When one company buys another company, or buys a collection of assets from it, the first accounting question is not “how much did we pay?” but “what did we buy?” Specifically: did we buy a business, or just a group of assets?
The answer changes the accounting substantially. If the acquisition is a business, it is accounted for as a business combination: assets and liabilities are measured at fair value, transaction costs are expensed, and any excess paid is recognised as goodwill. If it is not a business, it is an asset acquisition: the cost is spread across the assets acquired in proportion to their fair values, transaction costs are added to the assets’ cost, and no goodwill arises.
The course material on which this series draws explains how US standards (ASC 805) define a business and test for one. Australian standards (AASB 3 Business Combinations) use very similar concepts following amendments that took effect in 2020. This article explains the definition, its elements, the two-step test, and several worked examples. It is part of GoCore’s series on investments, groups and acquisitions.
Why the question matters
The differences between the two treatments, explored in Asset acquisition or business combination, include:
| Issue | Business combination | Asset acquisition |
|---|---|---|
| Measurement of assets | Fair value at acquisition date | Cost allocated by relative fair values |
| Transaction costs | Expensed as incurred | Added to the cost of the assets |
| Goodwill | Recognised for any excess | Never recognised |
| Deferred tax on initial recognition | Generally recognised | Generally not recognised under Australian standards |
| Contingent payments | Measured at fair value; later changes often in profit | Treatment differs |
These differences affect reported profit in the year of the acquisition and for years afterwards. That is why the classification deserves care.
Note that the accounting question is separate from the legal form of the deal. Buying the shares of a company that owns only a single property may be an asset acquisition for accounting purposes; buying a collection of assets and staff from a company may be a business combination. Tax and stamp duty outcomes depend on their own rules again.
What is a business?
The course material gives the broad definition: a business is an integrated set of activities and assets that is capable of being conducted and managed to provide a return, whether as dividends, lower costs or other economic benefits, to its investors or owners.
As the course notes, this definition on its own is too general to apply. It becomes practical through its three elements.
Inputs
An input is an economic resource that creates outputs, or can contribute to creating them, when one or more processes are applied to it. Examples include equipment, buildings, intellectual property, licences, materials, and access to necessary resources. Employees can also be inputs.
Processes
A process is a system, standard, protocol, convention or rule that, when applied to inputs, creates or can contribute to creating outputs. Examples include operational, strategic and resource management processes. Processes are often embodied in an organised workforce with the skills and experience to carry them out, although they can also exist in systems, documented procedures or intellectual property.
Administrative processes such as accounting, billing and payroll are generally not the kind of processes that make an acquired set a business, because they do not create outputs themselves.
Outputs
An output is the result of inputs and processes that provides goods or services to customers, generates investment income such as dividends or interest, or generates other revenue.
Businesses usually have outputs, but outputs are not required. As the course points out, a development-stage entity can be a business even though it has no outputs yet, provided it has inputs and substantive processes that together can contribute to creating outputs.
The minimum requirement is that the acquired set includes an input and a substantive process that together significantly contribute to the ability to create outputs.
The two-step business test
The course describes the US approach as a two-step test.
Step 1: the concentration screen
Ask: is substantially all of the fair value of the gross assets acquired concentrated in a single identifiable asset or a group of similar identifiable assets?
If yes, the set is not a business. It is an asset acquisition, and no further analysis is needed.
If no, move to step 2.
The screen captures common situations quickly. Buying a single investment property with existing tenants, for example, concentrates almost all of the value in the property, so it is not a business even though rent is being earned.
Some important details:
- Gross assets generally exclude cash, deferred tax assets and goodwill arising from deferred tax liabilities.
- A single identifiable asset can include an asset together with things that cannot be separated from it without significant cost, such as a building and the land it stands on, or in-place leases attached to the property.
- Similar assets must be of a similar nature and risk. Tangible and intangible assets cannot be grouped together, and assets of quite different kinds, such as different classes of property or very different types of intellectual property, may not be treated as similar.
Step 2: inputs and substantive processes
If the screen is not met, ask: were an input and a substantive process acquired that together significantly contribute to the ability to create outputs?
If not, the set is not a business. If so, it is a business, and business combination accounting applies.
Judging whether a process is substantive depends on whether the set has outputs.
If the set has no outputs yet, a process is generally substantive only if it is critical to developing or converting acquired inputs into outputs, and the set includes an organised workforce with the necessary skills, knowledge or experience to perform it, along with inputs that the workforce could develop or convert into outputs.
If the set already has outputs, a process is generally substantive if it is critical to the ability to continue producing outputs and is performed by an acquired organised workforce, or if it significantly contributes to that ability and is considered unique or scarce, or cannot be replaced without significant cost, effort or delay.
The Australian position
Australian standards adopted closely matching amendments, effective for annual periods beginning on or after 1 January 2020. The concepts of inputs, substantive processes and outputs are the same. One notable difference is that under Australian standards the concentration test is optional: an entity may choose to apply it to a particular transaction. If it is met, the set is not a business; if it is not applied or not met, the full assessment of inputs and processes is made. Under US standards, the screen is a required first step.
Worked examples
These are illustrations, simplified to show the reasoning.
Example 1: an investment property with tenants
A company buys a commercial building with long-term tenants in place. Almost all of the fair value lies in the building, land and in-place leases, which are treated as a single asset. The concentration test is met. Asset acquisition.
Example 2: a portfolio of similar houses
A company buys twenty similar residential rental houses in the same area, without any staff or management processes. The houses are a group of similar identifiable assets. The concentration test is met. Asset acquisition.
Example 3: a manufacturing operation
A company buys a factory, its equipment, inventory, customer contracts and the trained workforce that runs production, plans scheduling and manages suppliers. Value is spread across several kinds of assets, so the concentration test is not met. The organised workforce performs critical production processes that turn inputs into outputs. Business combination.
Example 4: a product licence alone
A company buys the rights to a product formula from another company, without any staff, manufacturing processes or supply arrangements. Substantially all the value is in one intangible asset. Asset acquisition.
Example 5: an early-stage technology company
A company buys a start-up that has no revenue yet but has a team of engineers actively developing software, along with the software code and related intellectual property. Value is spread across the code, other intellectual property and assembled know-how, so the screen is likely not met. The engineering team is an organised workforce performing a process critical to converting the code into a product. Likely a business combination, despite the absence of outputs.
Example 6: the course’s example in outline
The course material illustrates the difference with a component of a company containing equipment, a building and a patent. Without the people and processes that run it, the component is treated as a group of assets. When the same component also includes trained employees who perform the strategic and management processes that create outputs, it becomes a business, and the accounting changes from cost allocation to business combination accounting, with goodwill recognised for the excess paid.
Common situations in smaller deals
Small and medium businesses often make acquisitions where the classification is not obvious. Some typical situations, described in general terms:
- Buying an established outlet or franchise location that comes with trained staff, operating systems, supplier arrangements and existing customers will usually be a business, because the organised workforce and processes transfer with the assets.
- Buying a client list on its own, without staff or systems, often concentrates the value in one group of similar intangible assets, pointing towards an asset acquisition.
- Buying a fleet of vehicles together with drivers, routes, customer contracts and dispatch processes will usually be a business; buying the vehicles alone will usually not.
- Buying a website or online store may be either, depending on whether content production, marketing processes, supplier relationships and the people who run them are acquired along with the domain and software.
Each case depends on its facts, and the same label can cover very different transactions. The questions are always the same: where is the value concentrated, and were the inputs and substantive processes needed to produce outputs acquired together?
Who decides, and when
The acquirer’s management makes the assessment, usually with its accountants, and its auditors review it where an audit is required. The assessment is made as at the acquisition date, based on what was actually acquired, not on what the buyer plans to add afterwards. A buyer that intends to integrate acquired assets into its own operations, with its own staff and processes, must still assess the acquired set on its own terms.
Practical considerations for buyers
Assess early. Classification affects how transaction costs, goodwill and tax are reported. Knowing the likely answer before the deal is finalised helps set expectations for post-acquisition results.
Document the reasoning. The assessment involves judgement, especially about whether processes are substantive. A clear record supports the financial statements and any audit.
Consider what is really transferring. Staff, systems, supplier relationships and know-how can turn an apparent asset purchase into a business.
Remember the separate questions. Accounting classification, legal structure, tax treatment and stamp duty each follow their own rules, and a transaction can be classified differently for each.
Common mistakes
Assuming the legal form decides. Buying shares or assets does not by itself determine the accounting.
Assuming outputs are required. A development-stage entity can be a business.
Treating administrative processes as substantive. Billing and payroll do not usually make a set a business.
Grouping dissimilar assets in the concentration test. Tangible and intangible assets, or very different classes of asset, cannot be grouped.
Forgetting the differences between US and Australian rules. The concentration test is required in one and optional in the other.
Questions to ask
- Is substantially all the fair value in a single asset or group of similar assets?
- Does the acquired set include an organised workforce?
- Which processes are critical to producing outputs, and were they acquired?
- Does the set already produce outputs?
- For your own business: if you bought a competitor’s assets and hired its staff, would that be a business combination?
Bringing it together
The business test decides whether an acquisition is a business combination or an asset acquisition. A business consists of inputs and processes applied to them that can contribute to outputs; outputs themselves are not required. The test starts with a concentration screen, required under US standards and optional under Australian standards, and then examines whether an input and a substantive process were acquired together.
Because the classification changes how assets, transaction costs, goodwill and tax are reported, it deserves careful, early and documented analysis in any acquisition.
Sources: course materials from an advanced financial reporting course (Module 1, based on US GAAP), together with Australian Accounting Standards, including AASB 3 as amended. Examples are illustrations. This article is general information, not accounting, tax or legal advice; consult a qualified accountant about your circumstances.
