FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with investment property in Section 16 Investment Property.
At the outset it is important to appreciate the differences between old UK GAAP at SSAP 19 Accounting for investment properties and FRS 102. Some of these differences are noted in the table below:
Definition of investment property
The definition of investment property under FRS 102 is looser than what was the case under SSAP 19. Essentially, investment property is property that is held by the business in order to earn rentals, for capital appreciation or both.
Property which is held for use in the ordinary course of business (i.e. for the production or supply of goods or services or to perform administrative processes) will not meet the definition of investment property.
In addition, where an entity holds property for sale in the ordinary course of business this, too, will not meet the definition of investment property. Such properties are accounted for under Section 17 Property, Plant and Equipment.
Where there are uncertainties as to whether a property should be classified as investment property, and hence accounted for under Section 16, or property, plant and equipment under Section 17 of FRS 102, then the question to ask is ‘what is the property being used for?’. The answer to this question will usually lead you to the correct accounting treatment.
Complications can arise when property is ‘mixed-use’ property. In other words, where part of a property is investment property and the other part is used in the ordinary course of business. Paragraph 16.4 of FRS 102 says that mixed-use property must be separated between its investment property portion and its property, plant and equipment portion.
The investment property portion is accounted for under Section 16 (unless the fair value of the investment property portion cannot be measured reliably without undue cost or effort, in which case the entire property is accounted for under Section 17). The remaining portion is accounted for under Section 17.
Accounting treatment under FRS 102
One of the most notable differences that preparers of financial statements under FRS 102 will notice where investment properties are concerned is the accounting treatment for fair value gains and losses under Section 16.
Under previous UK GAAP, movements in the valuation of an investment property would have been taken to the revaluation reserve within equity and reported through the statement of changes in equity.
This was because under previous UK GAAP, fluctuations in open market value were accounted for under the Alternative Accounting Rules in the Companies Act which requires movements to be recognised in the revaluation reserve.
Under FRS 102, fair value gains and losses are accounted for under the Fair Value Accounting Rules and hence are taken to profit or loss.
Deferred tax considerations must also be brought into account where investment property fair value gains and losses are concerned. This was previously not the case under outgoing UK GAAP unless, at the balance sheet date, the entity had a binding agreement to sell the investment property and it had recognised the disposal in the financial statements.
It is important to emphasise that the accounting treatment is only different for investment properties. Where, say, a freehold property that is accounted for under Section 17 is measured under the revaluation model, the concept of the revaluation reserve remains and therefore gains and losses on revaluation are taken to the revaluation reserve, with associated deferred tax consequences (losses are taken to the revaluation reserve to the extent of a credit balance on the revaluation reserve).
Preparers must ensure they have a sound understanding of the accounting treatments for both types of fixed asset where fair value gains and losses are concerned as mistakes can be costly.
Example – Accounting for investment property fair value gains and losses
Faro Ltd has an investment property on its balance sheet as at 1 January 2015 (the date of transition) with a carrying value of £200,000 and an associated revaluation surplus of £80,000. On 31 December 2015 the fair value of the investment property had increased to £220,000 and on 31 December 2016 it had increased further to £225,000. The directors have previously not recognised deferred tax on this property. The directors expect the rate of tax to apply on the sale of property to be 17%.
Adjustments on transition
On transition to FRS 102, there are two options available to the directors where the treatment of the revaluation reserve is concerned. They can either transfer the balance into the profit and loss account reserves (retained earnings) because there is no concept of a revaluation reserve for investment properties under FRS 102.
Alternatively, they can rename the revaluation reserve the ‘Fair value reserve’ to enable them to ring-fence the fair value gains and losses, net of deferred tax, so that the company does not distribute such reserves to shareholders. This is because any gains or losses on the fluctuation of fair values are not realised gains or losses because they are not readily convertible into cash. In order for a gain to be a realised gain, and hence distributable, it must be readily convertible into cash and in almost all cases, such gains on investment property will not be readily convertible into cash and hence will be undistributable.
If the directors wish to move the revaluation reserve into profit and loss account reserves, this will be done by:
Dr Revaluation reserve £80,000
Cr Retained earnings £80,000
A further adjustment on transition will have to be undertaken to account for the deferred tax because paragraph 29.16 of FRS 102 requires deferred tax to be brought into account where investment properties are concerned. A fair value gain will give rise to a deferred tax liability and hence on transition the adjustment will be:
Dr Fair value reserve/retained earnings £13,600 (£80,000 x 17%)
Cr Deferred tax provision £13,600
Adjustments in the prior year
At the year-end 31 December 2015, the investment property had increased in value by £20,000. The entries under previous UK GAAP would have been:
Dr Investment property £20,000
Cr Revaluation reserve £20,000
Under FRS 102, fair value gains and losses are taken to profit and loss and therefore a prior year adjustment will have to be put through at 31 December 2015 as follows:
Dr Revaluation reserve £20,000
Cr Profit and loss £20,000
Additional deferred tax will also have to be brought into account amounting to £3,400 (£20,000 x 17%) as follows:
Dr Tax expense (P&L) £3,400
Cr Deferred tax (B/S) £3,400
Postings in the current year
At 31 December 2016, the investment property increased in value further by £5,000 and so the entries in the books will be:
Dr Investment property £5,000
Cr Profit and loss £5,000
Additional deferred tax is recognised as follows:
Dr Tax expense (P&L) £850
Cr Deferred tax (B/S) £850
Pitfalls to avoid
Some of the most common pitfalls to avoid where investment property accounting is concerned are as follows:
- posting fair value gains and losses to a revaluation reserve – the concept of a revaluation reserve does not exist for investment property under Section 16;
- forgetting to bring deferred tax into account – investment property is a non-monetary asset that is subject to revaluation and hence deferred tax should be brought into account (paragraph 29.16 also specifically requires this, with some exceptions);
- posting deferred tax incorrectly – the deferred tax element of the fair value gain or loss should follow its underlying transaction and hence should be included in profit or loss (tax expense); and
- keeping a track of the value of reserves which are undistributable under company law for investment property. This can be achieved by either ring-fencing such reserves in a separate ‘Fair value reserve’ in equity or by keeping a note of the value of undistributable reserves on a working paper (although the latter would give wider scope for errors). In any case it is vital that a track is kept of such reserves, particularly where the value of distributable reserves is already low.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.