Kirk Rogers, a partner in Grant Thornton’s Audit Services practice, examined the Form 10-K filings of some 150 publicly held real estate investment trusts (REITs) and found that many of these expected to list their purchases as asset acquisitions rather than business combinations, thanks to the new accounting rules in Accounting Standards Update (ASU) 2017-01. The results of this analysis revealed that, in most REIT sectors, REITs anticipate adopting ASU 2017-01 early and accounting for many of their future acquisitions as asset acquisitions.
The FASB issued ASU 2017-01 in January 2017. This standard clarifies the difference between an asset acquisition and a business combination acquisition. For real estate investors, particularly REITs, classifying a transaction as an asset acquisition versus a business combination results in significant accounting differences, which can affect the bottom line.
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Our findings indicated that real estate investors in the office, industrial, retail and apartment sectors appear most likely to categorize future purchases as asset acquisitions rather than business combinations. Meanwhile, REITs in the lodging sector stand out as a potential exception. Due to the unique characteristics of this sector, REITs acquiring real estate in the lodging industry may be more likely to characterize their future acquisitions as business combinations.
Overview of ASU 2017-01
ASU 2017-01 provides a screening process to determine whether a transaction is an asset or a business. If substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or in a group of similar identifiable assets, the set is not a business, and no further assessment is required under ASU 2017-01.
“The new definition of a business is more grounded in reality than the previous definition, especially for real estate acquisitions, as to whether a transaction constitutes an asset or a business combination,” said Rogers. “Yet, each real estate sector is different and each transaction has to be evaluated individually.”
If the initial screen is not met, an investor then performs an assessment to determine whether the acquisition has an input and a substantive process that contribute to its ability to create output. If the answer is yes, then the acquisition needs to be considered a business combination.
With the different conclusions come different accounting practices that REITs need to apply. The different conclusions also imply different costs. For instance, in an asset acquisition, transaction costs are capitalized as part of the purchase price. In a business acquisition, they are expensed. Other accounting considerations affected by the changing definition of a business include disposals, goodwill and consolidation.
Across most sectors, REITs anticipate more asset acquisitions
The crux of ASU 2017-01 is that real estate investors must determine whether an acquisition is largely asset-based, or has a set of inputs and substantive processes that, together, create an output that qualifies the acquisition as a business.
Rogers’ analysis showed that, across all real estate sectors, more than 30% of publicly held REITs anticipate classifying their future purchases as asset acquisitions, in all or most of their acquisitions. Another 8% anticipate future purchases “may” qualify for asset acquisition, depending on the transaction. Only 10% anticipate future acquisitions being a business combination under the new standard.
The percentage of REITs that disclosed in their recent Form 10-K filing that they anticipate future property acquisitions qualifying for asset acquisition accounting, by sector, is as follows:
Acquisitions by lodging industry REITs classify mostly as business combinations
- Office sector – 39%
- Industrial sector – 33%
- Retail – 26%
- Apartments – 50%
- Diversified – 42%
- Lodging – 13%
The research showed that the outlier of the list above was the lodging sector. In this sector, most registrants were not as confident that future acquisitions would be accounted for as asset acquisitions. Only 13% of publicly held lodging REITs anticipate in all or most of their future acquisition to be accounted for as an asset acquisition under the new standard, the lowest of all the REIT sectors.
Rogers noted that the acquisition of a hotel or resort includes other elements beyond the property, such as employees and substantive processes. The business could not continue to run without them, and so, a REIT acquiring the hotel or resort would be less likely to replace those employees and processes at the acquisition date. Or, another factor to be taken into consideration is renovation. A hotel that went through a renovation close to the date of the acquisition, might not pass the 90% screen test that ASU 2017-01 requires because the fair value of the acquired furniture and equipment might exceed 10% of the overall fair value of acquired net assets. Circumstances such as these increase the potential that an acquisition of hotel property still may not qualify as an asset acquisition under the new standard.
If an acquisition does not meet the screen, ASU 2017-01 then requires the acquirer to evaluate the inputs acquired as part of the acquisition, such as employees and management contracts that include employees. If these important inputs will be acquired with the acquisition, it is more likely to be a business combination.
However, this is not always the case. In contrast to a hotel, the acquisition of an office building would more likely not include the acquisition of an employee base that is deemed a significant input, and this type of acquisition would typically not contain a significant amount of furniture and equipment. A REIT acquiring an office building might also inherit employees such as security and maintenance workers, but the REIT could determine that such employees and processes are not critical in creating the final output (for instance, if the acquirer could easily replace them without disrupting the ability to create outputs). Thus, this type of acquisition is more likely to be classified as an asset acquisition.
ASU 2017-01 implementation timeline and current adoption of standards
For public business entities, the amendments are effective in annual periods beginning after Dec. 15, 2017, including interim periods within those years. For all other entities, the effective date begins after Dec. 15, 2018, and interim periods within fiscal years after Dec. 15, 2019. Early adoption is also allowed.
Grant Thornton’s examination of the 10-K disclosures of publicly held REITs shows that 17% chose early adoption of the standards in Q4 2016. In the Q1 2017, 27% chose early adoption. Finally, 52% of publicly held REITs didn’t indicate when they planned to adopt.