On December 2, 2009, I was a speaker at an IFRS conference in Toronto, Canada, organized by Acumen Information Services. There were 3 areas that I discussed, all of which seem to be attracting a lot of discussion on IFRS forums, on my web-site blogs, and when I’m talking to people;
• IAS 16 – Property, Plant & Equipment – Revaluation Model and Cost Model.
• IAS 36 – Impairment of Long-Lived Assets, which is tied to Property, Plant and Equipment.
• IAS 40 – Investment Property
The first two topics are relevant to almost every company. Investment Property may not apply to every company, but it does there is a fair value choice associated with it that is important to understand.
In this blog, I am summarizing the discussion on IAS 40 – Investment Property.
Investment Property and the Fair Value Model
The reason I thought it was important to include Investment Property in the presentation, is because Fair Value is a choice within IAS 40, and also to distinguish the Fair Value model from the Revaluation model previously discussed as part of Property, Plant and Equipment.
“Investment Property” under IAS 40 is defined as follows in the standard:
• Property – land and/or building, or part of a building.
• Held, or being constructed or developed to earn:
• Rentals income, or
• Capital appreciation.
It also generates independent cash flows.
Under Canadian GAAP, there are no standards that relate specifically to this type of Investment Property.
I wanted to highlight what Investment Property IS NOT:
• Used in the production or supply of goods or services,
• Used for administrative purposes,
• Available for sale in the ordinary course of business.
A property interest held by a lessee under an operating lease may be classified and accounted for as investment property if, and only if, the property would otherwise meet the definition of an investment property and the lessee uses the fair value model set out in IAS 40 for the asset recognized.
In other words, IAS 40 is primarily concerned with owed or leased rental properties, or properties held long-term in anticipation of a capital gain.
IAS 40 permits to choose either the Fair Value model, or the Cost model. The Fair Value model is set out in IAS 40.
Three of the key points of the Fair Value model are that;
• All changes in Fair Value all go through Operating Income.
• There is no change to depreciation resulting from Fair Value changes.
• Fair Value requires annual valuation.
Cost model is set out in IAS 16, “Property, Plant and Equipment”, and is similar to Canadian GAAP.
Some further details, as extracted from IAS 40….
When the cost model is chosen, fair value is disclosed or, when fair value cannot be reliably determined, the reason why this is not possible should be disclosed, along with a description of the investment property and, if possible, the range of estimates in which fair value is highly likely to lie.
The model chosen should be applied to all investment property.
Investment property under construction or development can be measured at cost until completed, if fair value cannot be reliably measured.
Fair Value Measurement Requirements
I wanted to indicate the definition of Fair Value contained within IAS 40. Fair Value is the price exchanged between:
• Knowledgeable, willing parties
• Arm’s length transaction
• Market conditions at the end of the reporting period.
• Professional appraiser is encouraged, not required (IAS 40.32)
Fair value specifically excludes:
• Price estimated or determined by special terms.
The key point here is that the Fair Value model does not permit estimations – it really needs to be based on market pricing, and if the pricing is readily available, an appraiser is not absolutely required. Estimations scribbled on the back of an envelope, are not what the standard setters had in mind for fair value calculations.
Fair Value Reporting Requirements
The key take away is that ALL changes in Fair Value of INVESTMENT PROPERTY impact the company’s Operating Income. And, Fair Value changes do not impact amortization.
You need to make sure that you understand the distinction between the Fair value model and the Revaluation model – they are two very different models, with two very different accounting treatments.
With the Fair Value model, the valuation must be done annually and any changes booked directly to Operating Income. In comparison, the Revaluation model does not require annual valuation but with sufficient regularity, and any changes are booked either to Balance Sheet as Equity, or possibly to the Income statement, depending on whether there has been a reduction in fair value below net book value.
A simple example to illustrate how the Fair Value model works…
In this example, a property having a cost basis of $100 has a fair value that changes from $120, to $110, and finally $90. All of the changes in Fair Value directly impact Operating Income – unlike the Revaluation model which impacts Equity.
Once again, under IFRS, lots of disclosures are required. I have highlighted some of the more prominent ones;
• Whether the company uses the FAIR VALUE model, or the COST model.
• Methods and significant assumptions applied in determining the fair value.
• Extent to which Fair value of investment property is based on a valuation by an independent valuator who holds a recognized and relevant professional qualification, and has recent experience in the location and category of the investment property being valued.
In addition to these disclosures, an entity that applies the fair value model, shall also disclose reconciliation between the carrying amounts of investment property at the beginning and end of the period, showing the Net gains or losses from fair value adjustments
There is a fairly lengthy list of additional disclosures required under IAS 40, which are detailed in the standard.
Internal Controls … one of my favourite topics
The TRADITIONAL controls would include:
• Investment sub-ledgers
• Reconciliations between the sub-ledger and GL
• Verification of the carrying values.
Some of the ADDITIONAL controls required for the FAIR VALUE Model would include:
• Fair Values – readily available, verifiable.
• Structured, consistent approach – is a system in place to review this annually?
• Professional Appraisers – are these required, and if so, qualifications and experience.
• Disclosure controls – there are about a dozen disclosures required under IAS 40, and there should be a process in place to make sure all pieces of information are gathered and reported. A checklist would come in very handy.
Fair Value or Cost Model
For Investment Property, companies can choose between using the Fair Value Model, or the Cost Model. Although there is a choice, I think for this class of assets, the standard setters are encouraging companies to use the Fair Value model, because it provides more up to date information for investors, and market data is usually readily available. Furthermore, the accounting is fairly straightforward.
The downside with the Fair Value model is the volatility in earnings that result from including changes in Fair Value within operating income.
It should be noted that even if a company elects to use the Cost Model, it must still report the fair values in the footnote disclosures.
Finally, IFRS-1 does provide some exemptions for Investment Property, such as using the fair value as a “deemed cost” at the time of transition, to avoid any problems with retrospective application when using the Cost Model.
I hope this helps. This is one of a series of blogs that is meant to convey information relating to Canada’s transition from Canadian GAAP to IFRS.
For further information, please refer to the ongoing series of IFRS blogs on the Edelkoort Smethurst Schein CPA’s LLP web-site or send me a note, and please remember to contact your accounting professional for further guidance.
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