definition of a Business
, as a response to feedback received from stakeholders in the Post-Implementation Review (PIR) of FASB Statement No. 141R (now codified as FASB Accounting Standards Codification 805, Business Combinations
This proposal endeavors to address two primary issues raised in the PIR:
- The definition of a business might be too broad, which has resulted in transactions that are more like asset acquisitions being accounted for as business combinations.
- Analyzing transactions under the current definition of a business is complex and costly.
Under the current definition of a business, an acquirer must analyze an acquired set of activities (a set) to identify the presence of three characteristics that constitute a business: inputs, processes and outputs. While that may seem straightforward, the determination of whether a set is a business can be complex. For example, the current definition of a business requires entities to perform an evaluation as to whether the acquirer has processes that could be used in conjunction with the acquired set’s inputs to produce an output when the seller’s substantive processes are not included in the acquired set.
In contrast, under the proposed definition, the acquired set would need to have its own inputs and a substantive process that together would create an output for an acquisition to qualify as a business. If a substantive process is not acquired in the transaction, then the transaction would be accounted for as an asset acquisition rather than a business combination.
In addition to changing the definition of a business, the proposal also allows for a practical expedient, or screen, to reduce the number of transactions that would be accounted for as business combinations. If substantially all of the fair value of the assets acquired is concentrated in a single asset or in a group of similar assets, then the acquisition of that target would not qualify as a business combination.
Since the acquisition of real estate often does not include the acquisition of a substantive process, it is expected that many real estate acquisitions would be accounted for as asset acquisitions, rather than as business combinations, under this proposal.
What does this mean for you?
Based on the proposed amendments, financial statement preparers would first consider whether substantially all of the fair value of the assets acquired is concentrated in a single asset or in a group of similar assets. In assessing whether the transaction qualifies for the practical expedient, tangible assets, such as land and building, would not be combined with intangible assets, such as in-place leases. This proposal would likely require preparers to perform a full purchase price allocation in order to conclude whether the analysis should proceed past this initial screen. Therefore, the practical expedient might not provide relief to preparers with respect to the valuation work required.
One of the FASB’s aims under the proposal is to reduce the number of transactions that are currently considered business combinations. Under the proposed amendments, many real estate transactions that were previously considered business combinations would likely be considered asset acquisitions. One of the key differences between accounting for a business combination and an asset acquisition relates to the treatment of transaction-related costs. While these costs are considered expenses in a business combination, they are included in the basis of the assets acquired in an asset acquisition.
Purchase price allocations
When acquiring real estate, the acquirer is often obtaining not just land and buildings, but lease contracts that are already in place. As noted above, intangible assets would not be combined with tangible assets for the purposes of assessing whether the transaction qualifies for the practical expedient under the proposed guidance. Therefore, the purchase price, inclusive of transaction costs, would still need to be allocated to the assets acquired on a relative fair value basis under the proposed guidance. Since determining the fair value of real estate and in-place leases is one of the more complex parts of performing a purchase price allocation under the current business combination guidance, the proposal does not appear to provide financial statement preparers with relief in terms of both effort and cost. What’s more, the proposed amendments do not currently address whether preparers can avail themselves of the oneyear measurement period under the existing business combination guidance to complete the valuation studies related to the assets acquired in an asset acquisition.
Under current guidance, the fair value of contingent consideration related to the acquisition of a property determined to be a business should be determined as of the acquisition date, and allocated to the assets acquired and liabilities assumed. If the transaction is deemed to be an asset acquisition under the proposed guidance, then, in most cases, the contingent consideration would be recognized when the contingency is resolved.
The proposed guidance also includes various industry-specific examples to illustrate how the FASB expects the guidance to be implemented. Case H
covers how a real estate investment trust (REIT) would evaluate the acquisition of an office building. In this example, the REIT acquires the property, in-place leases, and service contracts related to cleaning and security.2
While the cleaning and security services might represent an organized workforce, they are ancillary processes required to create output (rental income) from the office building and could easily be replaced without hindering the REIT’s ability to create additional outputs. Therefore, the acquisition of this property would be considered an asset acquisition, because no substantive process was acquired.
As noted in Case I
, if the transaction above also includes the acquisition of employees to perform leasing activities and other management functions of the tenants and property, then the transaction would be considered a business combination because substantive processes were acquired.3
This proposed guidance focuses only on the definition of a business and does not affect the accounting for a business combination or an asset acquisition. While the amendments are expected to reduce the number of real estate transactions that are currently determined to be business combinations, the requirement to either determine the fair value of assets received and liabilities assumed under the existing business combination literature, or the requirement to allocate the purchase price of an asset on a relative fair value basis for an asset acquisition, remains unchanged. While the proposal provides a practical expedient for determining if the acquired real estate is a business, acquirers of real estate would still need to perform a purchase price allocation as though the set was a business to determine if substantially all of the fair value of the assets acquired is concentrated in a single asset or group of assets, in which case the acquisition would be eligible for the practical expedient.
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