FASB Simplifies the Definition of "Business". Likely Benefits for the Real Estate Sector
FASBs first accounting update of the New Year appears to be the vaccine for real estate investors that have been plagued by unnecessarily complex accounting requirements, which are generally costly to implement. FASB update “2017-1 Clarifying a Business Definition” amends certain aspects of ASC 805 and by narrowing down the definition of what constitutes a business has a positive impact on owners of real estate who acquire property and report under US GAAP. This clarification is in response to complaints from various stakeholders that the current definition of a business was so broad almost all real estate purchase transactions were considered the purchases of businesses. In an unusual move for the FASB, they acknowledged the problem publically and issued this amended guidance in an effort to simplify the accounting required by real estate companies.
Why does this matter? Time and Money. If you are purchasing a business and reporting under US GAAP, the application of purchase accounting has been required under ASC 805. Purchase accounting in application would generally require reporting entities to obtain a business valuation, which is typically done by a valuation specialist. The standard requires entities to allocate portions of the purchase price to intangibles such as leases in place, tenant improvements, above and below market leases, and goodwill. Unfortunately, this allocation also caused more confusion among users of the financial statements than clarity. In short, the process was onerous and costly and, interpreting the commentary in the update, unintended.
This new update amends the definition of a business where most real estate purchases are exempted. The revised standard added the qualifier “if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets…” Since most real estate purchases are for a single building or a group of buildings having characteristics of one cohesive development, this qualifier eliminates the need for most purchasers of real estate to employ purchase accounting. Therefore no complicated valuation will be necessary and entities would allocate the purchase price to real property assets and in place lease intangibles only, but not goodwill. Eliminating the search for intangibles unrelated to in place leases as well as goodwill should reduce the complexity of the exercise: should an expert be needed. As less complex valuation method is needed it should save time and money.
A few other relevant differences between asset purchase accounting and business combination accounting include capitalization of acquisition costs which were heretofore expensed and relative allocation of purchase price without the creation of goodwill vs the recording of all fair values on an absolute basis.
One caveat to mention is that for purchases of real estate which involve multiple property types with varying risk structures (i.e. residential v. commercial and in distinct locations). Companies that own different property types (residential, commercial, industrial, etc.) may have significant processes and resources employed to coordinate and manage these assets. In the case where the portfolio has characteristics of an operating business, purchase accounting would be required.
This update is effective for public business entities to periods beginning after December 15, 2017 (calendar 2018) and all other entities after December 15, 2018 (calendar 2019). Early application is allowed for transactions which have not already been reported in financial statements.