DEFINITION OF A BUSINESS (AMENDMENTS TO Ind AS 103)

The definition of business
has been amended (vide MCA notification dated 24^th July,
2020) and continues to be intended to assist entities to determine whether a
transaction should be accounted for as ‘a business combination’ or as ‘an asset
acquisition’.

The accounting for the
acquisition of an asset and for the acquisition of a business are very different,
hence the classification is very critical. The amendments are applicable to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after 1^st
April, 2020 and to asset acquisitions that occur on or after the beginning of
that period. In a nutshell, the amendments have made the following broad
changes:

(i) the definition of a
business and the definition of outputs is made narrow.

(ii) clarify the minimum
features that the acquired set of activities and assets must have in order to
be considered a business.

(iii) the evaluation of
whether market participants are able to replace missing inputs or processes and
continue to produce outputs is removed.

(iv) an optional concentration
test that allows a simplified assessment of whether an acquired set of
activities and assets is not a business has been introduced.

The amendments replace the
wording in the definition of a business as follows:

The changed definition
focuses on providing goods and services to customers, removes the emphasis from
providing a return to shareholders as well as to ‘lower costs or other
economics benefits’, because many asset acquisitions are made with the motive
of lowering costs but may not involve acquiring a substantive process.

Under the revised
standard, the following steps are required to determine whether the acquired
set of activities and assets is a business:

OPTIONAL CONCENTRATION TEST

The optional concentration
test allows the acquirer to carry out a simple evaluation to determine whether
the acquired set of activities and assets is not a business. The optional
concentration test is not an accounting policy choice; therefore, it may be
used for one acquisition and not for another. If the test passes, then the
acquired set of activities and assets is not a business and no further
evaluation is required. If the test fails or the entity chooses not to apply
the test, then the entity needs to assess whether or not the acquired set of
assets and activities meets the definition of a business by making a detailed
assessment.

The amended standard does
not prohibit an entity from carrying out the detailed assessment if the entity
has carried out the concentration test and concluded that the acquired set of
activities and assets is not a business. The standard-setter decided that such
a prohibition was unnecessary, because if an entity intended to disregard the
outcome of the concentration test, it could have elected not to apply it.

In theory, the
concentration test might sometimes identify a transaction as an asset
acquisition when the detailed assessment would identify it as a business
combination. That outcome would be a false positive. The standard-setter
designed the concentration test to minimise the risk that a false positive
could deprive users of financial statements of useful information. The
concentration test might not identify an asset acquisition that would be
identified by the detailed assessment. That outcome would be a false negative.
An entity is required to carry out the detailed assessment in such a case and
is expected to reach the same conclusion as if it had not applied the
concentration test. Thus, a false negative has no accounting consequences.

What is a
single identifiable asset?

A single identifiable
asset includes any asset or group of assets that would be recognised and
measured as a single identifiable asset in a business combination. This will
include assets that are attached or cannot be removed from other assets without
incurring significant cost or loss of value of either asset. Examples of single
identifiable asset include land and buildings, customer lists, trademarks,
outsourcing contracts, plant and machinery, intangible asset (for example, a
coal mine), etc. Land and buildings cannot be removed from each other without
incurring significant cost or loss of value to either of them, unless the
building is inconsequential or very insignificant in value.

What is a
group of similar identifiable assets?

Assets are grouped when
they have a similar nature and have similar risk characteristics (i.e., the
risks associated with managing and creating outputs from the assets). The
following are examples of groupings which are not considered to be similar
assets:

(a) a tangible asset and
an intangible asset.

(b) different classes of
tangible assets under Ind AS 16, for example, equipment and building (unless
the equipment is embedded in the building and cannot be removed without
incurring significant cost or loss of value to either the building or the
equipment).

(c) tangible assets that
are recognised under different Standards (e.g. Ind AS 2 ‘Inventories’ and Ind
AS 16 ‘Property, Plant and Equipment’).

(d) a financial asset and
a non-financial asset.

(e) different classes of
financial assets under Ind AS 109 ‘Financial Instruments’ (e.g receivables,
equity investments, etc.).

(f) different classes of
intangibles (e.g. brand, mineral rights, etc.)

(g) assets belonging to
the same class but have significantly different risk characteristics, for
example, different types of mines.

In applying the
concentration test, one test is to evaluate whether substantially all of the
fair value of the gross assets acquired is concentrated in a single
identifiable asset or a group of similar identifiable assets? How is the fair
value determined?

The fair value of the
gross assets acquired shall include any consideration transferred (plus the
fair value of any NCI and the fair value of any previously held interest) in
excess of the fair value of net identifiable assets acquired. The fair value of
the gross assets acquired may normally be determined as the total obtained by
adding the fair value of the consideration transferred (plus the fair value of
any NCI and the fair value of any previously held interest) to the fair value
of the liabilities assumed (other than deferred tax liabilities), and then
excluding cash and cash equivalents, deferred tax assets and goodwill resulting
from the effects of deferred tax liabilities.

The
standard-setter concluded that whether a set of activities and assets includes
a substantive process does not depend on how the set is financed. Consequently,
the concentration test is based on the gross assets acquired, not on net
assets. Thus, the existence of debt (for example, a mortgage loan financing a
building) or other liabilities does not alter the conclusion on whether an acquisition is a business combination. In addition, the gross assets
considered in the concentration test exclude cash and cash equivalents
acquired, deferred tax assets, and goodwill resulting from the effects of
deferred tax liabilities. These exclusions were made because cash acquired, and
the tax base of the assets and liabilities acquired, are independent of whether
the acquired set of activities and assets includes a substantive process.

Example – Establishing the
fair value of the gross assets acquired

Ze Co holds a 30% interest
in Ox Co. A few years later, Ze acquires control of Ox by acquiring an
additional 45% interest in Ox for INR 270. Ox’s assets and liabilities on the
acquisition date are the following:

•  a building with a fair
  value of INR 720

•  an identifiable
  intangible asset with a fair value of INR 420

• cash and cash
  equivalents with a fair value of INR 180

•  deferred tax assets of
  INR 120

•  financial liabilities
  with a fair value of INR 900

•  deferred tax liabilities
  of INR 240 arising from temporary differences associated with the building and
  the intangible asset.

Ze determines that at the
acquisition date the fair value of Ox is INR 600, that the fair value of the
NCI in Ox is INR 150 (25% x INR 600) and that the fair value of the previously
held interest is INR 180 (30% x INR 600).

Analysis

When performing the
optional concentration test, Ze needs to determine the fair value of the gross
assets acquired. Ze determines that the fair value of the gross assets acquired
is INR 1,200, calculated as follows:

•  the total (INR 1,500)
  obtained by adding:

– the consideration paid
(INR 270), plus the fair value of the NCI (INR 150) plus the fair value of the
previously held interest (INR 180); to

– the fair value of the
liabilities assumed (other than deferred tax liabilities) (INR 900); less

• the cash and cash
  equivalents acquired (INR 180); less

• deferred tax assets
  acquired (INR 120).

Alternatively, the fair
value of the gross assets acquired (INR 1,200) is also determined by:

•  the fair value of the
  building (INR 720); plus

•  the fair value of the
  identifiable intangible asset (INR 420); plus

•  the excess (INR 60) of:

– the sum (INR 600) of the
consideration transferred (INR 270), plus the fair value of the NCI (INR 150),
plus the fair value of the previously held interest (INR 180); over

– the fair value of the
net identifiable assets acquired (INR 540 = INR 720 + INR 420 + INR 180 + INR
120 – INR 900).

MINIMUM REQUIREMENTS TO QUALIFY AS BUSINESS

What are the
minimum requirements to meet the definition of a business?

To qualify as a business,
the acquired set of activities and assets must have inputs and substantive
processes that together enable the entity to contribute to the creation of
outputs. However, the standard clarifies that outputs are not necessary for an
integrated set of assets and activities to qualify as a business. A business
need not include all of the inputs or processes that the seller used in
operating that business. However, to be considered a business, an integrated
set of activities and assets must include, at a minimum, an input and a
substantive process that together enable the entity to contribute to the
creation of outputs.

According to the
standard-setters, the reference in the old definition to lower costs and other
economic benefits provided directly to investors did not help to distinguish
between an asset and a business. For example, many asset acquisitions may be
made with the motive of lowering costs but may not involve acquiring a
substantive process. Therefore, this wording was excluded from the definition
of outputs and the definition of a business.

Ind AS 103 adopts a market
participant’s perspective in determining whether an acquired set of activities
and assets is a business. This means that it is irrelevant whether the seller
operated the set as a business or whether the acquirer intends to operate the
set as a business. An assessment made from a market participant’s perspective
and driven by facts that indicate the current state and condition of what has
been acquired (rather than the acquirer’s intentions) helps to prevent similar
transactions being accounted for differently. Moreover, bringing more subjective
elements into the determination would most likely have increased diversity in
practice.

When is an acquired process considered to be substantive?

The amended Standard
requires entities to assess whether the acquired process is substantive. The evaluation
of whether an acquired process is substantive depends on whether the acquired
set of activities and assets has outputs or not. For example, an early-stage
entity may not have any outputs / revenue, and is therefore subjected to a
different analysis of whether the acquired process along with the acquisition
of the development stage entity is substantive or not. Moreover, if an acquired
set of activities and assets was generating revenue at the acquisition date, it
is considered to have outputs at that date, even if subsequently it will no
longer generate revenue from external customers, for example because it will be
integrated by the acquirer.

For activities and assets
that do not have outputs at the acquisition date, the acquired process is substantive
only if:

(i) it is critical to the
ability to develop or convert an acquired input or inputs into outputs; and

(ii) the inputs acquired
include both an organised workforce that has the necessary skills, knowledge,
or experience to perform that process (or group of processes) and other inputs
that the organised workforce could develop or convert into outputs. Those other
inputs could include:

(a)    intellectual
property that could be used to develop a good or service;

(b)    other
economic resources that could be developed to create outputs; or

(c)    rights to
obtain access to necessary materials or rights that enable the creation of
future outputs.

Examples of the inputs
include technology, in-process research and development projects, real estate
and mineral interests.

As can be seen from the
above discussion, for an acquired set of activities and assets to be considered
a business, if the set has no outputs, the set should include not only a
substantive process but also both an organised workforce and other inputs that
the acquired organised workforce could develop or convert into outputs.
Entities will need to evaluate the nature of those inputs to assess whether
that process is substantive.

For activities and assets
that have outputs at the acquisition date, the acquired process is substantive
if, when applied to an acquired input or inputs:

(1) it is critical to the
ability to continue producing outputs, and the inputs acquired include an
organised workforce with the necessary skills, knowledge, or experience to
perform that process (or group of processes); or

(2) significantly
contributes to the ability to continue producing outputs and is considered
unique or scarce; or cannot be replaced without significant cost, effort, or delay
in the ability to continue producing outputs.

The following additional
points support the above:

(A) an acquired contract
is an input and not a substantive process. Nevertheless, an acquired contract,
for example, a contract for outsourced property management or outsourced asset
management, may give access to an organised workforce. An entity shall assess
whether an organised workforce accessed through such a contract performs a
substantive process that the entity controls, and thus has acquired. Factors to
be considered in making that assessment include the duration of the contract
and its renewal terms.

(B) difficulties in
replacing an acquired organised workforce may indicate that the acquired
organised workforce performs a process that is critical to the ability to
create outputs.

(C) a process (or group of
processes) is not critical if, for example, it is ancillary or minor within the
context of all the processes required to create outputs.

As can be seen from the
above discussions, more persuasive evidence is required in determining whether
an acquired process is substantive, when there are no outputs, because the
existence of outputs already provides some evidence that the acquired set of
activities and assets is a business. The presence of an organised workforce
(although itself an input) is an indicator of a substantive process. This is
because the ‘intellectual capacity’ of an organised workforce having the
necessary skills and experience following rules and conventions may provide the
necessary processes (even if not documented) that are capable of being applied
to inputs to create outputs.

The standard-setter
concluded that although an organised workforce is an input to a business, it is
not in itself a business. To conclude otherwise would mean that hiring a
skilled employee without acquiring any other inputs could be considered to be
acquiring a business. The standard-setter decided that such an outcome would be
inconsistent with the definition of a business.

Prior to the amendments,
Ind AS 103 stated that a business need not include all of the inputs or
processes that the seller used in operating that business, ‘if market
participants are capable of acquiring the business and continuing to produce
outputs, for example, by integrating the business with their own inputs and
processes’. The standard-setter, however, decided to base the assessment on
what has been acquired in its current state and condition, rather than on
whether market participants are capable of replacing any missing elements, for
example, by integrating the acquired activities and assets. Therefore, the
reference to such integration was deleted from Ind AS 103. Instead, the
amendments focus on whether acquired inputs and acquired substantive processes
together significantly contribute to the ability to create outputs.

Illustrative
examples

Example
–Acquisition of real estate

Base facts

Ze
Co purchases a portfolio of 8 single-family homes along with in-place lease
contracts for each of them. The fair value of the consideration paid is equal
to the aggregate fair value of the 8 single-family homes acquired. Each
single-family home includes the land, building and lease-hold improvements.
Each home is of a different carpet size and interiors. The 8 single-family
homes are in the same area and the class of customers (e.g., tenants) are
similar. The risks in relation to the homes acquired and leasing them out are
largely similar. No employees, other assets, processes or other activities are
received in this transaction.

Scenario 1 – Application of optional concentration test

Analysis

Ze elects to apply the
optional concentration test set and concludes that:

•  each single-family home
  is considered a single identifiable asset because:

•  the building and
  lease-hold improvements are attached to the land and cannot be removed without
  incurring significant cost; and

•  the building and the
  associated leases are considered a single identifiable asset, because they
  would be recognised and measured as a single identifiable asset in a business
  combination.

•  the group of 8
  single-family homes is a group of similar identifiable assets because they are
  all single-family homes, are similar in nature and the risks associated with
  operations and creating outputs are not significantly different. This is
  consistent with the fact that the types of homes and classes of customers are
  not significantly different.

Ze concludes that the
acquired set of activities and assets is not a business because substantially
all of the fair value of the gross assets acquired is concentrated in a group
of similar identifiable assets.

Scenario 2 –Corporate
office park

Facts

Assume the same base case,
except that Ze also purchases a multi-tenant corporate office park with four
15-storey office buildings with in-place leases. The additional set of
activities and assets acquired includes the land, buildings, leases and
contracts for outsourced cleaning, security and maintenance. However, no
employees, other assets, other processes or other activities are transferred.
The aggregate fair value associated with the office park is similar to the
aggregate fair value associated with the 8 single-family homes. The processes
performed through the contracts for outsourced cleaning and security are minor
within the context of all the processes required to create outputs.

Analysis

Ze elects to apply the
optional concentration test and concludes that the single-family homes and the
office park are not similar identifiable assets, because the risks associated
with operating the assets, obtaining tenants and managing tenants are
significantly different. This is consistent with the fact that the two classes
of customers are significantly different. As a result, the concentration test
fails because the fair value of the corporate office park and the 8
single-family homes is similar. Thus, Ze proceeds to evaluate whether the
acquisition is a business in the normal way.

The set of activities and
assets has outputs because it generates revenue through the in-place leases. Ze
needs to evaluate if there is an acquired process that is substantive. For
activities and assets that have outputs at the acquisition date, the acquired
process is substantive if, when applied to an acquired input or inputs:

•  it is critical to the
  ability to continue producing outputs, and the inputs acquired include an
  organised workforce with the necessary skills, knowledge, or experience to
  perform that process (or group of processes); or

•  significantly
  contributes to the ability to continue producing outputs and is considered
  unique or scarce; or cannot be replaced without significant cost, effort, or
  delay in the ability to continue producing outputs.

Ze concludes that the
above criterion is not met because:

•  the set does not include
  an organised workforce;

•  the only processes
  acquired (processes performed by the outsourced cleaning, security and
  maintenance personnel) are ancillary or minor and, therefore, are not critical
  to the ability to continue producing outputs.

• the processes do not
  significantly contribute to the ability to continue producing outputs.

•  the processes are not
  unique or scarce and can be replaced without significant cost, effort, or delay
  in the ability to continue producing outputs.

Consequently, Ze concludes
that the acquired set of activities and assets is not a business. Rather, it is
an asset acquisition.

Scenario 3 –Corporate
office park

Facts

Consider the same facts as
in Scenario 2, except that the acquired set of activities and assets also
includes the employees responsible for leasing, tenant management, and managing
and supervising all operational processes.

Analysis

Ze elects not to apply the
optional concentration test and proceeds to evaluate whether there is a
business in the normal way. The acquired set of activities and assets has
outputs because it generates revenue through the in-place leases. Consequently,
Ze carries out the same analysis as in Scenario 2.

The acquired set includes
an organised workforce with the necessary skills, knowledge or experience to
perform processes (i.e. leasing, tenant management, and managing and
supervising the operational processes) that are substantive because they are
critical to the ability to continue producing outputs when applied to the
acquired inputs (i.e. the land, buildings and in-place leases). Additionally,
those substantive processes and inputs together significantly contribute to the
ability to create output. Therefore, Ze concludes that the acquired set of
activities and assets is a business.

In the author’s view,
these amendments may result in more acquisitions being accounted for as asset
acquisitions as the definition of business has narrowed. Further, the
accounting for disposal transactions will also be impacted as Ind AS 110 Consolidated
Financial Statements will be applicable in case of the recognition of
proceeds from the sale of a business, while Ind AS 115 Revenue from
Contracts with Customers will be applied for the recognition of proceeds
from the sale of an asset.