The impacts of IFRS 3 on the real estate sector
INSIGHT ARTICLE |
Recent amendments to International Financial Reporting Standards (IFRS) will likely be top of mind, particularly for those in the real estate sector. As of Jan. 1, 2020, the amendments to the definition of a business within IFRS 3 Business Combinations, takes effect. Although relevant for many industries, real estate entities and investors may experience a significant impact depending on senior management’s investment strategy and frequency of purchases and sales, and the increased need to realize an expected return on investment.
This article intends to offer insights for investors and those who play financial roles in real estate companies as to what the amendments mean, as well as the actions real estate companies may consider taking in the new year.
Definition of a business
The International Accounting Standards Board (IASB) released Definition of a Business (Amendments to IFRS 3) in response to complexities that arose when entities set about to determine whether they had acquired a business or a group of assets. The narrow-scope amendments aim to clarify the process of distinguishing between a business and a group of assets, to clarify when an acquirer recognizes goodwill. The previous definition identified a business as an integrated set of activities capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits. The new definition is as follows:
An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generating other income from ordinary activities.
Under this new definition, a substantive process and an input are required before an acquisition can be classified as an acquisition of a business. Essentially, a substantive process relates to business outputs. For example, if, at the acquisition date, the acquired inputs, such as an organized workforce, technology, or real estate interests are critical to developing goods and services, then the acquisition may be deemed a business.
To provide guidance, the IASB introduced an optional fair value concentration test, based on gross assets, designed to determine whether or not a set of activities and assets is a business. Gross assets acquired can usually be determined based on the consideration transferred (plus the fair value of any non-controlling interest and previously held interest, if any) plus the fair value of any liabilities assumed, other than deferred tax liabilities. For purposes of the test, gross assets exclude cash, deferred tax assets and any goodwill that results from the effects of deferred tax liabilities.
Entities may elect whether or not to apply the concentration test on a transaction-by-transaction basis. If the test is met, the acquisition is deemed an asset acquisition, with no further assessment needed. If the entity fails the test, the acquisition defaults to the detailed assessment required by IFRS 3, Business Combinations. Entities can bypass this test and instead move directly to evaluating whether inputs and a substantive process exist in accordance with the full framework of IFRS 3.
A purchaser, let’s call them Real Estate Co, buys a portfolio of five multi-family residential apartments. Each apartment comes with 50 to 75 in-place short-term leases, land, and building and property improvements. While the apartments exist in the same location and house similar types of tenants, they all contain different interior designs and different floor areas. No processes, employees, assets or activities beyond the apartments themselves have been transferred and the fair value of the consideration paid equals the aggregate fair value of the apartments acquired. Real Estate Co applies the concentration test and determines the following:
- Each apartment is a single identifiable asset, as the property improvements and buildings belong to the land and removal of such would incur large expense;
- The in-place tenant leases are also identifiable assets, recognized and measured as identifiable assets in a business combination, per the narrow-scope amendments;
- All of the apartments constitute a group of similar identifiable assets – the associated management risks do not differ materially.
With this information, Real Estate Co concludes that its newest acquisition is not a business. Substantially all of the fair value of the gross assets is concentrated in a group of similar, identifiable assets; therefore, they are not required to proceed with the more detailed assessment.
The IASB expects that the amendments to IFRS 3 will lead to more consistency in applying the definition of a business across entities applying U.S. Generally Accepted Accounting Principles (GAAP) and IFRS. The amendments to IFRS and U.S. GAAP do differ in certain respects. For example, the concentration test is optional under IFRS, but mandatory under U.S. GAAP.
While these amendments will not have as big of an impact as recent new standards such as IFRS 16 Leases, their impact may be felt more by real estate lessors due to the likelihood of more real estate acquisitions being accounted for as asset acquisitions and the number of accounting differences between asset acquisitions and business combinations. Depending on the result of the concentration test, real estate companies will want to increase their focus on assessing operations and resource management to determine whether or not the process is substantive, for example, in cases where both a building and the personnel operating that building are acquired.
Another area is the change in the definition of business impacts relating to the accounting for disposal transactions where proceeds are received from an asset sale. IFRS 15 Revenue from Contracts with Customers is the standard applied to asset sale transactions. IFRS 15 may influence the timing of revenue recognition where complex sales contracts include variable consideration or significant financing components.
Real estate companies and investors may want to consult with an advisor to clarify the impact on their business, including the accounting treatment to be applied for financial reporting purposes as part of their due diligence processes.