IAS 40 Investment Property-some practical issues!
By Panicos Charalambous, FCCA, Director PKC Quality Training Ltd, Director-Professional Studies and Senior Lecturer at P. Stylianides Institute of Accountancy
IAS 40 Investment Property-some practical issues!
This article presents some practical issues in applying IAS 40 Investment Property.
Let us first set out the current definition of Investment Property as follows:
‘Investment property is 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 of for capital appreciation or both, rather than for:
- use in the production or supply of goods or services of for administrative purposes; or
- sale in the ordinary course of business”
Likewise the definition of owner-occupied property:
“Owner-occupied property is property held (by the owner or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes”
Let us now consider some issues relevant to the classification of property as investment property or not.
What happens if an entity temporarily uses land destined for future use as investment property in agricultural activity?
An entity owning land that is to be developed into a commercial office building to be rented out initiates the procedures to obtain all necessary licenses, permissions and approvals prior to starting the construction. This process is expected to last for a period between 12-18 months to complete. The entity decides to use the land for agricultural activity during this period.
Will the land be classified as “owner occupied and held for use in the production of goods or services” during this period of 12-18 months?
The (proven) stated main objective of the entity is to build a commercial office building which will be held to earn rentals and/or for capital appreciation. The temporary use of the land as agricultural activity is only incidental to the main objective. It may therefore be appropriate to classify the land as investment property from initial recognition.
What happens if a property is partly owner-occupied and partly held for rental income/or capital appreciation?
An entity owns an office building of 6 floors. It uses the top 2 floors as its own offices and rents the other 4 floors. Will the property be classified as owner-occupied or as an investment property?
As per IAS 40, if the floors could be sold separately (or leased out separately under a finance lease), the entity accounts for the floors separately, i.e. the entity should treat the top 2 floors as owner-occupied property and the rest of the floors as investment property.
If the floors could not be sold separately, the property is investment property only if an insignificant part is held for use in the production or supply of goods or services or for administrative purposes. Consider for example an entity that earns rentals from renting out a warehouse building of 2000 sq. m but at the same time is allowed to use a small part of it (e.g. 200 sq. m). If the different parts of the warehouse cannot be sold separately, then the property (warehouse) is an investment property because an insignificant part (200 sq. m) is held for use.
What is the appropriate classification for hotels?
An owner-managed hotel is regarded as owner-occupied property as it is used by the owner for the supply of goods and services. The services provided to guests are significant to the arrangement as a whole.
Judgement is involved if ancillary services are provided to/from the entity. It all boils down to whether the services are significant or not. For this reason, entities should disclose the criteria used in assessing whether a property is investment property or not, where this involves judgement.
For example, the owner of a hotel may have transferred the management function and provision of services to a third party under a management contract. Careful consideration of the provisions of the contract will need to be made. Judgement will be exercised to decide whether those services are significant (and therefore the owner is just a passive investor, which would lead to classification of the hotel as an investment property) or insignificant (and therefore the owner has retained significant exposure to variations in cash flows from the operation of the hotel, which would lead to classification as owner-occupied).
(Similar situations are considered in cases where entities own commercial office buildings that they rent out to tenants and at the same time they provide security and maintenance services to the lessees who occupy the building; such kind of services are considered insignificant and the whole property is therefore classified as an investment property)
Group complexities! (a small nightmare really for those that prepare group accounts!)
Property that is rented out between companies of the same group does not qualify as investment property in the consolidated financial statements because the property is owner occupied from the perspective of the group. However, from the perspective of the company that owns it, the property is investment property if it meets the definition is IAS 40. Appropriate adjustments will therefore need to be made in the consolidated financial statements.
It is worth mentioning that associates are not members of a group as mentioned above!
Moving on now to consider an issue relating to the measurement of investment property at initial recognition.
As per IAS 40, “an investment property shall be measured initially at its cost. Transaction costs shall be included in the initial measurement.”
Directly attributable expenditure can be capitalized. This includes for example professional fees for legal services, property transfer taxes and other transaction costs.
A common question that is often asked is whether costs incurred internally can be capitalized as part of the cost of acquisition. For example, employees of an entity (in-house lawyers) have worked for a significant number of hours on the acquisition of a property carrying out research activities and comparisons, drafting/reviewing the contract of purchase, taking part in negotiations, etc. Can the management capitalize part of their salary cost in the purchase cost of the property?
The answer is no! They are not ‘directly attributable to the acquisition of the property”. They are “general and administrative” internal costs. They would have been incurred by the entity even if the property was not finally acquired. On the contrary, legal fees paid to external lawyers in relation to the acquisition of an investment property can be capitalized as part of the purchase cost.
Another issue to consider, especially in times of falling and unstable market conditions is an inability to measure fair value reliably. Entities might be tempted to discontinue fair valuing investment property on the grounds that “fair value is not readily available”! IAS 40 however is very clear on this!
If an entity has chosen the fair value model for its investment property, it shall measure all of its investment property at fair value. Under IAS 40, there is a rebuttable presumption that an entity can reliably measure the fair value of an investment property on a continuing basis. This presumption can be rebutted only at initial recognition and arises when, and only wen, the market for comparable properties is inactive (e.g. there are few recent transactions, price quotations are not current or observed transaction prices indicate that the seller was forced to sell) and alternative reliable measurements of fair value (for example based on discounted cash flow projections) are not available.
IAS 40 clearly states that “If an entity has previously measured an investment property at fair value, it shall continue to measure that property at fair value until disposal (or until the property becomes owner- occupied property or the entity begins to develop the property for subsequent sale in the ordinary course of business even if comparable market transactions become less frequent or market prices become less readily available)
Our final consideration will deal with the now common situation of entities that are property developers with a history of developing properties for sale but due to depressed prices and few transactions decide to rent the properties until the market picks up. Should a transfer be made out of the inventory category?
One scenario is when the property developer rents out individual apartments/offices when completed in order to increase the possibility of selling the entire property after completion. In this scenario the tenants move in before the property is completed in its entirety.
The entity should continue classifying the property as inventory. The entity’s main activities and strategy for the property has not changed; it is still the sale of the property. The property continues to be held for sale in the ordinary course of business and continues to be marketed as such.
The second scenario that we will consider is similar to the first one; however, this time the property developer decides to rent out the property until the market picks up and prices begin to rise.
Careful consideration will need to be made and the final assessment requires judgement to be exercised:
- Is the property actively marketed for sale?
- Is the property still available for sale in its present condition in the ordinary course of business?
- Is there a market for properties with existing tenants?
- Has the entity’s strategy for the property changed?
- Has there been a change in management intention?
If the entity is not willing to sell the property at the current low prices this indicates that the intentions of management have indeed changed and that the property most likely now meets the definition of an investment property. Normally there would be a decision of the BOD to postpone the sale of the property until the market recovers.
The above are only a handful of practical complexities regarding the application of IAS 40.