FASB Contemplating Changes to Definition of Business – A Potentially Beneficial Change for Real Estate Reporting Under GAAP
December 14, 2015
I don’t mean to sound like some sort of reactionary, but remember that simpler era not so long ago -- a time where when you acquired a piece of real estate, the biggest accounting consideration was in determining how much to allocate to the land vs. the structure? In that kinder, gentler time, the acquisition was accounted for as an asset acquired-where the consideration paid and costs incurred to acquire the asset were simply allocated to the asset components acquired (land, structure, improvements, etc.) on a relative value basis.
Well, according to a FASB exposure draft issued at the end of November, under certain circumstances we may - in the not too distant future - return to those simpler times.
Under current GAAP, when you acquire real estate, the first significant accounting consideration impacting reporting is to determine whether the acquisition constitutes a “business.” Why does this matter? For starters, if you are deemed to have acquired a business through the real estate purchase, you need to apply ASC 805. This rule requires that you determine at fair value all (of the ”business”) identifiable assets acquired including intangibles such as the value of leases ”in place,” as well as evaluate and account for the fair value of the leases which provide for rentals either above or below the current market levels. You also must determine the fair values for the land, improvements and structure (the actual real estate) and account for and record each of the above assets/credits -- leaving open as well the possibility of ending up with a residual charge (usually goodwill) or credit (going to the income statement). Further, the generally significant costs of the acquisition are expensed immediately in the case of a business acquisition, but not for an asset purchase.
Currently, a business under GAAP is defined as a set of inputs, processes applied to those inputs, and the ability to create outputs therefrom (collectively, a set). In real estate as well as many other industries, it is difficult to apply these definitions in practice. It currently does not matter to either the definition or the accounting result whether there are actual outputs. Nor does it currently matter whether the fair value of the “set” is concentrated in a single identifiable asset or is concentrated among a group of similar identifiable assets. As we shall see, this is expected to change.
Under the proposed accounting, if there exists a concentration of value in an asset or a group of similar assets acquired in the set, you would not be considered to have acquired a business. Also, unlike current GAAP, continuation of outputs (in our context-rental revenue) would not in and of itself qualify a real estate acquisition as a business. Virtually all operating properties meet the definition of a business currently; however, this will no longer be the case under the new rules. Furthermore, to constitute a business, a set would have to contain at least one input and a substantive process which when applied to another acquired input would have the ability to develop or create outputs. And unlike the current practice, an existing workforce in place that can be substituted for by an acquirer would not constitute a business acquired.
As a side note, the FASB has reconsidered these definitions because of push-back from preparers. Opposition has come most notably from the real estate and pharmaceutical worlds. This is as a result of an overkill of complexity in those sectors caused by the existing definition of a business - borne by the preparers (and auditors) of the related financial statements - with dubious benefits for the users thereof. Someone is listening out there and that is good news.
Comments on this proposal are due to the FASB by January 22, 2016. Let’s hope that the preparer community gets some needed relief here, particularly in light of the coming burdens which will be imposed by the impending leasing standard.