InvestmentProperty - IAS Plus

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InvestmentPropertyThe future for UK property accounting under IASby Parizan Trewin

ContentsForeword1Executive Summary2Impact of IAS 40 on UK propertycompanies2UK Market: Old Habits Die Hard4Defining an investment property4Use of fair values4The Law vs the Renegade4Rules vs Practice4International Market6New boy in town – IAS 406Current application8Issues Facing UK PropertyCompanies10Who to Contact12

Foreword1On first reading IAS 40, it appears to be relatively straightforward, but theimplications of applying this standard go deeper. The effects of adoption will affectwhat can be included as an investment property, how the property is valued, and howchanges in value are reported. Its adoption may well start a gentle series of shockwaves throughout the financial statements and beyond to the analysts and themarkets.Although I hope that some aspects of IAS 40 will be changed, we need to stop andthink about how implementing International Accounting Standards will affect us –2005 is not that far away. This publication aims to give the reader a glimpse of whatlies ahead and an insight into the issues so that they are prepared.I commend this short Deloitte & Touche publication, and believe you will find it to bea useful starting point in considering the impact of IAS 40 on property accountingand in generating discussion on the issues for UK property companies.Simon MellissFinance DirectorHammerson plcJanuary 2002

Executive SummaryImpact of IAS 40 on UK property companies2Why should I read this?The European Union has done it again. In their quest todemonstrate their ability to compete with US regulatorsthey have focused on accounting standards and proposeda regulation:All entities with securities listed within the EU whichprepare consolidated accounts for periods beginningon or after 1 January 2005 must apply InternationalAccounting Standards (‘IAS’).While the regulation is still in draft and rumours aboundthat there is pressure to delay it, not only the EuropeanCommission, but also the member state governments, allappear to be committed to meeting the 2005 deadline.This means that affected entities will need to apply IASin 2004 in order to be able to report comparative figuresin 2005.Even earlier than this, companies will have to run systemsin parallel in 2003 in order to ensure that they report thecorrect figures under UK GAAP in 2003, can be sure thattheir systems can cope with the requirements of IAS for2004, and that the changes to the results arising from thenew basis are understood by management and analysts.Property accounting has been affected by many newaccounting treatments in the past year – FRS 15 governedwhat could and could not be capitalised, FRS 19 willhave a significant impact on deferred tax accounting,and UITF 28 detailed the treatment of lease incentives.It has been a time of substantial change, yet there ismore to come.Which brings us to the present day. Companies and theirmanagement need to plan how they aim to deal with thetransition. From systems design to rewriting accountingmanuals, training staff to determining policy, there is amultitude of things to think about.Companies with investment properties will beparticularly affected. This booklet contains guidance forproperty companies on the areas they need to considerwhen planning to implement the relevant internationalstandard, IAS 40.

INVESTMENT PROPERTY – EXECUTIVE SUMMARYValuationsCost vs fair valueBest practice will be for valuers to follow InternationalValuation Standards (‘IVS’), as opposed to the RICSAppraisal and Valuation Manual, as stated in the 2001edition of the IVS.Companies may choose to hold investment propertieseither at cost or at fair value. However, companies whichwish to avoid volatility in their results, and the cost ofexternal valuers, by adopting the cost model should notcelebrate too soon. IAS 40 still requires management todetermine and disclose the fair value of investmentproperty when the cost model is adopted.The time necessary to complete valuations will almostcertainly increase, as will costs.Management and valuers will need to work together to findtheir way through the maze.ClassificationMost UK property leases are operating rather than finance.This is because UK property leases tend to include upwardonly rent reviews which give the lessor, rather than thelessee, the substantial upside reward. Under IAS,properties held under operating leases may not be classifiedas investment property. As a consequence, such leaseholdswould be held on a cost basis and would not thereforeappear on the balance sheet.TaxationBased upon the recent evidence of the Inland Revenuetaxing on the basis of true and fair accounts, it is reasonableto suppose that they will review the basis of taxationfollowing the change to IAS. Certainly, under IAS,companies will have to provide in full for deferredtaxation on all revalued assets, which is a further changefrom FRS 19.ReportingUnlike UK GAAP, IAS requires any gain or loss onvaluation to be taken to the income statement in the year inwhich it arises, not to a statement of recognised gains andlosses. This will affect earnings, with implications forperformance-linked criteria and performance reporting toinvestors.This sounds great for properties which increase in value,but not so good for companies owning properties inunderperforming sectors. In either case, this requirementwill introduce a degree of volatility into the results ofproperty companies not hitherto experienced.3

4UK Market:Old Habits Die HardDefining an investment propertySSAP 19, first issued in 1981, is strict over the definition ofan investment property: an interest in land and/or buildings; or where development and construction work has beencompleted; and where the interest is held for its investment potential.Investment property excludes: owner-occupied properties; and properties let to and occupied by other groupcompanies.Use of fair valuesSSAP 19 is an early example of accounting based on fairvalues rather than cost. This could be said to be “userdriven” accounting in that fair value of an investmentproperty is more relevant to predicting future cash flowsthan historical cost.This disagreement is reconciled in practice by theaccepted use of the true and fair override. This use of theoverride is hardly the purpose for which it was put into thelegislation, but has become something of a necessaryloophole to enable property companies to report fair valueinformation which users believe achieves more relevantaccounting.Temporary or permanent movements in value?One further area where the law is out of date is its referenceto the recognition of changes in value: permanent falls invalue must be charged to the profit and loss account, buttemporary falls in value can be ignored.SSAP 19 states that all changes must be identified andrecognised: temporary movements in value, whether up ordown, should be reported in the statement of totalrecognised gains and losses, and stored in the revaluationreserve. However, all permanent impairments should bereflected in the profit and loss account.Rules vs PracticeThe Law vs the RenegadeHowever this use of fair values, and the consequentabsence of depreciation in particular, put SSAP 19 at oddswith the law.To depreciate or not to depreciate?The Act says yes.‘.any fixed asset should be depreciated’Whilst SSAP 19 thinks not.‘ current value is of prime importance’Ten of the largest investment property companies allconsistently adopt the treatment required by SSAP 19,as demonstrated in the table opposite, although some donot revalue investment properties in the course ofconstruction.Although there is no requirement to do so, somecompanies choose to revalue investment properties in thecourse of development.On the whole, most companies choose to have all theirproperties externally valued each year, although there are afair number which choose to have external valuationsperformed on a rotational basis with directors’ valuationsfor intervening years. However, where investment

INVESTMENT PROPERTY – OLD HABITS DIE HARD5properties represent a substantial proportion of the totalassets of listed companies, SSAP 19 expects the valuationsto be performed by appropriately qualified external valuersat least every five years.Treaan tmendd toefi f recits in valulin atioew nith surpSSA luP 1 leofreportedCompro pletpe ed irtie nvs re estmInvva enlue testofd?con menstr t prouct peion rtiExtrev es inernalu thal ved e coalu?urserse?Ten of the largest investment property companiesThe British LandCompany Every six months Exceptional item belowoperating profit Brixton Estate Every six months Exceptional item belowoperating profit Canary Wharf Group Every six months Exceptional item belowoperating profit Chelsfield Notspecified Annually Exceptional item belowoperating profit Great Portland Estates Every six months Exceptional item belowoperating profit Grosvenor Annually Exceptional item belowoperating profit Hammerson Every six months Exceptional item belowoperating profit Land Securities Every six months Exceptional item belowoperating profit Liberty InternationalHoldings Every six months Exceptional item belowoperating profit Slough Estates Every six months Exceptional item belowoperating profit Source: latest annual and interim reports.

International Market6New boy in town – IAS 40Cost does not include:On the international scene, fair value has formed the basisof accounting in three recent standards, derivatives inIAS 39, investment properties in IAS 40, and agriculturallivestock and produce in IAS 41. IAS 40 became effectivefor 2001 calendar years. Prior to IAS 40, investmentproperty was accounted for under the general tangible fixedasset standard IAS 16, Property, Plant and Equipment.Alternatively, a treatment similar to SSAP 19 was possibleby dealing with investment properties under theinvestment standard, IAS 25. However, the InternationalAccounting Standards Board (‘IASB’) believed that thecharacteristics of investment property were sufficientlydifferent from owner-occupied property. Thus IAS 40 wascreated and the definitions and choice of models arediscussed here. start-up costs unless they are necessary to bring theproperty to its working condition; initial operating losses incurred before the investmentproperty achieves the planned level of occupancy; abnormal amounts of wasted resources, such aslabour and materials, incurred in constructing ordeveloping the property.The detailed definition of what comprises investmentproperty under IAS 40 appears in the table opposite.Property which was previously classified as investmentproperty under SSAP 19 will generally also be classified asinvestment property under IAS 40 with one majorexception. Property held under an operating lease by alessee is not investment property under IAS 40 – the leasefalls under the remit of the international standard onleases and therefore the property may not be held on thebalance sheet.After initial measurement?Two options are available: fair value model; or cost model.The model chosen by management should be applied toall investment properties.Whichever model is chosen, management is requiredto determine the fair value of investment property,as the fair value needs to be disclosed if the cost modelis adopted.Independent valuation of fair value?Management is encouraged, but not required, to determinethe fair value of investment property on the basis of avaluation by an independent valuer:Initial measurement Investment properties are initially measured at cost.Cost includes any directly attributable expenditure:who holds a recognised and relevant professionalqualification; and who has recent experience in the locationand category of the investment property beingvalued. legal fees; property transfer taxes.

INVESTMENT PROPERTY – INTERNATIONAL MARKETWhat is an investment property?Land held for long-term capital appreciation rather than for short-termsale in the ordinary course of businessUnder UnderIAS SSAP4019 Land held for a currently undetermined future use A building owned and leased out under one or more operating leases A vacant building held to be leased out under one or more operating leases Investment property being redeveloped for future use as investment property Property held under an operating lease by a lessee Property held for sale in the ordinary course of business or in the process of constructionor development for sale Property being constructed or developed on behalf of third parties Owner-occupied property, including property intended to be used as owner-occupied property Property that is being constructed or developed for future use as investment property– this is a development property until construction or development is complete, at which time theproperty becomes investment property Fair value modelKey features of the fair value modelFair value is defined as:If management chooses to adopt the fair value model:‘The amount for which an asset could be exchangedbetween knowledgeable, willing parties in an arm’slength transaction’.The components of the definition are discussed in thetable below. all investment property should be measured at itsfair value; a gain or loss arising from a change in the fair value ofinvestment property should be reported in the incomestatement, and included in net profit or loss for theperiod in which it arises.What does the definition of fair value mean?KnowledgeableBoth parties are reasonably informed about: the nature and characteristics of the investment property actual and potential uses of the investment property the state of the market as of the balance sheet dateWilling buyerWill take the state of the current market into accountWilling sellerMotivated to sell the investment property at market terms for the best price obtainable inthe open market, i.e. an adequate number of potential purchasers should have beenmade aware that the investment property was for saleArm’s length transaction A transaction between parties who do not have a particular or special relationship thatmakes the transactions uncharacteristic of the market7

INVESTMENT PROPERTY – INTERNATIONAL MARKET8Evidence of fair valueCurrent prices on an active market for properties of a different nature, condition or location, adjusted to reflectthose differencesRecent prices on less active markets, adjusted to reflect any relevant changes in economic conditionsDiscounted cash flow projections based on reliable estimates of future cash flows using: terms of existing leases or other contracts current market rents for similar properties in the same location and condition discount rates that reflect current market assessments of the uncertainty and timing of the cash flowsCurrent applicationReportingIAS 40 states that all valuation movements should gothrough the income statement, but there is no finalguidance on what the income statement will look like underIAS. There are two ways to address the reporting issue:The latest available results of ten of the largest investmentproperty companies have been aggregated in the tablebelow. The effect of applying IAS 40 to the aggregatedresults has increased the aggregated retained profit by270%, even after fully providing for deferred tax on therevaluation gain as required under IAS. This is clearly asignificant change to the way that users of the accountswill receive and interpret information.1. Shoehorn the revaluation into the income statement.2. Revert to the cost basis in the statutory accounts andprovide supplementary information on whatever basisyou feel is most useful and/or relevant.Aggregated results for ten of the largest investment property companiesGross rental incomeLess: share of joint ventures’ turnoverNet operating costsOperating profitShare of operating profit in joint ventures and associatesProfit on disposal of investment propertiesNet interest payableExceptional itemsProfit on ordinary activities before taxationTaxationProfit on ordinary activities after taxation 1,052.5(177.5)875.0Minority interestsProfit for the financial yearDividends paid(25.7)849.3(392.5)Retained profit under UK GAAP456.8Retained profit under UK GAAPRevaluation gainLess: deferred tax on revaluation gain at 30%Retained profit after applying IASIncrease on IAS retained profit compared with UK GAAPSource: aggregation of profit and loss accounts from latest available annual reports for companies listed on page 5.456.81,763.4(529.0)1,691.2270%

INVESTMENT PROPERTY – INTERNATIONAL MARKETThe second option was virtually forced upon HongkongLand Holdings as 90% of their property portfolio comprisesleasehold property and so does not meet the definition ofinvestment property under IAS 40. Hongkong Landdecided to present supplementary information where thefigures were prepared in accordance with IAS with theexception that movements in the fair value of leaseholdproperties were reflected in the profit and loss account.Cost model with supplementary informationHongkong Land Holdings LimitedYear ended 31 December 2000Consolidated Profit and Loss AccountRevenueIAS basisIAS modified basis *US mUS m386.5386.5Recoverable and non-recoverable costs(97.1)(77.2)Net income from properties289.4309.3Other incomeAdministrative and other expensesFair value gain of investment set impairment (provisions)/reversals and disposals125.0(9.8)Operating profit388.12,295.6Net financing charges(41.1)(41.1)Share of results of associates and joint venturesProfit before tax13.416.6360.42,271.1Tax(27.0)(26.7)Profit after tax333.42,244.4Minority interestsNet profit(0.1)(0.1)333.32,244.3Net profit for the period is therefore US 1.9billion higher on the modified IAS basis than under the normal IASbasis, which is an increase of 573%.Source: latest available annual report.9

Issues Facing UKProperty Companies10There are a number of major issues which UK propertycompanies will need to address in the change to IAS 40.The major issues are covered here.Management will also need consider the impact of IAS 40on performance reporting to investors – changes inearnings will need to be communicated and explained toshareholders.ReportingAll gains and losses on valuation must be presented in theincome statement, although it is not precisely definedwhere in the income statement those gains or losses shouldbe shown.In addition, IAS requires the gain on initial valuation of aninvestment property which was constructed by the owner tobe included within income.One consequence will be that any performance criteria(e.g. for share options or executive remuneration) which arelinked to reported earnings will need to be re-evaluated.LeasesUnder the current IAS definition, properties held underoperating leases are excluded from investment property.This is a potentially huge problem as a large number of UKproperty leases are currently treated as operating leases.Under IAS, companies will have to account for theseproperties as operating leases under the IAS leasesstandard, which is similar to SSAP 21.

INVESTMENT PROPERTY – ISSUES FACING UK PROPERTY COMPANIESValuationsMoving targetsIVS will represent best practice in the valuation profession.IVS should therefore be followed by the valuers whenrevaluing investment property as opposed to the RICSAppraisal and Valuation Manual (the ‘Red Book’) which isused by all UK external valuers at the moment. IVS are stillbeing revised and updated by the International ValuationStandards Committee (‘IVSC’) which has the objective, by2002, of publishing “a set of comprehensive and robustinternational standards, covering all major areas ofbusiness” (foreword to IVS 2001). The chairman of the IVSChas stated that it continues to work closely with its sisterorganisation, the IASB.The IASB are still actively working on standards.Of particular relevance is the development of a newstandard which will replace the income statement with acombined performance statement. Companies need to besure that they are aware of the latest requirements.Deloitte & Touche, through monitoring of IASB activity, arewell placed to be aware of developments as, and when, theyhappen. All relevant developments are reported on theIASB website: http:\\www.iasb.org.uk and our website:http:\\www.iasplus.com which seeks to expand andinterpret IAS 40.Chartered Surveyors and management will need to worktogether to evaluate how different these standards are andassess the impact of using them to value investmentproperty.TaxationWith gains or losses on valuation going through the incomestatement, as opposed to the statement of total recognisedgains and losses and the revaluation reserve, and basedupon the recent trend of the Inland Revenue to tax on thebasis of true and fair accounts, it is reasonable to supposethat they will review the basis of taxation following thechange to IAS. At the very least, under IAS, companies willhave to provide in full for deferred taxation on all revaluedassets.11

Who to Contact12LondonParizan TrewinAssurance and Advisory020 7303 3037David JenkinsAssurance and Advisory020 7303 3302Mark GoodeyAssurance and Advisory020 7303 3883Andy SimmondsNational Assurance and Advisory020 7303 4605Deloitte & Touche would be pleased to advise on specificapplication of the principles set out in this publication.Professional advice should be obtained as this generalpublication cannot be relied upon to cover specificsituations; application will depend upon the particularcircumstances involved.

For more information on Deloitte &Touche, please access our web site atwww.deloitte.co.ukDeloitte & Touche in the UnitedKingdom and Deloitte & Touche inthe Channel Islands are eachauthorised to carry on investmentbusiness by the Institute of CharteredAccountants in England and Wales.Deloitte & Touche in the Isle of Manis authorised by the Institute ofChartered Accountants in Englandand Wales to carry on investmentbusiness in or from the Isle of Manand in the United Kingdom. Deloitte & Touche 2001.All rights reserved.Designed and produced byThe Deloitte & Touche Studio,London.

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