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Overview of the investment property industry
The investment property industry, or real estate
industry as it is also referred to, comprises entities
that hold real estate (land and buildings) to earn
rentals and for capital appreciation .
Some entities may be involved in construction of
properties on behalf of third parties
and holding properties for sale . Such activities
are not described in this chapter.
The investment properties are held through a variety
of structures that include listed and privately
held corporations, (investment) funds, partnerships
and trusts .
How to use this supplement
This chapter includes an overview of the main issues
encountered by investment property entities and
provides links to relevant solutions.
The issues are categorised as follows:
Principles/concepts
Reporting financial performance
Acquisitions and disposals
Revenue recognition
Measurement
Provisions
Financial instruments
Principles/concepts
Cost or fair value model
IFRS provides entities with a choice for the measurement
of investment properties: at depreciated historical
cost (less impairment losses) or at fair value (with
changes in fair value recognised in the income statement).
The choice has to be made on first application and
has to be applied consistently for all investment
properties .
An entity that chooses to change its accounting
policy from cost to fair value should account for
the change in accounting policy retrospectively.
Therefore, the opening retained earnings for the
comparative year should be adjusted together with
the comparative year income statement and balance
sheet as if the new accounting policy had always
been applied, except in the unlikely event that
retrospective application is impracticable [IAS8R.22-23].
Functional and presentation currencies
Management selects the most appropriate functional
currency based on the requirements of IAS 21R. There
is no free choice of functional currency . Functional
currency is the currency of the primary economic
environment in which the entity operates [IAS21R.8].
The primary economic environment in which an entity
operates is normally the one in which it primarily
generates and expends cash .
The functional currency determination is straightforward
for a simple IPE operating in a single country.
As IPE's become more complex the question of functional
currency can be more problematic.
A listed investment property fund might be domiciled
in a particular country, its shares traded on the
country's stock exchange and denominated in the
local currency. However it might not hold all or
any of its investment properties in that country
. An IPE may own and operate properties
that are impacted by a number of different currencies
. The currency of the primary operating
environment is the most relevant factor in determining
functional currency .
An entity may choose to present its financial statements
in any currency (or currencies) . The translation method
from the functional currency to the presentation
currency depends on whether the functional currency
is the currency of a hyperinflationary economy .
Taxation
The general principles of recognition and measurement
of income taxes set out in IAS 12R apply to all
domestic and foreign taxes that are based on taxable
profits .
Investment properties are, in some jurisdictions,
held in individual legal entities. This allows entities
to buy and sell properties without the need to change
the legal title and avoid paying stamp duties as
a consequence. Specific structures may also give
rise to tax planning opportunities where the tax
rate for the sale of property is different from
the sale of shares. The tax advantages may be shared
between buyer and seller which gives rise to issues
around transaction costs and deferred tax .
Start-up costs
Expenditure is incurred to provide future economic
benefits to an entity, but often no intangible asset
or other asset is acquired or created that can be
recognised. Such expenditure is recognised as an
expense when it is incurred [IAS38R.69]. An example
of expenditure that is recognised as an expense
when it is incurred includes start-up costs, unless
this expenditure is included in the cost of an item
of property, plant and equipment in accordance with
IAS 16 Property, Plant and Equipment. Start-up costs
may consist of establishment costs such as legal
and secretarial costs incurred in establishing a
legal entity, expenditure to open a new facility
or business (i.e. pre-opening costs) or expenditure
on starting new operations or launching new products
or processes (i.e. pre-operating costs) [IAS38R.69(a)]
.
Start-up costs when an entity is initially set up
should be expensed as incurred.
Reporting financial performance
The general principles of presentation of financial
information set out in IAS 1R apply to all financial
statements prepared in accordance with IFRS by investment
property entities .
Income statement
The general principles of presenting the income
statement apply to all investment property entities
.
The industry's performance is usually measured on
both the rental income and the appreciation in value
of the investment properties; therefore entities
may prefer to disclose their income statement by
function rather than by nature of expenditure .
The income statement should always be presented
in accordance with the requirements of IAS 1R. Additional
information that management may consider to be of
relevance to the users may be disclosed in the notes
or in the segment information. Such disclosure should
be presented consistently from year to year [IAS1R.27].
Segment reporting
An entity whose equity or debt securities are publicly
traded or is in the process of issuing equity or
debt securities in public securities markets should
provide segment reporting in accordance with the
requirements of IAS 14R [IAS14R.3] .
Segments are reported as either primary or secondary
segments [IAS14R.26]. Business segments is the primary
format if the products and services represent the
predominant source and nature of risks and returns,
and geographical segments are secondary. The order
is reversed if the geographical risks are dominant.
The risks and returns for certain entities are strongly
affected both by differences in the product groups
and by differences in the geographical areas. Where
there is a 'matrix' approach to internal reporting,
IFRS stipulate the use of business segments as the
primary segment reporting format and geographical
segments as the secondary reporting format [IAS14R.27(a)]
.
A geographical segment may be a single country,
a group of two or more countries, or a region within
a country. An entity that holds investment properties
in different geographical locations should consider
the risks and rewards of each individual region
in considering whether there is a reportable geographical
segment [IAS14R.9] .
Acquisition and disposal of investment properties
Investment properties can be acquired directly or
through the acquisition of another entity. The acquisition
of another entity may qualify as a business combination
.
The disposal of investment properties may be achieved
either through a disposal of business or through
direct disposal of the property. Revenue from the
sale of investment properties should be recognised
when the requirements of IAS 18R are met [IAS18R.14].
Consolidation
An investment entity should prepare consolidated
financial statements in which it consolidates all
its investments in subsidiaries [IAS27R.9-10] .
A subsidiary is an entity controlled by another
entity. Control is the power to govern the financial
and operating policies of an entity so as to obtain
benefits from its activities [IAS27R.4] .
Investments in joint ventures
Investment property entities may have investments
through joint ventures. A venturer may choose to
report its investment in a joint venture using either
proportionate consolidation or equity accounting.
Determining whether joint control exists depends
on the substance of the agreement(s) and requires
careful consideration of the IAS 31R criteria [IAS31R.9-12]
.
Special purpose entities - not qualifying
as businesses
Investment properties are sometimes held in special
purpose entities and their acquisition may not qualify
as a business .
On acquisition of special purpose entities that
do not qualify as business combinations, the acquirer
should follow the same treatment as for a direct
asset purchase. Therefore no goodwill or fair value
adjustments arise. The acquirer should record only
the fair value of the consideration paid or payable.
The same treatment should be followed for both the
acquirer's consolidated and stand alone financial
statements .
The acquisition of such entities and the subsequent
valuation of their investment properties have different
impact on deferred tax calculations for the purposes
of consolidated and stand-alone financial statements
(See section above: 125.3.3 - Taxation).
Disposal of investment property
Entities in the investment property sector may sell
properties for which a part of the consideration
is receivable at a future point in time. Revenue
should be measured at the fair value of the consideration
received or receivable [IAS18R.9]. The fair value
of revenue may be less than the nominal amount of
cash received or receivable when the receipt of
cash or cash equivalents is deferred. The fair value
of the consideration receivable is determined by
discounting all future receipts using an imputed
rate of interest when the arrangement effectively
constitutes a financing transaction [IAS18R.11]
.
Revenue recognition
Revenue recognition - lease income
Lease income from operating leases is recognised
in income on a straight-line basis over the lease
term, unless another systematic basis is more representative
of the time pattern in which use benefit derived
from the leased asset is diminished [IAS17R.50].
Lessors often give certain tenants incentives to
occupy property. Examples of incentives include
rent-free periods and discounts during the initial
periods of the lease. All incentives for the agreement
of a new or renewed operating lease should be recognised
as an integral part of the net consideration agreed
for the use of the leased asset. The incentive's
nature or the form or timing of payments is not
relevant [SIC15.3]. The lessor should recognise
the aggregate cost of incentives as a reduction
of rental income over the lease term, on a straight-line
basis unless another systematic basis is representative
of the time pattern over which the benefit of the
leased asset is diminished [SIC15.4] .
A lessor in an operating lease, who is a first-time
IFRS adopter, should recognise rent incentives from
the inception of the lease, not from the date of
IFRS adoption .
Investment properties may be subject to a lease
agreement which specifies that the amount receivable
under the agreement is also based on an underlying,
for example, the tenant's turnover for the period.
Revenue can be recognised only when the outcome
of a transaction can be estimated reliably [IAS18R.20].
The outcome of a transaction can be estimated reliably
when certain conditions (reliability of revenue
measurement, flow of economic benefits is probable,
reliability of measurement of stage of completion
and costs to complete) are met [IAS18R.20] .
Payment/receipt of premium for prime location
Lessors in the investment property sector may receive
initial premia over and above annual rents to grant
access to property in a prime location. All incentives
for the agreement of a new or renewed operating
lease should be recognised as an integral part of
the net contribution agreed for the use of the leased
asset, irrespective of the incentive's nature or
the form or timing of payments [SIC15.3]. The lessor
should recognise the aggregate cost of incentives
as a reduction of rental income over the lease term,
on a straight-line basis unless another systematic
basis is representative of the time pattern over
which the benefit of the leased asset is diminished
[SIC15.4] .
Revenue recognition - surrender/ break costs
Investment property entities may receive surrender
premiums/break costs from tenants seeking to vacate
leases before the expiry of the lease term. Surrender
premiums received should be taken directly to income
either when the break clause/surrender premium is
contractually arranged or when it is negotiated
and agreed .
In some cases a tenant pays monthly payments to the lessor to bring the building to its original (pre lease condition on the tenant's behalf. These monthly payments should be recognised as revenue on a straight-line basis over the lease term .
Revenue recognition - other
Investment property entities that are leasing out
properties under operating leases usually generate
rental income and other forms of revenue from the
lessees. The lessor may also undertake other transactions
that do not directly generate revenue but which
are incidental to the revenue generating activities.
Income and related expenses may only be netted off
when this presentation reflects the substance of
the transaction [IAS1R.34].
Items of income and expense are offset only when
IFRS requires or permits it [IAS1R.32]. Gains and
losses arising from a group of similar transactions
are aggregated unless material [IAS1R.35].
Service costs billed to tenants (the lessees) will
be presented gross in the income statement of a
lessor, unless the lessor acted as an agent on behalf
of a third party, for example as a tax collector
.
Measurement
Investment property is initially measured at cost
including transaction costs [IAS40R.20]. Cost comprises
the property's purchase price. Transaction costs
include legal fees, property transfer taxes and
all expenses directly attributable to the acquisition
of the property [IAS40R.21] .
Initial recognition
The cost of an investment property excludes start-up
costs (unless they are necessary to bring the property
to its working condition), initial operating losses
incurred before the investment property achieves
the planned level of occupancy and abnormal amounts
of wasted material, labour or other resources incurred
in constructing or developing the property [IAS40R.23].
Such costs, incurred in the period after the acquisition
(or completion) of an investment property, do not
form part of the investment property's carrying
amount, and should be expensed as incurred .
External transaction costs relating to the acquisition
of an investment property should be included in
the carrying amount of the investment property [IAS40R.21]
.
Internal transaction costs should be expensed as
incurred .
Borrowing costs incurred for the purpose of acquiring,
constructing or producing an asset may be capitalised
as part of its cost [IAS23.11]. Borrowing costs
capitalised will be mainly interest costs but can
include arrangement fees and exchange differences
arising on foreign currency borrowings to the extent
that they are regarded as an adjustment to interest
[IAS23.5(e)] .
The cost of a purchased investment property comprises its purchase price, and any directly attributable expenditure. Directly attributable expenditure includes professional fees for legal services, property transfer taxes and other transaction costs [IAS 40R.21]. A rental guarantee obtained from developer when purchasing the investment property should be accounted for as a separate financial asset under IAS 32.39
Group costs considered to be directly attributable should be capitalised in stand alone financial statements as part of the cost of the investment property. The recharge of costs should also be disclosed as a related-party transaction [in accordance with IAS 24R.3] and should be eliminated in the consolidated financial statements of the group.
Subsequent expenditure
Subsequent expenditure should be recognised in the
carrying amount of the investment property if, and
only if, such expenditure is expected to produce
future economic benefits to the entity, its costs
can be reliably measured and these costs demonstrably
add to, replace part of, or service a property [IAS40R.16]
[IAS40R.17] .
Such costs are, in general, capitalised within the
carrying amount of an investment property when they
increase the investment property's originally assessed
standards of performance or when they replace a
fully depreciated component .
The costs of the day-to-day servicing of the investment
property - primarily the cost of labour, consumables
and other minor parts (often described as "repairs
and maintenance") - should be expensed as incurred
[IAS40R.18].
Investment property entities may pay surrender premiums/break
up costs to their tenants in order to remove them
from the property before the expiry of their lease.
If, subsequent to the removal of the old tenant,
the investment property is either re-let or undergoes
extensive redevelopment, the cost paid for surrender
should be expensed as incurred
.
Subsequent measurement
Subsequent to initial recognition, an entity should
either carry investment property at fair value or
at depreciated historical cost .
Entities using the cost model are required to disclose
the fair value of an investment property in the
notes to the financial statements [IAS40R.79(e)].
Investment properties carried at fair value are
not subject to an impairment test [IAS36R.2(f)].
Investment properties carried at cost are subject
to impairment testing under the usual rules for
impairment testing .
Fair value considerations
Fair value is the amount for which an asset could
be exchanged between knowledgeable, willing parties
in an arm's length transaction [IAS40R.5]. Acceptable
valuation techniques include the use of market comparable
information and discounted cash flow techniques.
Investment property entities incur transaction costs
(for example, agents' fees and legal fees) on selling
an investment property. Transaction costs should
not be deducted from the estimated fair value. An
entity determines the fair value of an investment
property without any deduction for transaction costs
it may incur on sale or other disposal [IAS40R.37].
Transaction costs relating to a future sale should
only be considered when the property is held for
trading purposes (as inventory) or is held for sale.
An investment property in inventory is held "at
the lower of cost and net realisable value"
[IAS2R.9]. An investment property held for sale
is measured at the lower of carrying amount and
fair value less costs to sell [IFRS5.15]. Both measurement
bases include costs to sell .
The fair value of an investment property is usually
obtained using discounted cash flow. The valuer
will use the cash flows in accordance with the existing
lease agreement and the expected cash flows thereafter.
An anomaly may arise as a result of valuing the
investment property based on discounted cash flows
and the straight lining of rental income. The accrual
element of any revenue/incentive provided will be
shown on the entity's balance sheet; therefore an
element of double counting may occur. The fair value
of investment property excludes prepaid or accrued
operating lease income, as the entity recognises
it as a separate liability or asset [IAS40R.50(c)]
.
Redevelopment of investment property
An investment property under redevelopment for continued
future use should continue to be recognised as investment
property. It is measured at either cost or fair
value depending on the accounting policy adopted
by the entity.
Property held for sale in the ordinary course of
business is inventory rather than investment property
[IAS40R.9(a)]. Properties that are going to be redeveloped
before being sold should be re-classified to inventory.
When an entity decides to dispose of an investment
property without development it continues to treat
the property as an investment property [IAS40R.58].
An investment property will remain in this category
until it is classified as "non-current asset
held for sale" when it is available for immediate
sale in its present condition and sale is highly
probable. For a sale to be highly probable management
must be committed to a plan to sell the property
and have an active programme to locate a buyer and
complete the plan. The property must be actively
marketed at a price that is reasonable in relation
to its current fair value and the sale should be
expected to qualify for recognition as complete
within one year [IFRS5.8]. An investment property
carried at fair value is not re-measured [IFRS5.5(d)].
Investment properties under the cost model that
meet the criteria to be classified as held for sale
are re-measured in accordance with IFRS 5.
Provisions
Provisions can be distinguished from other liabilities
such as trade payables and accruals because there
is uncertainty about the timing or amount required
in settlement .
A provision should be recognised when and only
when :
| a) |
an entity has a present
obligation (legal or constructive) as a result
of a past event; |
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| b) |
it is probable (i.e. more likely than not)
that an outflow of resources embodying economic
benefits will be required to settle the obligation;
and |
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| c) |
a reliable estimate can be made
of the amount of the obligation. A reliable
estimate will be possible except in extremely
rare cases. |
A constructive obligation is an obligation that
derives from an entity's actions where through an
established pattern of past practice, published
policies or a sufficiently specific current statement
the entity has created a valid expectation on the
part of those other parties that it will discharge
those responsibilities [IAS37.10].
Future planned repairs and maintenance of an investment
property should not be provided for as they do not
meet the definition of a present obligation and,
therefore, a provision cannot be established .
Financial instruments
Deposits paid/received
Tenant deposits qualify as "financial instruments"
when the contract gives rise to a financial asset
of one entity (the lessee) and financial liability
of another entity (the lessor) [IAS32R.11]. Financial
instruments should be measured in accordance with
IAS 39R .
Embedded derivatives
IFRS requires all derivatives to be classified as
"Financial assets at fair value through profit
or loss" .
An embedded derivative is an instrument which qualifies
as a derivative instrument that is embedded in a
non-derivative host contract (i.e. lease contract)
.
An embedded derivative in a lease contract should
be separated from its host contract and accounted
for separately only if its economic characteristics
and risks are not closely related to the lease contract's
economic characteristics and risks [IAS39R.11(a)]
and a separate instrument with the same terms as
the embedded derivative would meet the definition
of a derivative within the scope of IAS 39R.
Property lease payments are often linked to general
country inflation indices, general country property
indices and revenue of the lessee's business (all
considered as closely related) or lessee's profitability,
lessee's stock market price or general country's
stock exchange indices (all not closely related).
Foreign currency denominated lease payments/receipts
in some circumstances may also represent a non-closely
related embedded derivative .
Upward-only rent reviews that arise within the lease
term do not qualify as embedded derivatives; instead,
they qualify as contingent rents .
Impairment
Lease receivables, recognised in accordance with
IAS 17, are subject to IAS 39R rules for impairment
. General provisions are not allowed.
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