The FASB's New Definition of a Business: Where is the Clarity?
A “screen”. The “framework”. “Single or similar asset threshold”. Is anyone else scratching their head when they read the Financial Accounting Standards Board’s (FASB) new definition of a business? What do these terms mean? The new guidance was issued under Accounting Standards Update No. 2017-01, Clarifying the Definition of a Business (“ASU 2017-01”), which is now effective for public business entities with a calendar year end. All other entities are required to apply this guidance in 2019. ASU 2017-01 amends the definition of a business in Accounting Standards Codification Topic 805, Business Combinations (“ASC 805”). The FASB issued ASU 2017-01 in response to feedback that the definition of a business in ASC 805 was applied too broadly. Stakeholders also said that analyzing transactions under the current definition is difficult and costly.
ASU 2017-01 generally amends ASC 805 as follows:
- Provides a “screen” that, if met, determines that the transaction is an asset acquisition. When substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the screen is met and the acquired assets and activities (collectively the “set”) is, therefore, not a business. The objective of the screen is to reduce the number of transactions that need to be further evaluated.
- Provides that if the screen is not met, a set constitutes a business only if it includes, at a minimum, an input and a substantive process that together significantly contribute to the ability to create outputs.
- Removes the evaluation of whether a market participant could replace missing elements.
- Narrows the definition of the term “output” to make it consistent with how outputs are described in ASC 606.
The following are some noteworthy considerations based on our experience with applying ASU 2017-01 to energy transactions:
Expect More Diversity in Practice
Historically, the general rule of thumb for upstream companies was that acquisitions of working interests in producing oil and gas properties were business acquisitions (with occasional exceptions to the rule, of course). Under the new definition, it is possible that acquisitions of producing properties could be accounted for as asset acquisitions, especially if they meet the “substantially all” threshold and pass the screen test. Acquisitions of both unproved and proved properties could be either an asset acquisition or a business combination. We believe that significant judgment will be required and, until industry precedents are established, we expect to see diversity in practice as companies apply the new guidance.
Focus on Risk
When determining if a group of similar assets has been acquired, management should focus on risk. For example, while proved developed and proved undeveloped properties in the same field are similar because both types of properties are comprised of mineral interests and are in the same major asset class, the risks may be substantially different. Factors to consider include, but are not limited to, the following:
- Likelihood of drilling an unsuccessful well;
- Differences in geological zones for producing and undeveloped properties;
- Presence of multiple different operators for non-operated properties; and
- Type of interests acquired. For example, a working interest and an overriding royalty interest in the same property would have different risk profiles.
Here is an example of a comment letter issued by the U.S. Securities and Exchange Commission (SEC) staff with respect to a registrant’s application of the guidance in ASU 2017-01:
“Tell us whether the oil and natural gas properties to be contributed by the [Partnerships] meet the definition of a business pursuant to FASB ASC paragraphs 805-10-55-3A through 805-10-55-9. Include sufficient detail describing the nature of these properties as part of the analysis in your response.”
In the analysis and response to the SEC, the registrant focuses on risk:
“The Company performed an assessment as to whether the [Properties] represent a business under the guidance contained in [ASC 805 and ASU 2017-01]. The Company adopted ASU 2017-01 on January 1, 2018…
…the [Properties] are made up of numerous individual wells, all of which are proved oil and gas properties located in the [Basin]. Accordingly, the Company analyzed whether the individual properties qualify as a group of similar assets...
…[Properties] are comprised exclusively of undivided working interests in oil and gas wells, principally located in [State] and [State], all of which are located in the [formation] within the [Basin]. All of the oil and gas reserves associated with the [Properties] are classified as proved reserves, most of which are proved developed (approximately 90% of the total proved reserves, and 94% of the estimated fair value). Although a portion of the proved reserves are undeveloped, those reserves are considered to be proved undeveloped as the probability of drilling successful wells is extremely high.
[Registrant] will be acquiring non-operated working interests in the [Properties] ranging from 0.1% to 57% with an average 15.6% working interest. All oil and gas production is marketed by the well operators. [Registrant] will not assume any personnel from the [Partnerships] as part of the [Acquisition], but rather will absorb the management of the [Properties] into its existing organization with minimal changes to its current staffing.
The risks associated with development of the [formation] are not significant based on recent history and experience in developing horizontal wells in this location. The reservoir is well delineated and there is no more than an insignificant risk of drilling an unsuccessful well. All production is typically sold at the wellhead or lease and infrastructure exists for transporting the production to its ultimate markets in Cushing, Oklahoma and the U.S. Gulf Coast. Neither the [Partnerships] nor [Registrant] take responsibility for, and do not participate in, the development of any infrastructure such as pipelines and other transportation methods.
We believe that the undivided interests in the [reserves] have similar risk characteristics. Further, all of these assets would be classified for balance sheet purposes as proved oil and gas properties, a long-term asset. Accordingly, we have concluded that the [Properties] do not meet the definition of a business for accounting purposes because substantially all of the fair value of the gross assets acquired is concentrated in a group of similar identifiable assets (proved oil and gas properties) that satisfy the criteria as defined in ASC 805-10-55-5A and ASC 805-10-55-5C of being concentrated in a single identifiable asset or group of similar identifiable assets.”
FASB & SEC Definitions ARE Not the Same
In general, the SEC’s Regulation S-X Rule 3-05 and Rule 8-04 require the filing of separate pre-acquisition historical financial statements when the acquisition of a significant business has occurred or is probable. In determining whether a business has been acquired, Rule 3-05(a)(2) refers to Rule 11-01(d), which states, in part:
“[T]he term business should be evaluated in light of the facts and circumstances involved and whether there is sufficient continuity of the acquired entity’s operations prior to and after the transactions so that disclosure of prior financial information is material to an understanding of future operations.”
Rule 11-01(d) also provides several attributes that should be considered in the determination of whether an acquisition is of a business, including:
- Whether the nature of the revenue-producing activity will generally remain the same after the acquisition; and
- Whether any of the following attributes will remain after the acquisition: the facilities, employee base, market distribution system, sales force, customer base, operating rights, production techniques or trade names.
We understand that an acquisition of an interest in producing oil or natural gas properties, by way of application of Section 2065.11 of the SEC’s Division of Corporation Finance Financial Reporting Manual, is considered by the SEC staff to be the acquisition of a “business” pursuant to Rule 11-01(d) for which pre-acquisition financial statements are required if significant. Thus, if an acquisition of proved developed producing properties meets the screen under ASU 2017-01, it would be accounted for as an asset acquisition under ASC 805, but would meet the definition of a business for the purposes of Rule 3-05 and Rule 8-04.
Book/Tax Differences Lead to Unexpected Book-Carrying Values
Accounting for transactions as asset acquisitions will result in implications for deferred taxes. Accounting Standards Codification Topic 740, Income Taxes, (“ASC 740”) requires the recognition of the deferred tax impact of acquiring an asset in a transaction that is not a business combination when the amount paid exceeds the tax basis of the asset on the acquisition date (See ASC 740-10-25-51). The recognition of the resulting deferred tax liability is recorded as an offsetting increase to the asset acquired. In other words, the deferred tax liability will result in an increase in a book-carrying basis. Additionally, the hidden computational complexity required by the literature means that a “tax-on-tax” effect (essentially a circular calculation) results. For example, with the new U.S. federal corporate tax rate of 21%, a $100 book-tax originating basis difference ($100 in book/fair market value with zero tax basis) would result in an additional $26.58 in recorded book-carrying value of the properties. This differs from traditional Topic 805 methodology where no tax effect is required to be recorded when the additional consideration given from the assumed (and undiscounted) deferred tax liability recorded results in book goodwill, as no deferred taxes are required to be recorded on this type of goodwill. Remember to keep that in mind when calculating pro forma depletion, as the carrying value of the asset is written up by over 26% in this example.
Ironically, it seems the analysis and impact of accounting for energy transactions under the new guidance may in fact be more complex. If you have questions or would like to discuss this guidance in more detail, please contact Amy Stutzman at firstname.lastname@example.org.
About the Author:
Amy Stutzman is a Managing Director in Opportune’s Complex Financial Reporting group with over 18 years of experience in technical accounting and SEC reporting. Amy leads teams that support executive management in understanding the structure and implications of complex transactions such as IPOs and acquisitions. She has strong technical skills and analytical ability and is the firm leader on all U.S. GAAP advisory matters. Prior to joining Opportune, Amy managed the financial reporting group for Apache Corporation in Buenos Aires, Argentina, and was an audit manager in PricewaterhouseCoopers’ energy practice. Outside of Opportune, Amy is an active member of the Tulsa Energy Council and the Women’s Energy Network. She is a speaker for industry groups such as the AICPA, OSCPA, Women’s Energy Network and University of Tulsa’s Master of Energy Business Program. She serves as Chair-Elect of Board of Directors for Street School, Inc., a high school for at-risk youth. She is fluent in Spanish.