For accounting periods beginning on or after 1 January 2005, listed companies within the EC will be required to prepare their consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). In addition, UK companies will have the option of using IFRS for their individual accounts.
Under IFRS, a distinction is made between investment properties and properties that a company occupies for the purposes of its own business (owner-occupied properties). Broadly, IAS16 is concerned with the accounting treatment of owner-occupied properties, IAS17 with leases and IAS40 with investment property.
This note offers a very broad overview of the changes that will take place under IFRS, but no more. Not only will some companies find that the figures contained in the balance sheet and income statement are significantly different under IFRS, but companies will also be subject to a much more onerous obligation to disclose information. Significantly more detail will be required about property holdings (including changes in property portfolios) both in relation to investment properties and owner-occupied properties. Lessors and lessees will be required to give substantial information about their leases.
It should also be noted that it is likely that the IASB will make further changes to these standards in the course of the next few years. Inevitably, the IASB will continue to move towards "fair value" accounts so that future standards in this area are likely to narrow further or exclude altogether the option of property featuring in the accounts at cost.
Perhaps, the most notable change under IFRS is the requirement for revaluation gains and losses on investment properties to go through the income statement together with the requirement to provide for deferred tax even if there is no intention to sell (or, even if sold, there would be an expectation that rollover relief would be available). This has the potential to make the reported income of property investment companies more volatile than under UK GAAP.
Owner-occupied properties
- IFRS gives owners the option of carrying the property at fair value rather than at depreciated cost. However, if the option to carry at fair value is exercised then this must be applied to all properties of the same class; there can be no cherry picking. This option has already been available to owner-occupiers in the UK.
- Properties must be carried at fair value in certain circumstances. For example, on a corporate acquisition the properties of the target must be brought in at fair value unless (very unusually) merger accounting is applied.
- The buildings element of the property must be depreciated whether this is carried at cost or fair value; the land element will not normally be depreciated.
- On a revaluation, shortfalls will be charged to income except to the extent that they reverse a previous surplus on the property in question. Any surpluses will usually go to reserves and not through the income statement.
- Deferred tax on all revaluation surpluses should be provided for. Under UK GAAP deferred tax would not normally be provided for where there is no intention to sell the property.
- Profits or losses on disposal of the property will represent the difference between the sale proceeds and the carrying amount and this will go through the income statement.
- IFRS does not require valuations where properties are carried at depreciated cost although they are encouraged.
- Where a company occupies under a lease the rules under IAS17 will apply to that lease (see below). The rules relating to leasehold investment properties (see below) will not apply in these circumstances
Leases
- The lessee will either account for the lease as an operating lease or a finance lease. Essentially, a finance lease is one where the lessee accepts substantially all the risks and rewards associated with ownership of the property albeit that he is not the owner. Under IAS17, a lease is divided into two separate elements: the lease of land and, separately, a lease of the buildings. The land element would normally be treated as an operating lease on the basis that the incidence of land ownership remains with the lessor. The buildings element may potentially be more difficult. However, it is envisaged that conventional UK occupational leases will usually be operating leases.
- Where a tenant occupies under an operating lease, the lease will not feature on the tenant's balance sheet. Rents are simply charged as an expense in the income statement whilst premiums are amortised over the term of the lease. In the case of a finance lease, this must be capitalised so that the lease will be shown as an asset on the balance sheet of the tenant with a corresponding liability, namely, the net present value of the rental obligations that arise under the lease.
- Tenants occupying under operating leases will nevertheless still be under an obligation to disclose rental obligations.
- The obvious effect on a tenant that is treated as occupying under a finance lease (as opposed to an operating lease) is that this will increase its gearing.
- In the case of a finance lease, the asset would normally be depreciated over the term of the lease as a charge against income whilst the rents would be apportioned between an interest charge and a loan repayment.
Investment properties
- The owner has the option of carrying a freehold investment property at depreciated cost or fair value; if depreciated cost is opted for, fair value must still be disclosed. A company may change from one basis to the other if this aids presentation but a switch from fair value to cost is unlikely to be regarded as aiding presentation. If depreciated cost is opted for this must be depreciated annually but no depreciation should be provided for where fair value is adopted. UK GAAP already requires investment properties to be shown at market value. A company that is required to apply IFRS could opt to apply the cost basis but it seems very unlikely that a company would choose to do this.
- Where the fair value option is exercised, annual valuations only would seem to be required although for those companies that currently undertake a valuation twice a year this practice is likely to continue.
- In contrast to the position for owner-occupier properties, surpluses and shortfalls on revaluation are put through the income statement. This has the potential to make profits much more volatile. This heralds a significant change; under UK GAAP surpluses and shortfalls go to reserves through the statement of total recognised gains and losses.
- Deferred tax on all revaluation surpluses should be provided for (under UK GAAP deferred tax would not normally be provided for if there is no intention to sell the property).
- On a disposal of the property, profit or loss is computed (the difference between the proceeds and carrying value) and this will go through the income statement.
- Where a leasehold property is treated as an investment property it must be accounted for as a finance lease (even though had that same lease been held by an owner-occupier) it may have been treated as an operating lease.
