Acquisition of investment properties – How 2 best account it

Acquisition of investment properties

– When should a purchase of investment property (or properties) be accounted for as a business combination, and when as a simple asset purchase? This is an important issue because the IFRS accounting requirements for a business combination are very different from asset purchases.

Asset acquisition or business combination

The IASB’s new guidance changes the definition of a business and will likely result in more transactions being recorded as asset acquisitions. The new definition of a business could have a significant impact in the real estate (RE) industry.

New guidance (from 1 January 2020 or earlier)

IFRS 3 ‘Business Combinations’ has been amended to update the definition of a business. The new model introduces an optional concentration test that, if met, eliminates the need for further assessment. To be considered a business, an acquisition would have to include an input and a substantive process that together significantly contribute to the ability to create outputs. The new guidance provides a framework to evaluate when an input and a substantive process are present.

Acquisition of investment properties

The concentration test

Under the concentration test, companies consider whether substantially all of the fair value of the gross assets acquired is concentrated in a single asset (or a group of similar assets). If so, the assets acquired would not represent a business and no further analysis is required. Gross assets acquired exclude cash, deferred tax assets and any goodwill that results from the effects of deferred tax liabilities.

The fair value of the gross assets acquired can usually be determined based on the consideration transferred (plus theAcquisition of investment properties 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. In order to compare like with like, any items excluded from the “gross assets acquired” would also be excluded from the fair value of gross assets acquired calculation.

The optional concentration test includes the concept of aggregating ‘similar’ assets. In the RE industry, it is common for acquisitions to include several properties.

Companies should carefully consider the specific facts and circumstances, including class of property and location when concluding whether assets purchased in a transaction are similar. A group of properties are not similar if they have significantly different risk characteristics. [IFRS 3 para B7B(f)(vi)].

Case – Acquisition of a residential real estate portfolio

Property Co purchases a portfolio of 10 residential homes. Each home is considered to be a separate investment property for accounting purposes. All homes are leased out to separate tenants and comprise land and buildings. Each home has a different design and layout but all homes are located in the same geographical area and the risk profile of the real estate market across that area is similar. No employees, other assets or other activities are transferred.

Is the arrangement the acquisition of a business?

Analysis

No. Property Co elects to apply the optional concentration test and would conclude that this is an asset acquisition, because substantially all of the fair value is concentrated in a group of similar assets. Property Co would treat this as an asset acquisition, assuming that it opted to use the concentration test.

A transaction is not automatically a business combination if the optional concentration test does not result in an asset classification. An entity would then need to assess the transaction under the full framework in IFRS 3.

Framework in IFRS 3

IFRS 3 requires a business to include, as a minimum, an input and a substantive process that together significantly contribute to the ability to create output. The new guidance provides a framework to evaluate when an input and a substantive process are present, differentiating between transactions with outputs and those with no outputs.

Outputs are defined as “the results of inputs and processes applied to those inputs that provide goods or services to customers, generate investment income (such as dividends or interest) or generate other income from ordinary activities”. [IFRS 3.B7].

  • Without outputs

An acquired process is considered substantive where:

  1. the process is critical in converting an acquired input to an output;
  2. the inputs acquired include an organised workforce that has the necessary skills, knowledge and experience to perform that process; and
  3. other inputs are acquired that can be developed or converted into outputs by the organised workforce, for example, intellectual property, other economic resources that could be developed to create outputs, or rights to obtain materials or that enable future output to be created.
  • With outputs

An acquired process is considered substantive where, either:

  1. the process is critical in continuing to produce outputs, and the input includes an organised workforce with the necessary skills, knowledge or experience to perform that process; or
  2. the process significantly contributes to the ability to continue to produce outputs and is unique or scarce or cannot be replaced without significant cost.
  • Contracted workforce

An acquired contract could give access to an organised workforce (for example, outsourced property management services). The entity needs to assess whether the organised workforce provides a substantive process that it controls. Factors to consider include: the service is not ancillary or minor; it would be difficult to replace the workforce; and the duration of the contract and renewal terms.

Case – Acquisition of a residential and office real estate portfolio

Property Co purchases a portfolio of 10 residential homes (the nature of these homes being as outlined in the example above) as well as an office park containing 5 fully let office buildings. In addition, an outsourcing contractAcquisition of investment properties for maintenance services for the office park is also acquired. The maintenance services are considered ancillary or minor in the context of generating rental income at the office park. No employees, other assets or other activities are transferred.

Is the arrangement the acquisition of a business?

Analysis

No, Property Co would conclude that this is an asset acquisition.

The concentration test is not passed, since all of the fair value is not concentrated in a single identifiable asset or a group of similar identifiable assets; this is because two dissimilar classes of real estate with different risk profiles are acquired.

Since there are leases in place for both the residential homes and office park buildings, Property Co would then analyse the transaction, referring to the framework with outputs and considering whether the acquired processes are substantive. No organised workforce is acquired and the maintenance services are considered ancillary or minor in the context of generating rental income.

Further, the maintenance services do not significantly contribute to the ability to generate

rental income and also could be replaced without significant cost.

Would the answer be different if there were no in-place lease contracts and, therefore, no outputs?

Analysis

No, Property Co would still conclude this is an asset acquisition.

In order for the definition of a business to be met when there are no outputs, an organised workforce with the necessary skills critical to the ability to develop and convert the inputs into outputs would need to be present. As no such organised workforce is acquired, the definition of a business is not met.

Case – Acquisition of a residential and office real estate portfolio

Property Co acquires a portfolio of residential and office assets (the nature of these assets being as outlined in the example above) and also acquires employees that are responsible for operational management of the assets as well as all tenant management and leasing activity

Is the arrangement the acquisition of a business?

Analysis

Yes. Property Co would conclude that this is a business combination.

The concentration test is not applied, because the fair value of the assets acquired is not concentrated in a single asset or a group of similar identifiable assets. Further analysis is required, following the framework with outputs, to assess whether a process is acquired and whether the process is substantive.

A business is acquired, because the organised workforce is a substantive process with the necessary skills that is critical to the ability to develop and convert the inputs (land, buildings and in-place leases) into outputs.

What is the impact of more asset acquisitions?

The changes to the definition of a business will likely result in more acquisitions being accounted for as asset acquisitions. There are a number of accounting differences between business combinations and asset acquisitions; these include the recognition of goodwill and the divergent treatment of deferred taxes, contingent consideration and transaction costs, amongst others.

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