IAS 40 Investment Property

Karlstads Business School, department of Economy Nicole Dang IAS 40 Investment Property The amendment of IAS 40 International Financial Accounting D-level thesis Date/Term: 09-10-26 Supervisor: Bernt Andersson Examiner: Bernt Andersson Karlstads universitet 651 88 Karlstad Tfn 054-700 10 00 Fax 054-700 14 60 Information@kau.se www.kau.se

Abstract Since IAS 40 Investment Property applies for all listed companies in EU year 2003 and the fair value valuation became available there have been discussions after the implementation. Now in year 2009, the latest discussion and amendment in the standard has gone through. The amendment in IAS 40 was concerning investment property under construction. IASB approved that IAS 40 Investment Property also will applies to investment property under construction, if their aim is to become investment properties in the future. At first, properties under initial development were excluded from IAS 40 and were treated as fixed assets carried at cost. Entities could therefore not calculate gains of building projects until they were completed (Marshall 2004). Wessels (2008) states the new standard takes out calculated guesses on the value of the development and reflects what is happening in the actual market. New Zeeland had a discussion about the supplementary costs for New Zeeland entities which comes with the new amendment, were an independent part is required for review when valuation is made (Chartered Accountants Journal 2008). Valuation of constructions is according to me a more difficult process than to valuate a completed property since there are higher risks and more uncertainties within the construction. Because of this I think it is necessary to be more concrete and specific about the valuation process of investment property under construction. In general I think the upcoming problems within the amendment are all about lack of guidance in IAS 40. Overall I think the forthcoming problems within the amendment are all about lack of guidance in IAS 40. However I do think this is an improvement, but an unfinished improvement which requires more development and needs to be more worked on.

Table of contents 1. METHOD... 1 2. THEORETICAL FRAMEWORK... 2 2.1 INTRODUCTION... 2 2.2 INTERNATIONAL ACCOUNTING STANDARDS BOARD... 2 2.3 IAS 40 INVESTMENT PROPERTY... 3 2.5 OPINIONS ABOUT THE AMENDMENT OF IAS 40... 5 3. DISCUSSIONS AND CONCLUSIONS... 7 4. BIBLIOGRAPHY... 9

1. Method In order to understand more about the new change within IAS 40 Investment Property, I have chosen to first describe the authority which issues the standard, International Accounting Standards Board (IASB). It is important to understand the structure of IASB and how they proceeding when develop and improving their framework, since this would clarify the question why they approved the amendment in IAS 40. Further on a definition of IAS 40 and the valuation methods in IAS 40 are also explained, which I think is needed in order to understand the amendment of IAS 40 and the following dilemmas which are discussed in the paper. To obtain a more complete picture of the standard I have also chosen to describe how the amendment of IAS 40 was proposed to IASB and was first dismissed. I think it is necessary in turn to get a critical view and to understand why it is still disagreements about this improvement in IAS 40. There have been difficulties in finding scientific articles and research material on this area since IASB recently approved this amendment. For that reason I wanted to include opinions about the amendment from a diversity of users. Their opinions are important since they practice this standard at a daily basis and thus could encounter and identify problems. As mentioned, this amendment of IAS 40 is still fresh and there is not much written about the outcome, because of this I obtained the most information from trustworthy homepages, published articles from auditing firms, exposure drafts from authorities which deal with investment property, lesson notes from Bo Nordlund s lecture about real estate and some scientific articles. With this as basis, I am presenting a discussion containing my areas of interest and focus points for this paper, from my own perspective. Conclusions and suggestions for improvements will be presented in the final part of my writings. Page 1

2. Theoretical framework 2.1 Introduction The original version of IAS 40 Investment Property was first available in year 2000. EU later implemented the standard and it then applied for all listed companies within member countries. Fair value accounting was then offered as measurement basis for investment properties. The first major change in IAS 40 came when IASB approved leaseholds to be accounted as investment properties. Now in year 2009, the latest discussion and amendment in the standard has gone through. The amendment in IAS 40 was concerning investment property under construction. Investment property under construction which before was in the scope of IAS 16, will now be accounted as for investment property and fall within IAS 40.The EU has yet so far not implemented the amendment of IAS 40. Since this is a recent change in the standard, there are so far no studies about how this amendment would effect valuation of property under constructions. 2.2 International Accounting Standards Board International Accounting Standards Board (IASB) are the issuer of the International Financial Reporting Standards (IFRS), which is applicable to general financial statements of all commercial, industrial or business reporting entities whether it is private or public. 1 EU implemented IFRS in 2002 and all listed companies in member countries must therefore use the IFRS in their annual consolidated financial statement (Tew 2003). The IASB is an independent standard setting body and is overseen by the Trustees of the International Accounting Standard Committee (IASC) (IASB 1 2009). IASB describes their objective as to develop a single set of high quality, understandable and enforceable accounting standards to help participants in the world s capital markets and other users make economic decisions (IASB 3 2009). The purpose of IASB is also to provide users and investors with relevant information that could be useful in their decision making when facing financial issues 2. The Trustees are experts and have longtime experiences within different economic areas and are selected for a three-year period in order to act for the best of public interest (IASB 2 2009). The Trustees reviews and support IASB in their work and also oversees the use of IFRS. The Trustees are involved in the consultation process, the developing process of IFRS, where they improve amendments after discussions with organizations around the world and interested individuals. The consultation process is divided in several stages and the Trustees are responsible for steering the process to the final stage, meaning publish the amendment after approval 3. While the Trustees working with improvements within the IFRS framework, the International Financial Reporting Interpretations Committee (IFRIC) acts as reviewer of the IFRS. They are chosen by the Trustees for reviewing arising issues within the IFRSs and also for develop interpretations of the standard (IASB 4 2009). 1 Dominic Ranches. Lecture; Introduction to IFRS 090915. 2 Bo Nordlund. Lecture; Valuation and Accounting property 091009. 3 Gunnar Rimmel. Lecture; Current International developments 090929. Page 2

2.3 IAS 40 Investment property Definition IAS 40 paragraph 5 defines an investment property as (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. In other words, an investment property is not aimed for business purposes or sale. The purpose of an investment property is to generate rental income or capital appreciation or a combination of these. Further on in IAS 40 paragraph 10, states that if a part of the investment property is used for business purposes, that part shall be accounted separately, but this is only due to if it can be sold separately. If the portions cannot be sold separately, the property can only be classified as investment property, if the portions which are aimed for business purposes are insignificant (Sundgren et al. 2007). Valuation methods, Fair value and Cost-model At the Swedish implementation of IAS 40, IASB permits users to retain value accounting under cost-method or adopt fair value (IAS 40:30 2009). If fair value method is chosen, it is not possible to revert to the cost-model method (IAS 40:31 2009). However, the same method is required for all investment properties, but with the exemption in IAS 40:53 which implies that "reliable market valuation can be made" (Sundgren et al.2007). The cost-model uses the historical cost with a reduction of accumulated depreciation, when calculating values of investment properties. If relevant, the impairment losses of the property will also be considered in the calculation (Nordlund 2 2008). Fair value is described in IAS 40 paragraph 5 as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm s length transaction 4. Fair value method obliges entities to carry the fair value of their investment properties and present it within the Balance sheet. Adjustments of the fair value shall be reported in the income statement and there will be no depreciation on the properties (Nordlund 2 2008). The change in fair value of investment properties will be included in the entities operating profit thus affecting the income statement more than valuation at cost, but in return it will provide a greater relevance in the balance sheet (Sundgren et al. 2007). A recent study made by Stella So and Malcolm Smith demonstrates that fair value method is highly preferred, though the free choice between the two methods (So & Smith 2009). Pursuant to Laux & Leuz (2009), cost accounting may not be the most appropriate measurement in situations where the value only can be decided by an operating market. In such circumstances the operating market would be volatile and thus cost accounting would not reflect the current fundamental value of the object (Laux & Leuz 2009). Further on Muller et al. (2008) also implies that entities which chose to not provide fair value accounting are facing higher information asymmetry. Trussel & Rose (2009) have a another perspective and indicates that those who support cost accounting thinks fair value accounting as less reliable, since it could lead to short term fluctuations and extreme volatility in the balance sheet. 4 Dominic Ranches. Lecture; Introduction to IFRS 090915. Page 3

2.4 Amendment of IAS 40 The proposal of adjustment of IAS 40 was discussed in 2007 and by May 2008 the IASB approved the new change in IAS 40 (IVSC 2 2009). The issue from the beginning was if investment property under construction should be included in IAS 40 Investment Property instead of under the rules of IAS 16 Property, Plant and Equipment (IASB 2006). At first, properties under initial development were excluded from IAS 40 and were treated as fixed assets carried at cost. Entities could therefore not calculate gains of building projects until they were completed (Marshall 2004). IFRIC proposed to IASB in 2006 and reflected about the inconsistency within the IAS 40, where investment property redevelopment is included but investment property under construction is excluded and instead fall in the scope of IAS 16. They appointed the major similarities between the two categories, and also thought the two should be valued within the same standard (IASB 2006). IFRIC also though fair value accounting has become more pervasive and the valuation techniques more robust, therefore should investment property under construction belong within the scope of IAS 40 (IASB 2006). IFRIC also reflected that there was an increasing experience regarding the use of fair value as measurement basis among entities. Because of this, it would let entities to be more able of measure the fair value of investment property under construction with reliability (IASB 2006). This proposal was first dismissed by IASB, since they thought there may be no existing market for investment property under construction thus making fair value valuation complicated. Secondly the IASB also feared about the uncertainty costs which occur to complete investment property under construction and also about the future income it will generate (IASB 2006). However, IASB did agree upon the fact that fair value accounting is the most reliable measurement when it comes to property valuation (IASB 2006). IFRIC appointed about the retain cost-model method in existing IAS 40, which is available for countries with less develop property markets. After discussions with organizations and other authorities which mainly are in agreement with IFRIC, IASB approved that investment property under construction will in the future also be in the scope of IAS 40 Investment Property (Deloitte 2009). The amendment of IAS 40 applies to all investment properties under construction on the 1 st of January 2009 or after, meaning all investment properties under construction of this date or after will be measured at fair value (IVSC 2 2009). This is only due to if the purpose of the property under construction is to become an investment property in the future (Nordlund 2008). There is though an exemption within the standard that allows entities to apply the amendment of IAS 40 to investment property under construction before the 1 st January 2009, but this is only if there are a possibility of determining the fair value of the property construction before the issue date of the amendment (Ernst & Young 1 2009). The amendment of IAS 40 allows entities to choose between the fair value methods or the costmodel method, this selection applies to all investment properties within the entity. Meaning it is not admissible to use fair value method for investment property, but exercise cost-model for investment property under construction (PricewaterhouseCoopers 2009). If the cost-model is chosen as a measurement for investment property under construction instead of fair value method, an estimation of fair value is still required to be presented in a note within the balance sheet (IVSC 2 2009). Page 4

There are situations where an entity has chosen to practice the fair value method as a measurement basis, but afterwards not be able to determine the fair value of its properties under construction. In such cases, IAS 40 allows those properties under construction to be calculating at cost until the fair value could be reliable determined or when the construction is completed (IAS 40:53 2009). This exemption is only accepted when there is lack of comparable market transactions and reliable alternatives for estimation of the fair value are not available (IAS 40:53 2009). It is assumed by IASB that the fair value becomes reliable determined when the property construction is completed and therefore are entities obliged to change back to the fair value method when this occurs (IAS 40:53A 2009). 2.5 Opinions about the amendment of IAS 40 According to Wessels (2008) was the old way of calculating investment property under construction not the best or accurate method to present truth value. She states the new standard takes out calculated guesses on the value of the development and reflects what is happening in the actual market. This means that entities not only have to calculate construction cost but also have to estimate the asset value depending on what it would be sold in the market (Wessels 2008). In 2008 New Zeeland had a discussion about the amendment in IAS 40. The concerning was about supplementary costs for New Zeeland entities which comes with the new amendment, were an independent part is required for review when valuation is made (Chartered Accountants Journal 2008).Valuate an investment property in accordance to the fair value method is already tricky enough and it would be a more problematic situation if this applies to a property under construction (Chartered Accountants Journal 2008). According to the standard, an independent part is not required when determining the fair value of properties, but they are encouraged to do so (IAS 40:32 2009). Wessels (2008) also mentioned that this change could affect entities either in a positive or negative way, depending on the property market. It would be positive for entities if there is a rising property market and thus reflecting higher values of the asset in the books than the construction costs. On the other hand it would be negative for entities if there is high inflation or a declining property market. Since it would lead to low property market values and therefore could construction costs exceeds fair values of properties being built. According to Ernst & Young (1 2009) there will be some difficulties in finding comparable properties under construction thus estimation models will be required for valuation. So far there is no specific valuation guidance in IAS 40 about investment property under construction and thus making the valuation process more complicated for users (Ernst & Young 1 2009). In another perspective Ernst & Young (2 2009) thinks this new amendment of IAS 40 is an overall improvement since measure investment property under construction at fair value will also give investors further information about the profit potential. PricewaterhouseCoopers (2009) reflects that the old version of IAS 40 included major investment property reconstruction thus excluding investment property under construction, which results an inconsistency within the standard. This dilemma was also agreed by Ernst & Young, which appointed that this new amendment would improve the consistency of IAS 40 (Ernst & Young 2 2009). Ernst & Young (1 2009) suggests entities to present value of the investment property under construction as a part of total investment property in the Balance sheet. If entities have both investment properties under construction and completed investment properties, it is best to present these two categories separately (Ernst & Young 1 Page 5

2009). To be more precise and provide external parties a more accurate view, notes and also further assumptions and accounting estimations for both categories could be added within the Balance sheet (Ernst & Young 1 2009). Page 6

3. Discussions and conclusions In the past few years there have been discussions about the valuation issues within IAS 40, whether if fair value accounting is more appropriate as measurement basis for investment property than cost accounting. There are still disagreements among users and authorities upon this matter. However, the use of fair value seems to be more accepted than before and according to IFRIC there are increasing experiences among entities regarding the use of fair value. This was one of the reasons of why IAS 40 now also applies to property under constructions. I do think this was positive change within the standard and also an improvement. First of all I do not understand why property constructions were first excluded from the standard while property rebuilding was not. I do not see any differences between a property construction and a property rebuilding. A major rebuilding of the property could mean tearing the entire property down to bare ground and starts to build up again, even though there is no property left to be rebuilt. In such situations I think it is more likely to define the property as under construction rather than as a property rebuilding. However the definition line between those two terms was very subtle and thus I agree with PWC and Ernst & Young that this amendment would reduce the previous inconsistency within the standard. According to Wessels (2008), is fair value accounting able to show the real value of the property construction, since it would reflect the value of the construction project due to the existing market. As I know the property market is in many ways similar to the stock market, it all depends on the willingness of what others would pay for the stock or the asset within the existing market. Because of this I think practice fair value accounting on investment property under constructions would lead to a more truthful picture of the property and it would also be beneficial to investors as they can later easier estimate or determine the fair value of the completed property. Although this change is welcomed by me and most users, I still find some weakness within the amendment. First of all, I think the market for property under construction is in general very poor. As Ernst & Young mentioned about difficulties in finding comparable properties under construction thus estimation models will be required in order to find fair value of the construction. I agreed with Ernst & Young, that it should be a specific guidance in this area or otherwise it could cause confusions among users. I think the lack of specific guidance in the standard could result a huge range of diversity when it comes to valuation of investment property under construction among entities. The management of entities would use different calculation methods to estimate the value of their construction projects. I therefore think the use of different estimation models would lead to a biased fair value accounting since it no longer is about the fair value, but about the value which is found depending on what kind of estimation model has been used. In general I think the valuation process of a property construction is a more complicate and difficult process than the valuation process of a completed property, since there are higher risks and more uncertainties within the construction itself. There could be unpredicted changes in the economic environment which could lead to unexpected costs. For example, unexpected rectification costs because of damages on the construction, or price changes of construction materials. There is also a chance of a construction risk, meaning additional work Page 7

is required in order to complete the property. Because of this I think it is necessary to be more concrete and specific about the valuation process of investment property under construction. I also think those typical problems mentioned above should be described in the standard and guidelines of resolving those problems should also be included. I think the implementation of this standard will be succeed if there were more restricted guidelines which in some way forcing users to use the standard in a similar way and not give them too much options. I believe too much options could sometimes lead to own interpretations and also to misunderstandings. This were I think an independent part should be drawn in. Even though there are no requirements within the standard for an independent part to be involved in the valuation process, I believe it is needed as long as the standard offers a wide range of options. Overall I think the forthcoming problems within the amendment are all about lack of guidance in IAS 40. However I do think this is an improvement, but an unfinished improvement which requires more development and needs to be more worked on. Page 8

4. Bibliography Deloitte (2009). Förbättringar till International Financial Reporting Standards. Annual improvements project. [Online]. Available: http://news.deloitte.se/ifrs_news/ifrsnov2008.pdf [2009-10-6] Ernst & Young 1 (2009). Accounting for investment property under construction: a practical guide. [Online]. Available: http://www.ey.com/publication/vwluassets/accounting_for_investment_property_under_co nstruction_-_june_09/$file/ipuc%20guidance%20secured.pdf [2009-10-10] Ernst & Young 2 (2009). Caution: fair value in progress. Accounting for investment property under construction. [Online]. Available: http://www.ey.com/publication/vwluassets/ifrs_fair_values_under_construction/$file/ifr S_Fair_values_under_construction.pdf [2009-10-10] FRSB (2008). FRSB developments. Chartered Accountants Journal, 87 (4), pp. 47-48. IAS 40 (2009). International Accounting Standard 40; Investment Property. England: Issued by IASB and effective by 1 st January 2009. IASB 1 (2009). About IASB. [Online]. Available: http://www.iasb.org/about+us/about+the+iasb/about+the+iasb.htm [2009-10-01] IASB 2 (2009). About the Trustees of the IASC Foundation. [Online]. Available: http://www.iasb.org/about+us/about+the+trustees/about+the+trustees.htm [2009-10-01] IASB 3 (2009). Who we are and what we do. [Online]. Available: http://www.iasb.org/nr/rdonlyres/f9ec8205-e883-4a53-9972- AD95BD28E0B5/0/WhoWeAre13July2009.pdf [2009-10-01] IASB 4 (2009). About the International Financial Reporting Interpretations Committee. [Online]. Available: http://www.iasb.org/about+us/about+the+ifric/about+the+ifric.htm [2009-10-01] IASB 1 (2006). Information for observers. Annual improvement process: Investment property under construction (Agenda Paper 18A). Board meeting, London. [Online]. Available: http://www.iasb.org/nr/rdonlyres/994a8e5b-157e-4441-aacc- 0CF731CFFFA5/0/AIP0610ob18a.pdf [2009-10-13] IASB 2 (2006). Board meeting: 17 October 2006, London. Investment property under construction (Agenda Paper 18A). [Online]. Available: http://www.iasb.org/nr/rdonlyres/994a8e5b-157e-4441-aacc- 0CF731CFFFA5/0/AIP0610ob18a.pdf [2009-10-04] IVSC 1 (2009). About the International Accounting Valuation Standards Council. [Online]. Available: http://www.ivsc.org/about/index.html [2009-10-01] Page 9

IVSC 2 (2009). Published paper: The Valuation of Investment Property under construction under IAS 40. [Online]. Available: http://www.ivsc.org/pubs/papers/ps090100-propconstr.pdf [2009-10-04] Laux & Leuz (2009). The crisis of fair-value accounting: Making sense of the recent debate. Accounting, Organizations & Society, 34 (6/7), pp. 826-834. Marshall, A (2004). Financial Reporting Real estate and IAS; Structural changes. Accountancy Marshall, 133 (1327), pp. 92-93. Muller III Karl, A., Riedl Edward, J. & Sellhorn, T. (2008). Consequences of Voluntary and Mandatory Fair Value Accounting: Evidence Surrounding IFRS Adoption in the EU Real Estate Industry. Working Papers - Harvard Business School Division of Research, pp. 1-40. Nordlund, B. 1 (2008). Valuation and performance reporting in property companies according to IFRS. Stockholm: Department of Real Estate and Construction Management, Building & Real Estate Economics, Royal Institute of Technology Stockholm. Nordlund, B. 2 (2008). Fastighetsredovisning inom IFRS förändringar på gång. Fastighetssnytt 1/2008. PriwaterhouseCoopers (2009). A practical guide to amended IAS 40: Accounting for investment properties under construction. [Online]. Available: http://www.pwc.com/gx/en/asset-management/assets/practical-guide-to-amended-ias-40.pdf [2009-10-12] So & Smith (2009). Value-relevance of presenting changes in fair value of investment properties in the income statement: evidence from Hong Kong. Accounting & Business Research, 39 (2), pp. 103-118. Sundgren, S., Nilsson, H., Nilsson S. (2007). Internationell redovisning: teori och praxis. Lund: studentlitteratur. Tew Phillip (2003). In search of a fair value. Estates Gazette, 5/3/2003 (318), p. 108. Trussel, J. & Rose, L. (2009). Fair Value Accounting and the Current Financial Crisis. CPA Journal, 79 (6), pp. 26-30. Wessels, M. (2008) Key change to property investment valuation. Money Management, 8/21/2008, 22 (31), p. 10. Page 10