There are many scenarios that students, and professional accountants, will come across that examine the concept of investment property and it is important that accountants at all levels understand the fundamental concepts as to why investment properties are subjected to a completely separate standard other than that of IAS 16 Property, Plant and Equipment.
This article will take a look at the broad concepts behind IAS 40 Investment Property and the accounting requirements that the standard itself provides.
The main reason that investment property is outside the scope of IAS 16 is because the characteristics of investment properties differ significantly from the characteristics of owner-occupied property, as well as the fact that the International Accounting Standards Board (IASB) recognise that the values attributed to such properties, and the changes in those values (particularly in today’s turbulent economic times) are relevant to the users’ of financial statements, hence there is a need to have a completely separate standard on the area of investment property.
IAS 40 is fairly wide in its overall scope and includes property that is held for capital appreciation purposes, or property from which rentals are earned. The scope of IAS 40 also includes property that is leased out by the entity under an operating lease, but be careful here! IAS 40 does not deal with other aspects of leased property which are dealt with under IAS 17 Leases.
Paragraph 5 to IAS 40 defines investment property as:
When a property interest is held by a lessee under an operating lease, such a property may be treated as an investment property if, and only if:
- Property (land or a building – or part of a building – or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
- use in the production or supply of goods or services or for administrative purposes; or
- sale in the ordinary course of business.
- It can meet the rest of the definition of investment property.
- The lessee uses the fair value model in IAS 40.
- The initial cost of a property interest held under an operating lease and classified as an investment property should be treated as for a finance lease – in other words the asset should be recognised at the lower of the fair value of the property and the present value of the minimum lease payments. [IAS 40 para 6; IAS 17 para 19]
The Gabriella Group owns a portfolio of properties one of which is a converted mill that it leases out (as lessor) to a manufacturer of curtains and soft furnishings under an operating lease. The mill itself is built on land that is leased by the government to the Gabriella Group (as lessee) for a period of 999 years. Title to the land on which the mill is built does not pass to the Gabriella Group at the end of the lease and the mill’s useful life is expected to be 50 years. The terms of the lease do not require the land to be returned with the building intact at the end of the 999 year lease term.
In this scenario, the land element should be accounted for an as operating lease under the provisions in IAS 17 and can be recognised as investment property only if it meets the definition of such and the Gabriella Group has chosen the fair value model for the investment property. The converted mill does meet the definition of an investment property and should be accounted for under the provisions in IAS 40. A building is recognised as an investment property if the lease of the land extends beyond the building’s expected useful life and there are no provisions in the lease to return the land with the building intact.
Examples of investment property
IAS 40 cites several examples of what is and what is not investment property. Examples of investment property as per paragraph 8 to IAS 40 include:
- Land held for long-term appreciation in value, rather than for short-term sale in the ordinary course of business.
- Land whose future use has not yet been determined. If the future use has not yet been determined, land is assumed to be held for capital appreciation.
- A building owned or held under a finance lease and leased out under an operating lease.
- A building that is vacant, but held to be leased out under an operating lease.
- Investment property being redeveloped for continued use as investment property.
Paragraph 9 to IAS 40 then goes on to say what investment property does not include:
- Property intended for sale in the ordinary course of business or for development and resale.
- Property under construction for third parties.
- Owner-occupied property, including property held for such use or for redevelopment prior to such use.
- Property occupied by employees.
- Owner-occupied property awaiting disposal.
- Property that is leased to another entity under a finance lease.
It is imperative, therefore, to ensure that in the real world, or in exam situations, you are familiar with what is and what is not investment property, because the accounting requirements differ significantly. Getting the classification incorrect can be both costly and misleading to the users’ of the financial statements.
Investment property should be recognised as an asset within the financial statements when it is probable that future economic benefits that are associated with the property will flow to the entity, and the cost of the property can be reliably measured.
Once management is satisfied that a property meets the definition and recognition criteria of investment property, the initial recognition in the financial statements is exactly the same as the initial recognition for other property, plant and equipment – at cost. Cost includes:
- The purchase price.
- Directly attributable costs (see below).
IAS 40 recognises that start-up costs, abnormal waste, or initial operating losses incurred before the investment property achieves the planned level of occupancy should not be recognised.
IAS 16 at paragraph 17 outlines examples of directly attributable costs as follows:
- The cost of employee benefits as defined in IAS 19 Employee Benefits, that arise directly from the construction or acquisition of the item.
- The costs of site preparation.
- Initial delivery and handling costs.
- Installation and assembly costs.
- Professional fees.
- Costs of testing whether the asset is working properly (commissioning costs), after deducting the net proceeds of sale of any items produced while bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.
IAS 40 permits the reporting entity to adopt either the fair value model or the cost model as its accounting policy for investment property.
Under the fair value model the investment property is revalued to fair value. ‘Fair value’ is defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. ‘Knowledgeable parties’ in the context of IAS 40 means that both the buyer and the seller are reasonably informed about the nature and characteristics of the property, its actual and potential uses and the state of the market at the reporting date. A ‘willing buyer’ is one who is motivated, but not forced to buy, nor is such a buyer over-eager or determined to buy at any price. Such a buyer will not pay a higher price than a market made up of knowledgeable willing buyers and sellers would require.
Under the cost model an entity will carry an investment property at cost less accumulated depreciation and any accumulated impairment losses. This treatment is consistent with the requirements in IAS 16. However, when an entity adopts the use of the cost model, they must still obtain fair values as IAS 40 requires the disclosure of such fair values within the financial statements, so the benefits of using the cost model are not evident when fair values still have to be obtained.
An important point to flag up is the situation that may occur when management wish to switch from measuring investment property at fair value to measuring investment property under the cost model. The following example illustrates a problem in switching from the fair value model to the cost model:
Lucas Property Company (Lucas) has two properties, both of which meet the definition of investment property under IAS 40. Management previously declared that Lucas will carry the investment property using the fair value model, but have now expressed a desire to carry the properties under the cost model.
Where the entity has adopted the fair value model, the IASB considers that it should not then subsequently change to the cost model. This is because the provisions in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors allows a change of accounting policy only if the revised policy will provide reliable and more relevant information about the effects of transactions, other events or conditions. The IASB have concluded that it is highly unlikely that a switch from the fair value model to the cost model will result in such a switch providing more reliable and more relevant information.
Changes in fair values
Changes in the fair values of investment property are recognised within profit or loss for the period in which they arise. The standard itself requires disclosure of net gains or losses arising from fair value adjustments, but it does not specify where such gains and losses on revaluation should be shown within the statement of comprehensive income (income statement). They should, however, be shown separately from rental income and direct operating expenses, which IAS 40 requires to be disclosed separately.
As part of their ‘Improvements Project’ in 2003, the IASB revised IAS 1 Presentation of Financial Statements and following this project IAS 1 no longer requires the disclosure of a line item for the results of operating activities. In the ‘Basis for Conclusions’ section of IAS 1 (specifically IAS 1 para BC13) the IASB have said that if an entity voluntarily discloses a line item for the results of operating activities, it should ensure that the amount disclosed is representative of activities that would normally be considered to be ‘operating’. Revaluation gains and losses would form part of the operating results and should, therefore, be disclosed in arriving at operating profit, if such a line item is disclosed. When an entity does not disclose such a line item, it is generally considered that gains and losses on revaluation should be shown in the line item before ‘finance costs’. The general consensus here is that finance costs are generally not part of operating profit, unless the entity carries on a finance related business.
Under IAS 40, an entity is required to make extensive disclosures within the financial statements relating to all investment property, whether carried at fair value or at cost less depreciation. The disclosure requirements are as follows:
When the entity adopts the use of the fair value model, it needs to disclose a reconciliation of the carrying amount at the beginning and end of the period showing:
- Whether the entity uses the cost model or the fair value model.
- If the entity applies the fair value model, whether and in what circumstances it classifies, and accounts for, property interests held under an operating lease as investment property.
- Basis of distinguishing investment property from owner-occupied property and property held for sale in the ordinary course of business, where classification is difficult.
- Methods and significant assumptions for determining fair value, including a statement as to whether fair value was supported by market evidence or was more heavily based on other factors (which the entity should disclose) because of the nature of the property and lack of comparable market data.
- Extent of involvement of independent professional valuers with recent experience in the location and category of investment property being valued (in determining fair value for measurement or disclosure purposes) or, if there has been no independent valuation, disclosure of that fact.
- Amounts included in profit or loss for rental income and direct operating expenses relating to investment property (such as repairs and maintenance) giving amounts separately in the latter case for property that generated rental income and property that did not.
- The cumulative change in fair value recognised in profit or loss on a sale of investment property from a pool of assets in which the cost model is used into a pool in which the fair value model is used.
- Details of the existence and amount of restrictions on the realisability of investment property or on remittance of income and proceeds of disposal.
- Contractual obligations to purchase, construct or develop investment property or for repairs, maintenance of enhancements.
- Additions from acquisitions.
- Additions from subsequent expenditure recognised in the carrying amount of an asset.
- Additions from business combinations.
- Assets classified as held for sale or included in a disposal group classified as held for sale in accordance with IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations, and other disposals.
- Net gains or losses from fair value adjustments.
- Net exchange differences arising from retranslation of the reporting entity’s financial statements into a different presentation currency (where applicable) and from retranslation of a foreign operation (for example, an overseas subsidiary undertaking) into the reporting entity’s presentation currency.
- Transfer to and from inventory and owner-occupied property.
- Other changes.
Comparative amounts are also required for the above disclosures.
When an entity carries investment property under the cost model, it should make the following additional disclosures (including disclosure of the fair value of the investment property):
- The depreciation methods used.
- The useful lives or depreciation rates used.
- The gross carrying amount and the accumulated depreciation (combined with accumulated impairment losses) at the beginning and end of the period.
- A reconciliation of the carrying amount of investment property at the beginning and end of the period showing:
- Additions from acquisitions.
- Additions from subsequent expenditure recognised as an asset.
- Additions from business combinations.
- Assets classified as held for sale or included in a disposal group classified as held for sale in accordance with IFRS 5.
- Amount of impairment losses recognised and the amount of impairment losses reversed during the period under IAS 36 Impairment of Assets.
- Net exchange difference arising from retranslation of the reporting entity’s financial statements into a different presentation currency (where applicable) and from retranslation of a foreign operation (for example, an overseas subsidiary) into the reporting entity’s presentation currency.
- Transfers to or from inventory and owner-occupied property.
- Other changes.
- Fair value of investment property. Where, in exceptional circumstances, the entity cannot reliably determine the fair value of an investment property it should disclose:
- A description of the property.
- An explanation as to why fair value cannot be reliably determined.
- If possible, the range of estimates of fair value within which the fair value of the property is highly likely to lie.
The accounting rules contained in IAS 40 are very extensive and cover a wide scope of issues relating to investment properties. Students should ensure that they study their respective syllabuses carefully so as to gain a broad understanding of the issues that may crop up in an exam situation. Professional accountants should ensure they are also familiar with the content in IAS 40 to ensure correct accounting treatment. It is important that students fully understand the initial recognition and subsequent measurement issues relating to investment properties and how to account for such changes. Gaining a sound understanding of theoretical knowledge is also important, particularly where there is scope for a discursive style questions to be examined in a financial reporting examination.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd and the author of Interpretation and Application of International Standards on Auditing (March 2011) and IFRS For Dummies (April 2012). He was also named Accounting Technician of the Year at the 2011 British Accountancy Awards.