Introduction
When Merck acquired Prometheus Biosciences in June 2023 for $11.0 billion, it did not record any goodwill, and it did not capitalize Prometheus's lead drug candidate, tulisokibart, as an intangible asset. Instead, it charged $10.2 billion to research and development expense in a single quarter. The reason was that tulisokibart accounted for substantially all of the fair value of the gross assets acquired, so the deal was an asset acquisition rather than a business combination, and an in-process research asset with no alternative future use acquired that way is expensed. Merck's non-GAAP earnings per share (EPS) for 2023 were reduced by $6.21 by charges for licensing deals and pre-approval assets bought in asset acquisitions.
Had the same company been judged a business, Merck would have recorded tulisokibart as an indefinite-lived intangible asset at fair value, with goodwill for any remainder, and none of the price would have hit earnings at closing. The question of whether an acquired set of activities and assets is a business can therefore move billions between the balance sheet and the income statement.
The Definition of a Business
Since Accounting Standards Update (ASU) 2017-01, the business combinations standard, Accounting Standards Codification (ASC) 805, applies a two-step test. The first step is a screen: if 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, the screen is met, the set is not a business, and the analysis stops. Cash and cash equivalents, deferred tax assets and goodwill from deferred tax liabilities are excluded from gross assets for this purpose. Merck applied exactly that test to Prometheus.
- Business
Under ASC 805, an integrated set of activities and assets that is capable of being conducted and managed to provide a return, in the form of dividends, lower costs or other economic benefits, directly to its investors or other owners. To be a business, the set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create outputs: goods or services to customers, investment income or other revenues.
If the screen is not met, the second step asks whether the set includes an input and a substantive process. A set that already produces outputs needs either an organized workforce performing a process critical to continuing them, or an acquired process that contributes significantly to continuing them and is unique, scarce or not replaceable without significant cost, effort or delay. A set without outputs, such as a development-stage company, needs an organized workforce with the skills to develop or convert another acquired input into outputs, as Deloitte's roadmap on the definition of a business sets out. Buildings with leases, single drug candidates, portfolios of similar loans and individual oil and gas properties often meet the screen; operating companies with employees and customers almost always clear it and pass the second step.
Judgment at the Margins
The screen has its own details. A building and the in-place leases attached to it are treated as a single asset, so buying a leased office tower is usually an asset acquisition. Assets count as similar only if they share their nature and risks: a portfolio of residential properties may be a group of similar assets, but a building and the equipment inside it are not, and neither are two drug candidates with significantly different development risks. And an early-stage company with an experienced research team can still be a business, even without revenue, if that team is an organized workforce capable of turning its research into products. Small changes in what is included in a deal can therefore change the answer.
Why the Answer Matters
The two outcomes follow different accounting models. A business combination uses the acquisition method, described in the acquisition method, which measures everything at fair value. An asset acquisition uses a cost accumulation model, as Deloitte's guide to accounting for asset acquisitions explains:
| Item | Business combination | Asset acquisition |
|---|---|---|
| Goodwill | Recognized as the residual | Never recognized; any excess is spread over the assets |
| Measurement of assets | Fair value at the acquisition date | Cost, allocated by relative fair value |
| Transaction costs | Expensed | Capitalized as part of the cost of the assets |
| In-process research and development | Capitalized as an indefinite-lived intangible | Expensed if it has no alternative future use |
| Contingent consideration | Fair value at closing, remeasured through earnings | Usually recognized only when probable and estimable |
| Bargain purchase | Gain in earnings | No gain; the assets' values are reduced |
| Assembled workforce | Part of goodwill | Recognized as an intangible asset |
Research and Development: Capitalized or Expensed
The research treatment is the largest practical difference, and it is why the definition of a business matters so much in pharmaceuticals and biotech. In a business combination, acquired in-process research is capitalized at fair value and tested for impairment until the project succeeds, when it is amortized, or fails, when it is written off. In an asset acquisition, research assets with no alternative future use are expensed immediately under the research and development rules covered in R&D accounting under US GAAP. Merck's 2024 annual report records the pattern across several deals: besides Prometheus, it expensed $1.35 billion on acquiring EyeBio and $656 million on acquiring Harpoon Therapeutics, both asset acquisitions concentrated in a single drug candidate.
Costs, Taxes and Contingent Payments
Smaller differences add up. Direct transaction costs, which are expensed in a business combination, are capitalized into the assets in an asset acquisition, unless those assets are themselves expensed, as research assets are. Deferred taxes on a book-tax difference in the assets acquired are calculated with a simultaneous equation, because the deferred tax itself changes the allocated cost. And milestone or royalty payments contingent on future events are generally not recognized at closing but when they become probable and estimable, then either capitalized or, for research assets, expensed; Merck expensed a further $100 million milestone on EyeBio's candidate when a later-stage trial began.
What Bankers Watch
For companies that buy pipeline assets regularly, asset acquisition charges are a recurring part of earnings, not a one-off. Merck's adjusted earnings include them, which is why its 2023 adjusted EPS fell sharply in the year it bought Prometheus. Comparing such a company with peers that grow through business combinations, or that report under IFRS, requires deciding whether to treat acquired research as an expense or an investment, and applying the choice consistently, a recurring debate in the use of non-GAAP measures.
The classification also affects what follows. A business combination brings goodwill and impairment testing; an asset acquisition does not. A real estate buyer that acquires buildings one at a time as asset acquisitions capitalizes its deal costs into the properties and depreciates them, while one that buys an operating property company records goodwill and expenses its costs. Two buyers paying the same price for similar assets can therefore show quite different balance sheets and earnings for years, and the purchase price allocation behind each, covered in purchase price allocation, is where the difference begins.
