By Simon Fisher, Partner, RSM Eastern Africa - taken from RSM Reporting - Issue 27.
IAS 40 was first issued in 2000. The standard requires an entity to determine whether property (land and buildings) should be classified as investment property, defined as property held to earn rentals or for capital appreciation (or both). If so, the entity then has a choice of whether to account for it using the cost model or the fair value model. Since fair value gains on property can be significant, the appropriateness of the classification is important.
The standard was revised in 2003 to allow property held under an operating lease, that otherwise met the definition of investment property, to be classified as investment property. The revision also brought investment property under construction within the scope of the Standard. In the last ten years, however, there has not been any significant change to the Standard. There is therefore plenty of implementation experience, but issues of interpretation and implementation still arise in practice, while the Standard itself recognises that judgement is needed to determine whether a property qualifies as an investment property.
Our first example of this relates to investment property under construction, where an entity has purchased land for development and has, say, entered into a contract for the construction of a building. Classification on initial recognition and subsequent measurement of this property will be dependent on whether the property, when developed, will:
- be occupied by the owner (own use), in which case it will be classified as property, plant and equipment and measured in accordance with the entity’s accounting policy (cost or revaluation model);
- be sold, in which case it will be classified as inventory and measured at the lower of cost and net realisable value; or
- be held to earn rentals or for capital appreciation or both, in which case it should be classified as investment property, and could be measured at fair value if that can be measured reliably.
If the entity wanted to subsequently reclassify such property, IAS 40 requires such a change to be supported by evidence. At present, the Standard is specific in saying that inventory can only be reclassified to investment property on commencement of an operating lease. A recent exposure draft proposed a relaxation of this whereby it would be recognised that there could be other examples of evidence that could support reclassification, but a change in intention is not sufficient – it must be supported by appropriate evidence.
AS 40 is silent, however, on the need for any evidence to support the classification on initial recognition. So, can that be based purely on management’s representations as to their intentions? Our view is that management would still be expected to provide supporting evidence: for example, do management’s cash flow projections support their intention to hold the property for rental subsequent to completion, or is there a need to sell the property on completion to meet financing obligations? Is the entity already looking for a buyer, or tenants?
Suppose that management has simply not decided whether to sell the property on completion of the development, perhaps because the decision will depend on the strength of property prices around the time of completion, or on the entity’s other financing needs at that time. IAS 40 provides examples of investment property, which include ‘land held for a currently undetermined future use’ and ‘property that is being constructed or developed for future use as investment property’. Note that the first example refers only to land (presumably undeveloped) and excludes buildings. So there is no guidance on how to classify property that is being constructed or developed for undetermined future use. It is therefore an area where judgement would need to be exercised, taking into account all the facts and circumstances, but clearly the more prudent approach would be to classify such property as inventory until such time that there is evidence to support its reclassification to investment property.
Another issue that has arisen in practice is whether land and buildings should be treated as separate assets when determining their classification. IAS 16 Property, Plant and Equipment (PPE) requires that land and buildings be accounted for separately, even when acquired together, but this is because the useful life of each component for the purposes of depreciation is likely to be different. IAS 40 does not require such separation for classification purposes, but if investment property is accounted for using the cost model, then IAS 16 would apply. Instead, IAS 40 refers to ‘portions’ of properties and states that if these portions could be sold separately then an entity accounts for the portions separately, and hence would determine the classification of each portion separately. An obvious example is land surrounding a factory that is surplus to the entity’s requirements. If the surplus land could be sold separately, and is of undetermined future use, then it should be classified as investment property, whereas the factory and the portion of land on which it stands would be classified as PPE. However, it could also be argued that a finance lease for the factory building could be sold to a third party and the whole of the land could be sold to a different third party. In our view, judgement needs to be exercised to consider whether selling each portion separately is a realistic option, not just legally possible.
IAS 40 states that if the portions cannot be sold separately, the property is investment property only if an insignificant portion is held for use in the production or supply of goods or services or for administrative purposes. As with other IFRS, no quantitative guidance is given as to what might be considered ‘insignificant’. In this case, neither does the Standard provide any guidance on how the significance of a portion might be measured. In a simple situation of an office building, where some of the lettable space is occupied for own use, then one would probably consider the lettable space (e.g. floor area) occupied as a percentage of the total lettable space in determining whether the ‘own use’ portion was significant. In other circumstances it might be more appropriate to consider the values of each portion. An example might be an old building on a plot of land, which cannot be sold separately, but where the value of the building is an insignificant portion of the value of the plot.
IAS 40 makes it clear that classification on consolidation by a parent may need to be different from the classification in a subsidiary entity that owns the property. Thus, if entity C, which is 60% owned by entity A and 40% owned by entity B, owns property of which, say, 20% is leased out to entity A and 80% to entity B, entity C should classify the property as investment property and could apply the fair value model. Assuming that entity A controls entity C, then in its consolidated statement of financial position, entity A would need to classify the property as property, plant and equipment under IAS 16, since it occupies a significant portion of the property. On the other hand, if entity B accounts for its interest in entity C using the equity method, then it could recognise its share of the fair value gain on the property, even though it occupies 80% of the property. This difference occurs because C’s property does not appear in B’s statement of financial position, so the issue of classification does not arise for entity B.
There could also be a situation where a subsidiary is developing a property for future use as an investment property, but the parent has the firm intention to sell its interest in the subsidiary as soon as the development is complete. Judgement would have to be exercised to determine whether in this case the parent entity should classify the property as inventory in its consolidated statement of financial position.