Common errors when accounting for investment property (IAS 40) – Part 2

When preparing financial statements, it is easy to get confused about whether property should be classified as investment property or property, plant and equipment (“PPE”). This distinction is important because if we incorrectly classify a property at the outset, the accounting that follows will also be wrong. The standards that apply to property, plant and equipment are IAS 16 Property, Plant and Equipment (“IAS 16”) for for-profit entities and PBE IPSAS 17 Property, Plant and Equipment (“PBE IPSAS 17”) for public benefit entities (“PBEs”).  The standards that apply to investment property, which is a special type of PPE, are IAS 40 Investment Property (“IAS 40”) for for-profit entities and PBE IPSAS 16 Investment Property (“PBE IPSAS 16”) for PBEs.

In the August 2018 edition of Accounting Alert we identified six common errors where preparers could mistakenly classify investment properties as PPE, and vice versa. This article highlights another five.

Error 1 – Dual purpose properties

Investment properties sometimes have a dual purpose, i.e. they can be used partly as an investment property and partly as owner-occupied property (PPE).
The definitions of PPE and investment property suggest an all or nothing approach to classifying properties and this principal is reinforced in paragraph 10 of IAS 40 (paragraph 14 of PBE IPSAS 16), which only permits splitting one property between investment properties and PPE if the parts used for different purposes could be:

• Sold separately, or
• Leased out separately under a finance lease.

Some properties comprise a portion that is held to earn rentals or for capital appreciation and another portion that is held for use in the production or supply of goods or services or for administrative purposes. If these portions could be sold separately (or leased out separately under a finance lease), an entity accounts for the portions separately. If the portions could not be sold separately, the property is investment property only if an insignificant portion is held for use in the production or supply of goods or services or for administrative purposes.  IAS 40, paragraph 10 In some cases, entities hold some property that comprises (a) a portion that is held to earn rentals or for capital appreciation rather than to provide services, and (b) another portion that is held for use in the production or supply of goods or services or for administrative purposes. For example, a hospital, charity or a university may own a building, part of which is used for administrative purposes, and part of which is leased out as apartments on a commercial basis. If these portions could be sold separately (or leased out separately under a finance lease), an entity accounts for the portions separately. If the portions could not be sold separately, the property is investment property only if an insignificant portion is held for use in the production or supply of goods or services or for administrative purposes. PBE IPSAS 16, paragraph 14

A common error is to assume that the property can automatically be split for classification purposes if the separate area is physically identifiable.

Example:

Property Co owns a 20-floor commercial building in the CBD which it rents out to tenants. However, it occupies the first floor of the building for its administration department.
In this example, it is unlikely that the property could be split between PPE and investment property because:

• There is no indication that the office or floor used for administrative purposes could be sold separately (e.g. as would be the case if each floor was on a separate title), and
• While the separate floor could be leased out separately under an operating lease, paragraph 10 of IAS 40 (paragraph 14 of PBE IPSAS 16) requires that it be leased out separately under a finance lease.

Except in specific circumstances, it would be unlikely for a tenant to enter into a finance lease (i.e. a very long lease) for office premises. However, there could be cases for specialised buildings where a portion of the property could be leased separately as a finance lease.
Note:
In this example, only one floor of the 20-floor building is used for administrative purposes. Therefore, despite the floor not being capable of being sold or leased separately under a finance lease, paragraph 10 of IAS 40 (paragraph 14 of PBE IPSAS 16) would nevertheless permit this property to be classified as investment property in its entirety because only an insignificant portion is being used as PPE. Because the term “insignificant portion” is not defined in IAS 40/PBE IPSAS 16, entities need to set a threshold for determining what they consider an insignificant portion and this threshold should be disclosed as a significant judgement in the financial statements.

Error 1 Assuming dual usage of a property always results in part of the building being classified as PPE.

 

Error 2 – Extent of ancillary services provided

Another common classification error occurs because preparers fail to give adequate consideration to the level of services provided to tenants when deciding whether a property is an investment property or PPE.
Investment properties are generally passive investments and involve little, if no services to tenants other than the provision of rental space. On the other hand, PPE is used in the production or supply of goods or services to customers, and therefore involves the provision of significantly more services than for investment properties.
In order for a property to be classified as investment property, paragraph 11 of IAS 40 (paragraph 15 of PBE IPSAS 16) is clear that ancillary services provided to tenants must be insignificant to the arrangements as a whole, otherwise the property is considered owner-occupied PPE.
 

In some cases, an entity provides ancillary services to the occupants of a property it holds. An entity treats such a property as investment property if the services are insignificant to the arrangement as a whole.  An example is when the owner of an office building provides security and maintenance services to the lessees who occupy the building. In other cases, the services provided are significant. For example, if an entity owns and manages a hotel, services provided to guests are significant to the arrangement as a whole. Therefore, an owner-managed hotel is owner-occupied property, rather than investment property. IAS 40, paragraphs 11-12 In some cases, an entity provides ancillary services to the occupants of a property it holds. An entity treats such a property as investment property if the services are insignificant to the arrangement as a whole. An example is when an entity (a) owns an office building that is held exclusively for rental purposes and rented on a commercial basis, and (b) also provides security and maintenance services to the lessees who occupy the building. In other cases, the services provided are significant. For example, an entity may own a hotel or hostel that it manages through its general property management agency. The services provided to guests are significant to the arrangement as a whole. Therefore, an owner-managed hotel or hostel is owner-occupied property, rather than investment property. PBE IPSAS 16, paragraph 15-16

The following examples illustrate how judgement is required in relation to the classification of investment property due to the extent of ancillary services provided.

Example 1

ILU Co owns a property comprising 100 independent living units which it rents outs to residents.
All units have a fully equipped kitchen.
As part of the rental agreement with residents, ILU Co provides:

• Cleaning services for all common areas
• Landscaping of common areas
• 24-hour security staff.

ILU Co could classify the independent living units as investment property because the services provided to residents (cleaning, maintenance, landscaping, and security) are ancillary services and appear to be insignificant to the arrangement as a whole.

Example 2

Aged Care Co owns an aged care facility comprising 100 apartments which it rents outs to residents.
As part of the rental agreement with residents, Aged Care Co:

• Provides daily cleaning services for all areas of the facility
• Employs 15 nurses/carers at the facility, 24/7 to look after the residents
• Provides security staff
• Provides on-site maintenance services and staff
• Provides all meals for residents
• Organises and provides entertainment and other activities for residents.

Aged Care Co is effectively using the property in the supply of nursing home services to residents, and as such, could classify the apartments as PPE because the services provided to residents (cleaning, permanent carers, security, meals, maintenance, etc) appear to be significant to the arrangement as a whole.

Example 3

Aged Care Co owns an aged care facility comprising 100 independent living units which it rents outs to residents.
Units have one bedroom, one bathroom, a small fridge (no freezer), a microwave and a toaster. There is no full kitchen or laundry in each unit.
As part of the rental agreement with residents, Aged Care Co provides:

• Cleaning services for all common areas
• Landscaping of common areas
• Maintenance of common areas and individual units
• 24-hour security staff
• Daily meal package for three meals a day (stated to be at $5 a day)
• Free laundry services.

Providing daily meal packages at a stated $5 a day does not represent arm’s length prices and because units do not have a fully equipped kitchen, most residents would be expected to use the daily meal service. Most residents would also be expected to take advantage of the free laundry service. This means that the services provided by Aged Care Co are unlikely to be considered to be ancillary (insignificant to the arrangement as a whole) and the more appropriate classification would be PPE.
However, Aged Care Co must apply judgement before making a final determination, and details of the criteria used to distinguish investment property from PPE are required to be disclosed by paragraph 75(c) of IAS 40 (paragraph 86(c) of PBE IPSAS 16).
 

Error 2 Failing to consider the level of ancillary services when classifying a property as an investment property.

 
Error 3 – Outsourcing services to third parties under a management contract
Investment properties are generally passive investments with few services provided to tenants. Properties failing the insignificant services test as described in error 2 above should therefore be classified as PPE, with fair value movements recognised in other comprehensive income.
A common error occurs when preparers attempt to structure service arrangements for owner-occupied property via a third party management contract so that the property appears to be a passive investment to the investor. These types of structuring arrangements could be entered into for tax or legal reasons, or simply to try and engineer a particular accounting outcome. However, for accounting purposes we look at substance over form. Such arrangements are often incorrectly classified as investment property where the investor has merely outsourced the day-to-day running of the property, but remains exposed to variations in cash flows generated from the property.

It may be difficult to determine whether ancillary services are so significant that a property does not qualify as investment property. For example, the owner of a hotel sometimes transfers some responsibilities to third parties under a management contract. The terms of such contracts vary widely. At one end of the spectrum, the owner’s position may, in substance, be that of a passive investor. At the other end of the spectrum, the owner may simply have outsourced day-to-day functions while retaining significant exposure to variation in the cash flows generated by the operations of the hotel. IAS 40, paragraph 13; PBE IPSAS 16, paragraph 17 (with some minor wording differences)

 
The example below indicates the types of services typically required by a hotel operator.

Example: Hotel operation – no outsourcing arrangement

Hotel Co owns a hotel and is responsible for:

• Performing major refurbishments of the building
• Performing required upgrades to hotel fit-out
• Performing required repairs and maintenance
• Hiring and management of staff
• Management of day-to-day operations, including front desk, room service, etc
• All marketing and advertising of the hotel
• Management of the booking process
• Receiving income and paying expenses associated with operating the hotel
• Either managing hotel restaurants and shops itself or outsourcing such operations under separate agreements.

Hotel Co could classify the hotel as PPE because it is using the hotel building to supply hotel services to guests. It is also bearing all associated risks and rewards of operating the hotel. The hotel could not be classified as an investment property since it is not being held to earn rentals or for capital appreciation.
The analysis in the above example becomes more complex as the fact pattern is altered for outsourcing arrangements. The following two examples illustrate how judgement needs to be applied to determine the appropriate classification where the property owner of a hotel has outsourced all, or some, services under a management contract.

Example: Investment property

Property Co A owns a hotel. The hotel is managed by Fancy Hotels, a company that operates chains of hotels under management agreements with the owners. 
The management agreement between Property Co A and Fancy Hotels stipulates that:

• Property Co A:
  • Provides the hotel building
  • Performs major refurbishments of the building
  • Receives a fixed fee for use of the hotel building.
• Fancy Hotels:
  • Hires and manages all staff
  • Manages day-to-day operations, including front desk, room service, etc
  • Manages advertising of the hotel
  • Takes bookings and bears risk of non-payment
  • Either runs hotel restaurants and shops itself or outsources them
  • Manages all income and expenses of the hotel (Fancy Hotels bears all risks and rewards of operating the hotel)
  • Performs required repairs and maintenance
  • Performs required upgrades to hotel fit-out (e.g. rooms, bathroom, restaurants, etc).

Property Co A could classify the hotel as an investment property because it is being held to earn rentals (i.e. fixed fee for use of the building) and Property Co A does not bear the associated risks and rewards of supplying hotel services to guests.

Example: Hotel

Property Co B owns a hotel. The hotel is managed by Fancy Hotels, a company that operates chains of hotels under management agreements with the owners. 
The management agreement between Property Co B and Fancy Hotels stipulates that:

• Property Co B:
  • Provides the hotel building
  • Performs major refurbishments of the building
  • Performs required upgrades to hotel fit-out (e.g. rooms, bathroom, restaurants, etc)
  • Performs required repairs and maintenance
  • Hires staff based on recommendations from Fancy Hotels
  • Receives income and pays expenses associated with operating the hotel.
• Fancy Hotels
  • Manages staff
  • Manages day-to-day operations, including front desk, room service, etc
  • Manages advertising of the hotel
  • Manages the booking process
  • Either manages hotel restaurants and shops itself or outsources such operations under separate agreements
  • Receives a fixed management fee for operating the hotel
  • Receives a variable management fee for operating the hotel, calculated as 5% of EBITDA of the hotel.

Property Co B could classify the hotel as PPE. Despite outsourcing the day-to-day operations of the hotel to Fancy Hotels, Property Co B has retained the risk of significant variations in the cash flows generated by the operations of the hotel, suggesting that the hotel is still owner managed by Property Co B.
Fancy Hotels does not bear the associated risks and rewards of ownership of the hotel since it receives a fixed management fee for operating the hotel, as well as a variable fee based on the overall performance of the hotel. The variable fee is akin to a performance fee, i.e. if Fancy Hotels manages the hotel well, profits increase and the variable fee increases, whereas if management is poor the variable fee decreases.

Error 3 Incorrectly assuming that outsourcing property services via a management contract results in a passive investment, and classification as an investment property.

 

Error 4 – Different classifications in group and individual entity financial statements

The accounting treatment of items in the separate financial statements and the consolidated financial statements is not always the same.
In some cases, one entity in a group may own a property that it rents out to another group company. In the consolidated financial statements, this property is classified as PPE because it is owner-occupied from the perspective of the group.
A common error occurs when preparers fail to change the classification to investment property in the individual financial statements of the property owner, who is merely holding the property to earn rentals. In addition, any accumulated fair value increments recognised in other comprehensive income in the consolidated financial statements in relation to the property must be transferred to retained earnings in the financial statements of the property owner, with the current period movement in fair value recognised in profit or loss.

In some cases, an entity owns property that is leased to, and occupied by, its parent or another subsidiary. The property does not qualify as investment property in the consolidated financial statements, because the property is owner-occupied from the perspective of the group. However, from the perspective of the entity that owns it, the property is investment property if it meets the definition in paragraph 5. Therefore, the lessor treats the property as investment property in its individual financial statements. IAS 40, paragraph 15 In some cases, an entity owns property that is leased to, and occupied by, its controlling entity or another controlled entity. The property does not qualify as investment property in consolidated financial statements, because the property is owner-occupied from the perspective of the economic entity. However, from the perspective of the entity that owns it, the property is investment property if it meets the definition in paragraph 7. Therefore, the lessor treats the property as investment property in its individual financial statements. PBE IPSAS 16, paragraph 19

 

Error 4 Incorrectly classifying property as PPE in separate financial statements of the property owner.

 

Error 5 – Business combination or asset acquisition

When acquiring a property that meets the definition of investment property, a common error occurs when preparers assume that the acquisition is an asset acquisition, and fail to assess whether the purchase constitutes a business combination under IFRS 3 Business Combinations.
The implication of this is that the purchase price is allocated entirely to property purchased, whereas in a business combination, the investment property acquired is measured at fair value on acquisition date, any excess consideration is allocated to goodwill, and a deferred tax liability is recognised where the fair value of the property exceeds its tax base.
 

Judgement is also needed to determine whether the acquisition of investment property is the acquisition of an asset or a group of assets or a business combination within the scope of IFRS 3 Business Combinations. Reference should be made to IFRS 3 to determine whether it is a business combination. The discussion in paragraphs 7–14 of this Standard relates to whether or not property is owner-occupied property or investment property and not to determining whether or not the acquisition of property is a business combination as defined in IFRS 3. Determining whether a specific transaction meets the definition of a business combination as defined in IFRS 3 and includes an investment property as defined in this Standard requires the separate application of both Standards. IAS 40, paragraph 14A; PBE IPSAS 16, paragraph 18.1 (with some minor wording differences)

 

Error 5 Failing to identify investment properties acquired as part of a business combination.