'Investment properties' are properties, being land or building or both, held for earning rentals and/or for capital appreciation. In India until recently, there were no clear guidances on how these properties are to be accounted for in the books of account of an entity. Accounting Standard 13 on 'Accounting for Investments' provided very little guidance on investment properties.
Investment Property under AS - 13
Interpretation
An investment in land or building that are not intended to be occupied substantially in the operation of the entity are considered as investment property.
Classification
AS 13 requires an entity to classify all investments into current and long term investments distinctly in the financial statements. Current and long term investments are further need to be classified as per applicable statute which, inter-alia, includes investments in investment properties.
Measurement and Recognition
An investment property under AS 13 is recognised as per cost model that is the recognition price is the purchase price plus minus transaction costs directly attributable to such investment property.
Challenges under AS - 13
Interpretation issue
AS 13 defines investment property as land or building which are not substantially used in the operation of the investing entity. What is substantial has not been discussed in the standard and is up for managements' own judgement. What if some part of land or building is used for entity's own business and other space is leased out in order to earn rent. The current guidance is also silent on investment properties held by lessee under a finance lease. Thus, the definition of investment property needed more clarity to cover multiple use land or building.
Classification issue
AS 13 classifies all investment properties as either current or long term investments. A land or building is, generally, acquired for long-term purposes, thus current classification does seem to be otiose. Further, for infrastructure entities (whose principal operation is to manage a real estate property to earn rentals), there was no separate classification available and therefore treated as part of entity's property, plant and equipment based on the principle that these properties are substantially used for the operation of the investing entities.
Measurement and Recognition issue
Land or buildings are appreciative assets whose value tend to increase with passage of time. How much it increases is a difference matter but over the period of significant time, their value does increase. AS 13 only allows cost model to follow. Therefore, significant increase in fair value of land or building is neglected and not accounted for in the financial statements of an entity.
In sum, there was a need to have separate standard for investment properties with exhaustive definition, scope inclusion and exclusion, appropriate classification and measurement based on fair valuation as well.
New Standard in Ind AS 40
The Institute of Chartered Accountants of India (ICAI) issued converged standards in line with International Standards (IFRS and IAS). Ind AS 40 on 'investment properties' has significantly covered issues discussed supra barring not allowing fair valuation mode for subsequent recognition of investment properties.
Meaning and interpretation
Under Ind AS 40, investment properties have been defined as 'properties being land or building or both held to earn rentals or capital appreciation or both'. The definition also includes investment property held by lessee as right-of-use asset that is used for stipulated purposes. Further, land or building or both used in the production of goods, supply of goods, supply of services, for administrative purposes (to be classified as PPE as per Ind AS 16) or for sale in ordinary course of business (to be classified as inventories as per Ind AS 2) have been excluded from the definition of investment properties.
Dual purpose property
There may be cases where a land or building is used both to earn rentals and for production or other administrative purposes. In that case if both areas of property can be separately sold out or leased out under a financial lease, entity shall account for both portions separately. If both portions cannot be separated, entity shall account for property as investment property only if portion held for production or other administrative purposes is insignificant.
Because 'Insignificant portion' is not defined in Ind AS 40, entities need to set a threshold for determining such portion and such threshold shall be disclosed as significant judgement.
Hotels as investment property
Entities who own hotels, rent out rooms for short-term period. But hotels also provide anciliary services which are significant to renting activities. In such a case, property can only be classified as owner's occupied property as ancillary services provided to guests are important to the arrangement as a whole.
Malls as investment property
Entities who manage and leased out space at malls to earn rentals should account for these properties as investment properties even if they also provide ancillary services like security and maintenance services. This is because these ancillary services are insignificant to the arrangement as a whole.
In nutshell, whether anciallary services are significant or not, is up for the judgement of an entity based on the facts of the case. Accordingly, classification shall be made to classify such property as investment property or owners' occupied property.
Outsourcing arrangements
For example, an entity who own a hotel, has entered into a service agreement with third party to manage the operations of the hotel. In these cases, what must be looked after is the substance over form of the arrangement. Structure of service arrangement for day-to-day operations while the risk associated with cash flows are still with the owners, would make such property as owner's occupied property even if it appears to be a 'passive investments' by owners.
Investment property in group entities
In group transactions, a holding company may provide property on lease to its subsidiary company for its (subsidiary) business use. In such a case, property is investment property in separate financial statements of the holding entity. While, as a group, the property is used for business purposes only and therefore accounted for as owner's occupied property in consolidated financial statements.
The Confusion
When I was first reading Ind AS 40, I had a confusion about classification of property, which you may also have. E.g. an entity is in the business of providing properties on lease (like infrastructure entity that operates malls). Careful reading of the definition will tell you that properties used in the rendering of services are not investment properties rather than owner's occupied property. In the given example, one may conclude that entity is using such malls (being building) in rendering of services which itself is to let-out space and earn rentals and thus they should be classified as owner's occupied property and accordingly out of scope of Ind AS 40. However, literally speaking, that is not the case as once the property is let-out, it is no longer "used" (emphasis added deliberately) by the entity itself rather it is used by the lessee. Further, investment properties generate cash flows largely independent of other assets held by an entity. This is what makes them different from owner's occupied properties (PPE).
Classification
In terms of Schedule-III to the Companies Act, 2013, an investment property will always be classified as non-current asset as separate line item. Classification of investment property as a current asset is not allowed. However, in case investment property is covered under Ind AS 105 'non current asset held for sale', such classification shall be made accordingly in terms of Ind AS 105.
Recognition and Measurement
An entity shall recognise investment property when:
➡ It is certain that future economic benefits will flow to the entity; and
➡ Its cost can be measured reliably.
At initial recognition, an entity shall measure investment property at its transaction price. Subsequently, also entity is allowed to follow only cost model for all investment properties except those classified as held for sale under Ind AS 105.
Note that under Ind AS 40, entities are not allowed to follow fair value model for investment properties. However, entities are required to "disclose" fair value of investment property.
Subsequent measurement at cost only
I feel that this is where Ind AS 40 has not been upto the mark. Reason being:
➡ Like i said earlier, investment properties are land or building whose values increase with passage of time. Therefore, entities would want to take benefit of this and carry their investment properties at fair value.
➡ One argument for not allowing fair value model, may be that fair valuation at every year would involve additional cost. But Ind AS 40 requires that fair values must be disclosed in the financial statements. Thus, entity is, anyway, required to compute fair value every year.
➡ Even property, plant and equipment have option to opt for revaluation model under Ind AS 16. Why investment properties have not been allowed is something not appropriate,
➡ With evolving concepts like REIT whose principal business is to earn from real estate only, Ind AS 40 should have, atleast, given an option to opt for fair valuation.
Position under IAS 40
IAS 40 is not materially different from Ind AS 40 barring that IAS 40 allows fair value model for subsequent measurement of investment properties.
Subleasing arrangements
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Practically, one can hold land or building in three capacities, either:
(a) as owner; or
(b) as lessee under a finance lease; or
(c) as lessee under an operating lease.
A wrap
Separate standard on investment properties has definitely provided needed guidance on their meaning, classification and recognition principle. Ind AS 40 allows us to identify an investment property, its classification and initial recognition. What will happen to subsequent recognition will have to be seen in other applicable standard(s). E.g. for depreciation of investment property, one has to refer Ind AS 16.
