When investing in property, properly recognizing and measuring its value is critical, yet complex.
This article will clearly explain the key principles around investment property recognition and measurement under IAS 40.
You'll learn the definitions, initial and subsequent measurement, derecognition triggers, and journal entries to accurately account for investment properties.
Introduction to Investment Property Recognition and Measurement
Investment properties are properties held to earn rental income or for capital appreciation, or both. As per IAS 40, investment properties are initially measured at cost, including transaction costs. Subsequently, entities can choose either the fair value model or the cost model to measure investment properties.
Defining Investment Properties
For a property to be classified as an investment property under IAS 40, it must meet the following criteria:
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The property must be held to earn rental income, for capital appreciation, or both. Properties held for own use or for sale in normal course of business are not investment properties.
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The property must be able to generate cash flows largely independently from other assets held by the entity. This distinguishes investment properties from other properties used in production or supply processes.
Some examples of investment properties are land held for long term capital appreciation, land held for currently undetermined future use, building leased out under an operating lease, and vacant building held to be leased out under an operating lease.
Initial Measurement of Investment Properties
As per IAS 40, investment properties are initially measured at cost, which includes:
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Purchase price plus any directly attributable expenditures such as legal fees and brokerage charges for acquiring the property.
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Cost of borrowing if the investment property meets the criteria for a qualifying asset as per IAS 23.
For an acquired investment property, cost is the purchase price and any directly attributable expenditure. For a self-constructed investment property, cost is the cost of materials and direct labor plus any other costs directly attributable to bringing the investment property to working condition for its intended use.
Subsequent Measurement of Investment Properties
After initial recognition, IAS 40 allows entities to choose either:
Fair value model: Investment property is measured at fair value, which is the price that would be received to sell the investment property in an orderly transaction between market participants at the measurement date. Any gain or loss arising from a change in fair value is recognized in profit or loss.
Cost model: Investment property is measured at depreciated cost less any accumulated impairment losses. The depreciation policies for investment properties measured using the cost model are same as those used for owner-occupied properties.
An entity should apply the chosen policy consistently to all investment properties within its jurisdiction. A change from one model to the other is permitted only if it results in more appropriate presentation.
Investment Property Accounting Entries
Some examples of accounting entries for investment properties:
Initial measurement
Dr Investment property $100,000
Cr Cash / Payables $100,000
Subsequent measurement - Fair value increase Dr Investment property $10,000 Cr Gain on fair value adjustment - P&L $10,000
Subsequent measurement - Impairment loss Dr Impairment loss - P&L $5,000 Cr Investment property $5,000
Derecognition - Asset disposal Dr Cash $120,000 Cr Investment property $100,000 Cr Gain on disposal - P&L $20,000
What is the initial recognition and measurement of investment properties?
An investment property shall be measured initially at its cost according to IAS 40. This includes the purchase price of the property and any directly attributable expenditures such as legal fees, property transfer taxes, and other transaction costs.
The standard states that investment properties acquired through an exchange transaction should be measured at fair value, unless the transaction lacks commercial substance or the fair value cannot be reliably determined. In that case, the cost would be measured at the carrying amount of the asset given up.
After initial recognition, IAS 40 allows entities to choose one of two models for subsequent measurement of investment property:
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Cost model - The property is measured at depreciated cost less any accumulated impairment losses. The fair value of the investment property should still be disclosed in the notes to the financial statements.
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Fair value model - The property is measured at fair value at each reporting date, with changes in fair value recognized in profit or loss.
According to IAS 40, if an entity chooses the fair value model, that policy should be applied to all of its investment property assets. An exception would be if fair value cannot be determined reliably on a continuing basis, in which case the cost model should be used.
To summarize, investment properties should initially be recognized at cost. Subsequently, entities can choose between a cost model with depreciation or a fair value model where changes in fair value affect net income. The choice of valuation model can have a significant impact on financial reporting.
How do you determine the value of an investment property?
The gross rent multiplier (GRM) approach is one of the simplest ways to determine the fair market value of an investment property.
To calculate the GRM, you divide the property's price or value by its annual gross rental income:
Gross Rent Multiplier = Property Price or Value / Gross Annual Rental Income
For example, if a property is valued at $1 million and it generates $100,000 in gross annual rents, the GRM would be:
GRM = $1,000,000 / $100,000 = 10
This means the property sells for 10 times its annual gross rental income. The higher the GRM, the more expensive the property is relative to the rent it generates.
Some key things to note with the GRM approach:
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It provides a quick "rule of thumb" estimate of value based purely on rent. More complex valuation methods also account for expenses, growth rates, etc.
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GRMs can vary significantly by property type and location. Comparing a property's GRM to similar properties in the same market can indicate if it is over or undervalued.
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Rental income should be stabilized and sustainable at market rates for the GRM approach to be meaningful. It does not account well for irregularities or volatility in rents.
So in summary, while limited, the gross rent multiplier gives a straightforward baseline indication of property value based on the key driver of investment real estate - rental income generating potential.
How are property plant and equipment recognized and measured in financial accounting?
Property, plant, and equipment (PP&E) are long-term assets vital to a company's operations and productivity. Their recognition and measurement on financial statements is an important accounting concept.
Initial Recognition
PP&E is initially measured at its historical cost, which includes:
- The actual purchase price paid
- Delivery and handling costs
- Installation charges
- Professional fees for architects and engineers
- Import duties
- Non-refundable taxes
- Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management
Subsequent Measurement
After initial recognition, IAS 16 allows entities to choose either the cost model or revaluation model for subsequent measurement:
- Cost model - The asset is carried at cost less accumulated depreciation and impairment losses
- Revaluation model - The asset is carried at a revalued amount, which is the fair value at the date of revaluation less subsequent depreciation and impairment losses
Entities applying the revaluation model must revalue assets with sufficient regularity to ensure carrying amounts do not differ materially from fair values at the reporting date.
Derecognition
The carrying amount of an item of PP&E is derecognized:
- On disposal
- When no future economic benefits are expected from its use or disposal
The gain or loss arising from derecognition is included in profit or loss when the item is derecognized.
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What is recognition and measurement of an asset?
The two main principles for measuring assets are historical cost and fair value.
Historical cost is the original purchase price paid for the asset. This is the easiest method, since it is based on a factual historical transaction.
Fair value aims to estimate the current market value of the asset. This can be more complex to determine, often requiring professional valuations or estimates.
For investment properties like buildings or land, International Accounting Standard (IAS) 40 allows entities to choose either:
- Historical cost model: The investment property is measured at depreciated historical cost less any accumulated impairment losses. This is the simpler method.
- Fair value model: The investment property is measured at fair value at each reporting date, with changes in fair value recognized in profit or loss. This method provides more relevant information to users, but requires regular valuations.
When initially recognizing an investment property, it must be measured at cost under both models. Cost includes purchase price plus any directly attributable expenditures such as legal fees and property transfer taxes.
After initial recognition, the entity then chooses either the historical cost or fair value model to subsequently measure the asset over time. The model choice must be applied consistently to all investment properties.
In summary, investment properties can be measured based on either historical cost or current fair value estimates, depending on which model better suits the entity's accounting policies and provides more useful information to financial statement users. The initial recognition is always at historical cost.
IAS 40 Investment Property PDF - A Comprehensive Guide
Investment property is defined under IAS 40 as property held to earn rentals or for capital appreciation. This standard outlines the accounting treatment and disclosure requirements for investment properties.
An Investment Property Shall Be Measured Initially At - IAS 40 Requirements
As per IAS 40, an investment property shall be measured initially at cost. This includes purchase price and any directly attributable expenditures such as legal fees, property transfer taxes, and other transaction costs.
If payment for the investment property is deferred, cost is determined as the cash price equivalent. Interest charges that would have been avoided if payment was not deferred are also included in the initial measurement.
Investment Property IFRS - Subsequent Measurement Principles
Under IFRS, entities have the option to choose either the cost model or the fair value model for subsequent measurement of investment properties.
Cost model - Investment property is carried at cost less accumulated depreciation and impairment losses.
Fair value model - Investment property is measured at fair value at each reporting date, with changes in fair value recognized in profit or loss.
Revaluation of Investment Property Journal Entries
When an investment property is revalued under the fair value model, the journal entry is:
Debit: Investment property asset account Credit: Gain on revaluation of investment property
If the revaluation results in impairment or a reversal of previous gains, the entry would be:
Debit: Loss on revaluation of investment property Credit: Investment property asset account
These entries record changes to the carrying amount of the investment property on the balance sheet.
Disclosure Requirements for Investment Property under IAS 40
Key disclosures under IAS 40 include:
- Measurement model used
- Reconciliation between carrying amount at the beginning and end of period
- Restrictions on ability to realize investment property value
- Contractual obligations for purchase, construction, repair, maintenance, or enhancements
- Fair value and methods/assumptions used in determination
Key Accounting Impacts and Journal Entries
Fair Value Gains and Losses
Investment properties are measured at fair value under IAS 40. Any gains or losses from changes in the fair value of investment properties are recognized in profit or loss in the period they arise.
For example:
Dr Investment Property $100,000
Cr Gain on Investment Property $100,000
This journal entry records a $100,000 increase in the fair value of an investment property. The gain is recognized on the income statement.
Depreciation and Impairment
If the cost model is used, investment properties are depreciated over their useful lives. Depreciation expense is recorded on the income statement.
Additionally, investment properties are assessed for impairment indicators each reporting period. If impairment exists, the carrying amount is reduced to the recoverable amount via an impairment loss recognized in profit or loss.
Investment Property (IAS 40) - Changes in Fair Value
Under IAS 40, investment properties are measured at fair value with any changes recognized in profit or loss. Fair value gains increase net income while fair value losses decrease net income in the period they occur.
These fair value adjustments can introduce volatility into the income statement but provide more relevant information to users of financial statements regarding an investment property's performance. The notes to the financial statements should disclose the valuation techniques used to determine fair value.
Accounting for Rental Income from Investment Property
Rental income from investment properties is recognized on a straight-line basis over the lease term. Any incentives granted to the lessee are considered part of the total rental income and allocated over the lease term.
The initial direct costs incurred in negotiating and arranging an operating lease are capitalized to the carrying amount of investment property and recognized as an expense over the lease term.
For example:
Dr Cash $10,000
Cr Rental Income $10,000
Records receipt of monthly rent from tenant of investment property. Rental income is recognized on a straight-line basis per the lease agreement.
Derecognition of Investment Properties
Determining Timing of Derecognition
According to IAS 40, an investment property shall be derecognized (eliminated from the statement of financial position) upon disposal or when the investment property is permanently withdrawn from use and no future economic benefits are expected from its disposal.
The derecognition date is typically the date the recipient obtains control of the investment property in an exchange transaction. Other events that would trigger derecognition include the investment property being destroyed by fire or other events, or being expropriated by government without compensation.
Calculating Gains and Losses on Disposal
Upon derecognition of an investment property, any gains or losses arising shall be calculated as the difference between the net disposal proceeds and the carrying amount of the property. The carrying amount is the fair value recorded on the last reporting date before derecognition.
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Calculation of Gain/Loss on Disposal:
- Net disposal proceeds from sale of investment property
- Less: Carrying amount/fair value at last reporting date before disposal
- Equals: Gain or loss on disposal
The gain or loss shall be recognized in profit or loss in the reporting period when the derecognition occurs.
An Investment Property is Derecognized When - Understanding the Triggers
According to IAS 40 paragraph 57, an investment property shall be derecognized on disposal or when the investment property is permanently withdrawn from use and no future economic benefits are expected from its disposal.
Specific events triggering derecognition include:
- Sale of the investment property
- Investment property destroyed by fire or other events
- Expropriation of property by government without compensation
- Property transferred to owner-occupied property or inventory
The derecognition date is typically the date control passes under the sale contract. At this point, the risks and rewards of ownership have transferred so the property is removed from the financial statements.
Journal Entries for Derecognition of Investment Properties
Sale of Investment Property Example
- Carrying value (fair value) of investment property at 1/1/X1: $250,000
- Sold for proceeds of $300,000 on 12/31/X1
Journal entries:
On disposal date 12/31/X1
Dr Cash $300,000
Cr Investment property $250,000
Cr Gain on disposal of IP $50,000
Recognize gain on disposal and derecognize investment property.
Investment Property Destroyed Example
- Carrying value of investment property at 1/1/X1: $180,000
- Property destroyed by fire on 6/30/X1
Journal entry on 6/30/X1
Dr Loss on disposal of IP $180,000
Cr Investment property $180,000
Recognize loss and derecognize destroyed investment property.
Conclusion: Synthesizing Investment Property Recognition and Measurement
Recap of IAS 40 Investment Property Principles
IAS 40 provides guidance on the accounting treatment for investment property, which are properties held to earn rentals or for capital appreciation. Some key principles under IAS 40 include:
- Investment properties are initially measured at cost, including transaction costs.
- An entity can choose either the cost model or the fair value model to subsequently measure all of its investment properties. The chosen model is applied consistently.
- Under the fair value model, changes in fair value are recognized in profit or loss.
- Investment properties are derecognized on disposal or when withdrawn permanently from use and no future economic benefits are expected.
- Proper disclosure in the financial statements is required, such as the measurement models used, restrictions on titles, contractual obligations, and reconciliation of fair value changes.
Adhering to these principles enables transparent reporting and comparison of investment properties between entities.
Final Thoughts on Investment Property Accounting
The accounting treatment of investment properties can significantly impact financial statements. Following IAS 40 guidelines on recognition, measurement and disclosure ensures high-quality financial reporting.
Entities should carefully assess if a property qualifies as an investment property under IAS 40. The appropriate measurement model should then be selected and applied consistently. Tracking fair value changes and providing relevant disclosures also enables investors to make informed decisions.
Overall, compliance with IAS 40 investment property accounting standards is vital for accurate financial reporting and transparency.
