Accounting for Investment Property Under Construction
Cecilia Lambert†
Lela Pumphrey†
Abstract
The recognition of unrealized gains has long been a contentious issue in
accounting. The use of fair value for non-financial assets has been regarded by
some as more problematic than financial assets as the market valuation of nonfinancial assets is perceived to be less reliable. Furthermore, International
Financial Reporting Standards (IFRSs) have permitted differential accounting
treatments for the valuation of investment property and owner-occupied
property; however investment property under construction has been subject to
accounting rules for owner-occupied property. This anomaly has recently been
addressed by the International Accounting Standards Board (IASB) who has
proposed that firms with investment property under construction should be
permitted the option to use fair value accounting and, more recently, where fair
value cannot be reliably determined to use cost as a proxy for fair value until
construction is completed. This paper explains the current reporting
requirements, the changes that take effect from January 2009 and the likely
impact of those changes for property developers in the UAE.
†
Zayed University, Abu Dhabi, United Arab Emirates
Introduction:
The recognition of unrealized gains has long been a contentious issue in
accounting. Holding gains from changing market prices have largely been
deferred, or if recognized, taken directly to equity, bypassing the income
statement. Accounting regulators are slowly extending the scope of application of
mark-to-market accounting and, with it, have been subject to increasing
criticism by preparers of financial statements. During the recent financial crisis
some have questioned the wisdom of permitting standard-setting bodies the
authority to issue standards with such far-reaching economic consequences. For
its part, the Financial Accounting Standards Board (FASB) and International
Accounting Standards Board (IASB), the two dominant standard-setters in
accounting, have jointly initiated a review of accounting requirements for
financial assets and have reached consensus on the relaxation of rules for
marking some financial assets to market.
The use of fair value for non-financial assets has been regarded by some
as more problematic than financial assets as the market valuation of nonfinancial assets is perceived to be even less reliable, and in the light of recent
events, potentially more damaging in extending the application of market values
to non-financial assets (PriceWaterhouseCoopers, 2008). Non-financial assets
include tangible long-lived assets such as property, plant and equipment as well
as intangible assets such as patents and brand names. The contention that
market
valuation
of
non-financial
assets
has
low
reliability
reflects
characteristics of both the market(s) for trading non-financial assets and the
assets themselves. For example, non-financial assets are more likely to have
qualities that make them unique or heterogeneous; the markets are lessdeveloped with thinner trading. The combination of these factors is more likely
to lead to the use of surrogates for market values, with perceived deficiencies in
reliability.
1
Furthermore, International Financial Reporting Standards (IFRSs) have
permitted differential accounting treatments for the valuation of investment
property and owner-occupied property. Two separate accounting standards
govern accounting for property: International Accounting Standard (IAS) 40
and IAS 16, with the former applicable to investment property while the latter
pertains to property used for productive or administrative purposes. Each
standard permits the choice between cost or fair value. While the application of
the cost model is applied consistently (with the asset carried at its cost less any
accumulated depreciation and accumulated impairment losses), the treatment of
unrealized holding gains or losses are operationalized in different ways.
Investment property under construction was initially intended to be
included in IAS 40 however concerns about the reliability of measurement of fair
value culminated in its express exclusion from the final standard. Proposed
changes included in the Annual Improvements of IFRSs Exposure Draft in
October 2007 were approved by the IASB in May 2008 with effect from January
2009. This paper explores the implications of the change and investigates its
likely impact in the UAE where property development continues apace.
Regulatory Environment
Existing regulation
The specific regulation governing accounting for investment property is
contained in IAS 40 Investment Property. IAS 40.05 defines investment property
as “property (land or a building–or part of a building–or both) held (by the
owner or by the lessee under a finance lease) to earn rentals or for capital
appreciation or both, rather than for use in the production or supply of goods or
services or for administrative purposes; or sale in the ordinary course of
business”. The latter type of property is described as owner-occupied property
2
and is accounted for under the rules contained in IAS 16 Property, Plant and
Equipment.
Distinguishing between investment and owner-occupied property is
justified by reference to differing economic characteristics. IAS 40.07 explains
that investment property generates cash flows that are largely independent of
other assets of the business while the cash flows generated by owner-occupied
property are interdependent with other assets of the firm. Although the
definitions are presented as exclusive, in practice there may be ambiguity in the
classification of property for financial reporting purposes. Alternatively, a
property may satisfy a dual purpose. In such circumstances the standard (IAS
40.10) recommends bifurcation if feasible, otherwise the property may only be
classified as investment property if an “insignificant portion” is held for owneroccupation.
Following general principles for initial recognition of assets at cost,
investment property is recorded at cost; thereafter the firm may choose either to
periodically remeasure to fair value (the fair value model) or maintain initial
cost (the cost model) subject to depreciation and impairment write-downs.
Changes in fair value are recognized in income for the period.
Fair value is defined in IAS40.05 as “the amount for which an asset could
be exchanged between knowledgeable, willing parties in an arm’s length
transaction”. The standard provides for a two-level hierarchy of evidence of fair
value, with “the best evidence…given by current prices in an active market for
similar property in the same location and condition and subject to similar lease
and other contracts” (IAS40.45). In the absence of such value, active markets in
dissimilar properties, similar properties in less active markets and discounted
cash flows may be used.
In contrast the cost model requires investment property to be measured at
depreciated cost (less any accumulated impairment losses). Systematic charges
are made for depreciation (as provide in IAS 16) with additional charges (or
3
reversals) for impairment losses (gains) as appropriate. Using the cost model for
valuation does not relieve the firm from determining the fair value of its
investment property: fair value must be disclosed as a note to the accounts.
In a period of rising prices the fair value model which regularly
remeasures and recognizes holding gains will result in higher carrying amounts
for investment property and stockholders’ equity relative to the cost method.
However, realized gains or losses arising from the disposal of investment
property will generally be smaller than the cost model.
International Accounting Standard 16 (IAS 16) prescribes the accounting
treatment for property, plant and equipment used for productive or
administrative purpose. Like IAS 40, IAS 16 permits choice between two
permissible valuation alternatives: cost or revaluation. IAS 40 draws on the cost
model described in IAS 16 ensuring consistency in carrying amounts based on
cost less accumulated depreciation and accumulated impairment losses. Firms
adopting the cost method are encouraged, though not required, to disclose the
fair value of property, plant and equipment.
The revaluation model in IAS 16 differs from the fair value model
adopted in IAS 40 in one important respect: the treatment of changes in fair
value. A gain in fair value is recognized in a reserve, not directly in income. In
contrast, a fall in value is recognized in income except to the extent any available
balance in the reserve is sufficient to offset the loss. While the reserve forms part
of stockholders’ equity the gains do not pass through the income statement (a
“dirty surplus” as the income statement does not articulate fully with the balance
sheet).
Thus a company using fair value would report similar asset and equity
under either IAS 40 or IAS 16 but reported income will be higher under IAS 40.1
1
Of lesser significance is (1) depreciation: while all property (other than land) subject to IAS 16 is
depreciated irrespective of the model chosen, property covered by IAS 40 is only depreciated if the cost
model is used. (2) impairment: recoverable amount is an entity-specific measure of value which, by
definition, is of limited applicability to investment property.
4
Proposed regulation
Despite the development of separate standards for investment and owneroccupied property, investment property under construction was subject to
accounting rules governing owner-occupied property. At the time of developing
IAS 40, the IASB originally proposed that investment property under
construction be measured at fair value, however in the Basis for Conclusions it
notes that it was persuaded against following through with the treatment at that
time on the grounds that a market for property under construction may not exist
and the reliability of measurement was potentially complicated by insufficient
certainty about costs to complete a property and the income expected to be
generated from it (see B17). Thus IAS 40 expressly excluded property under
construction from its scope.
Moreover, differences in opinion began to emerge about whether the
application of IAS 16 permitted the use of the revaluation model for investment
property under construction. The matter was referred to the International
Financial Reporting Interpretations Committee (IFRIC) for inclusion on its
agenda. However in late 2006 it issued a statement stating that it would no longer
consider the matter as it was now the subject of the Annual Improvements
projects under the control of the IASB.
The IASB included the proposed changes to IAS 40 in the Annual
Improvements to IFRSs Exposure Draft of October 2007. At that time the IASB
reasoned that “since IAS 40 was issued in 2000…concerns (about reliable
measurement of fair value) have lessened significantly as the use of fair values
has become more widespread and valuation techniques have become more
robust” (Basis for Conclusions BC1).
5
Following feedback on that exposure draft the IASB reported in its
February 2008 update on the improvements project that it had tentatively
decided that if a firm used fair value for investment property but was unable to
determine fair value reliably for investment property under construction, then it
may use cost as a proxy for fair value until construction is completed. The
amendment had not been canvassed in the earlier document. The improvements
to IAS 16 and 40 were approved in May 2008 and effective 1 January 2009.
Evaluating the Proposal
The Addendum to Agenda Paper 4L to accompany the IASB meeting in
February 2008 provided a summarized account of comments on the proposed
changes to IAS 40 set out in the exposure draft issued in the preceding October.
One of two2 major reasons for disagreement with the proposal was the
consequence for choice of valuation models if the fair value of an investment
property under construction was unable to be reliably determined. Did that
preclude subsequent use of fair value for that property once completed or,
indeed, preclude the use of fair value for investment property as a class?
This matter has now been clarified. An entity using fair value is not
precluded from using fair value for completed properties if fair value cannot be
reliably estimated for investment property under construction. Rather, fair value
continues to be used for other investment properties and cost for property under
construction, with the latter remeasured to fair value when it can be reliably
determined.
However, the concession to allow the use of cost as a proxy for fair value
departs from the provisions in both IAS 16 and 40 which permit the use of fair
value only if that value can be reliably determined. Moreover the proposed
changes to IAS 40 require conformity to an extant provision that requires all
2
The other major reason cited was the significance of the change making it unsuitable for the
improvements program.
6
property to be treated as a single class (IAS40.30). This conflicts with IAS 16
which does not restrict the scope of a class of assets (although a consistent policy
must be used for each designated class).3
The new rules do have the potential to reduce the significance of
classification ambiguities between construction and completion of investment
property. As all investment property is now covered by IAS 40, and the use of a
single measurement basis, differences in interpreting the standard are unlikely to
have significant economic consequences (See Eccles & Holt, 2001).
Staff papers provided to the IASB for its February 2008 meeting
suggested that the fair value measurement of property under construction is
likely to have lower reliability than that for completed property, reflecting
immaturity of markets for partially completed property as well as the
uncertainty associated with costs to completion. Ernst and Young (2008) suggest
that an extended planning horizon, unexpected construction costs, changes in the
price of inputs and changes in the economic environment affecting demand
amplify the risks for property under construction relative to completed property.
It could also be hypothesized that market valuations in developing and emerging
markets will be less reliable than in developed markets.
Since fair values should be disclosed, even if the cost model is adopted, the
transparency and quality of disclosures will be critical, as will the independence,
training and qualifications of valuers employed to provide market values. In
recent years the IASB and FASB have engaged with the International Valuations
Standards Committee seeking input on measurement issues and standardizing
practices applicable to valuations for financial reporting purposes.
Where firms with investment property use fair value for (completed)
investment properties and cost for investment property under construction, the
proposed standard is unlikely to be benign. They are no longer able to defer
unrealized gains until completion if fair value can be reliably determined
3
Staff briefing papers provided to the February 2008 meeting of the IASB indicated that creating two
classes of asset would require significant drafting changes to IAS 40.
7
(although in its absence cost will continue to be used), accelerating the
recognition of gains/losses in income. Even where fair value has been used for
property under construction, gains will now be taken to income rather than
equity.
More generally the treatment of holding gains and losses has important
consequences for any requirements based on net income. For example countries
differ in their laws relating to the distribution of income as dividend. OwusuAnsah and Yeoh (2006) describe the change in rules in New Zealand moving
from capital maintenance in favor of solvency. Capital maintenance may be
achieved in a number of ways. Many countries for example stipulate the use of
statutory reserves. As discussed above, the use of fair values in a period of rising
prices will accelerate the earning of income, which in turn may indirectly affect
the distribution of dividends once appropriations to statutory reserves meet the
requisite minimum. Diversity across legal systems of countries adopting IFRSs
may cause confusion at best and potentially misleading information at worst.
Accounting for Property in The UAE
To assess the likely impact of application of the new regulation we
examine firms with investment property in the UAE. The UAE provides an
interesting case study for two reasons. First, the property market is experiencing
intense growth, with a vast portfolio of property under construction. Moreover,
as land grants are common the “appreciation” of property has considerable
upside potential.
Second, the use of fair value as a valuation tool in the property sector has
been subject to recent criticism in the UAE. For example, an article published in
a local newspaper in September 2008, titled “UAE real estate companies exploit
fair value loophole” contends that fair value is being used to inflate net profits
and is being misused, with potentially deleterious consequences for the
credibility of its financial markets. It states “Some fund managers in the UAE
8
say the current practice of using fair value to calculate earnings is undermining
the ambitions of sheikdoms such as Dubai to become international financial hubs
to rival New York, London, Paris and Tokyo.” The valuation of investment
property in the UAE is therefore worthy of study.
The next section describes the property held by listed real estate and
construction firms in the UAE as reported in their financial statements for the
year ended 31 December 2007.
Sample Selection
There are three stock exchanges in the UAE—the Dubai Financiafl
Market (DFM), the Abu Dhabi Securities Exchange (ADX) and the Dubai
International Financial Market (DIFM). The first two are domestic markets
regulated by the Emirates Securities and Commodities Authority (SCA)4 while
the DIFM is currently at a much earlier stage of development with its own
regulatory arrangements. We restrict our sample to local companies listed on the
DFM and ADX.
We restrict our sample of firms to those expected to have material
exposure to investment property. The DFM provides a subcategory of Real
Estate and Construction. All ten of the companies listed in the subcategory of
Real Estate and Construction were selected. Of these four companies were
excluded that were incorporated in Kuwait. A further company for which
financial information was unavailable was also excluded. This process produced
a reduced sample of five companies.
The Abu Dhabi exchange does not provide classification criteria to
directly identify property firms; the companies selected were those identified by
the researchers based on knowledge of companies in the property industry. A
4
The SCA is a member of the International Organization for Securities Commissions (IOSCO).
9
further three companies were identified for inclusion in the study. The final
sample comprises eight companies.
The financial statements for the year ended December 2007 provide
detailed information on investment property, property under construction and
the accounting choices currently selected by these companies.5 Recall that all
property under construction is accounted for using IAS 16. The disclosures on
property under construction generally permit a clear distinction between
investment and owner-occupied property for one company (one exception,
Arabtec, is noted below) hence property under construction shown in Table 1
provides a reliable guide to the potential impact of the change in regulation.
Accounting Policies for Investment Property or Property Under Construction
Three companies have no investment property: Arab Heavy Industries,
Arabtec and Deyaar Development. Of these, both Arab Heavy Industries and
Arabtec report property under construction at cost less impairment loss.
Arabtec does not identify whether the property under construction is for owneroccupation or investment purposes while Arab Heavy Industries describes
capital works in progress as production-related. Deyaar Development, in
contrast, has neither investment property nor property under construction. On
this basis we exclude all three companies from any further discussion.
Emaar is the sole company in the sample with investment property that
adopts the cost model. Hotels and serviced apartment buildings are classified as
Property Plant and Equipment rather than investment properties. 6 The
remaining companies, Union Properties, RAK Properties, Sorouh and Aldar
report investment property at fair value. However all companies value
investment property under construction at cost less impairment losses.
5
6
All companies reported using International Financial Reporting Standards.
IAS 40 provides a discussion of the discretion used in determining whether property is classified as
investment or owner-occupied property.
10
The review of accounting policies for investment property under
construction suggests that if property under construction can be reliably
measured at fair value then all companies currently using the fair value model
for investment property will need to extend the fair value model to remaining
property.
Materiality of the change for Investment Property and Property Under
Construction
Table 1 reports the amounts of investment property and property under
construction for the firms in our sample, the change in value (fair value or
impairment (write-off)/reversal during 2007) and reported assets, stockholders’
equity and net income for the year.
11
Table 1: Investment Property and Property under Construction (AED ‘000)
Name
Company
of Investment
Property
Investment
Property
Under
Construction
Total Assets
Stockholders’
Equity
Net Income
Reported
Gain/(Loss)
or
Impairment
291,076*
Emaar
5,635,573‡
4,160,014
54,790,875
37,188,266
6,536,358
Properties
307,521
Union
2,814,043
3,992,911
3,363,372
5,224,812
684,431
Properties
79,201
RAK
377,199
128,763
3,274,139
2,903,788
496,228
Properties
852,979
408,438
7,220,667
4,462,996
1,257,391
(16,808)^
Sorouh
1,821,235
Aldar
3,328,381
4,523,421
22,715,096
7,689,399
1,941,298
Properties
‡The fair value of investment property is 11,501,223.
*This amount represents a reversal of impairment losses recognized in previous years. Depreciation on investment property,
not included in this figure, is a further 25,300.
^This amount comprises 0 gain on investment property and an impairment loss of $16,808 on investment property under
development.
12
Table 1 reveals that investment property under construction is significant.
For two companies (Aldar and Union Properties) the value of properties under
construction (determined using cost) exceed the (market) value of completed
investment properties. Indeed, it is significant for all remaining firms, varying
between approximately one-third and three-quarters of existing completed
investment property.
The gains reported in income in 2007 are also significant. A comparison of
the reported net income and gains/reversal of impairment losses for the year
show that unrealized gains contribute material amounts to net income, in one
case exceeding operating performance for the year.
Concluding Comments
This paper describes a change to IFRS likely to affect a small, but
significant, group of companies listed on the domestic exchanges of the UAE. It
remains to be seen whether fair values can be reliably determined for investment
property under construction. Although the IASB identified a small number of
companies using fair value for property under construction, all companies were
domiciled in countries with mature financial reporting and governance
frameworks in place. We await the next reporting season with interest.
13
References:
Anon (2008) UAE real estate companies exploit fair value loophole, Khaleej Times, 6
September 2008, p.32.
Eccles, T and Holt, A. (2001) Accounting for investment properties in the UK:
Problems of definition and implementation, Briefings in Real Estate Finance, 1(2),
122-134.
Ernst & Young (2008) Caution: Fair values in progress: EYGM.
International Accounting Standards Board (IASB), (2008) Exposure draft of
Proposed Improvements to IFRSs, August, London: IASB.
―(2007) Annual Improvements to IFRSs-Exposure draft, October, London: IASB
―(2003) International Accounting Standard 40 Investment Property, London: IASB.
―(2003) International Accounting Standard 16 Property, Plant and Equipment,
London: IASB.
Owusu-Ansah, S. and Yeoh, J. (2006) Relative value relevance of alternative
accounting treatments for unrealized gains: Implications for the IASB, Journal of
International Financial Management and Accounting, 17(3), 228-255.
PriceWaterhouseCoopers (2008) Fair value accounting: Is it an appropriate
measure
of
value
for
today’s
financial
instruments?,
April:
http://pwc.com/extweb/pwcpublications.nsf
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