Property valuations under FRS 102
This article featured in International Accountant magazine in the spring of 2022
FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with investment property in Section 16 Investment Property and property, plant and equipment in Section 17 Property, Plant and Equipment. Micro-entities choosing to prepare their financial statements under FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime apply Section 12 Property, Plant and Equipment and Investment Property.
This article covers the accounting treatment for both fair value gains and losses on investment property and revaluation gains and losses on owner-occupied property under FRS 102 and examines some of the more notable accounting issues that preparers often face.
Investment property
FRS 102 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:
(a) use in the production or supply of goods or services or for administrative purposes, or
(b) sale in the ordinary course of business.’
Therefore, where a property generates a rental income stream for the business, the property will meet the definition of investment property and will be accounted for under FRS 102, Section 16. Land that is being held for capital appreciation purposes will also be classified as investment property.
Initial recognition
On initial recognition, a property that meets the definition of investment property is recognised at cost. Cost may comprise several elements and includes the initial purchase price plus all directly attributable costs such as legal fees and property transfer taxes.
An entity may incur certain costs which relate to the property’s subsequent use but are not directly attributable costs. Typical examples include marketing costs to attract new tenants and operating costs which are incurred prior to the property reaching its target occupancy rate. These sorts of costs are not recognised within the cost of the investment property on initial recognition – they are recognised in profit or loss as incurred.
Subsequent measurement
FRS 102, Section 16 applies the Fair Value Accounting Rules in company law and all investment property (with the exception of intra-group investment property which can be measured under the cost model – see FRS 102, para 16.4A) must be remeasured to fair value at each reporting date. Changes in fair value are taken to profit or loss (not a revaluation reserve).
| Example – Change in fair value of investment property
Sunnie Ltd has an investment property on its balance sheet which is measured under FRS 102, Section 16. At the year end 31 December 2021, the property had increased in value from the prior year by £35,000. The company has been making annual profits amounting to approximately £500,000 per annum for the last five years and the company’s forecasts indicate that this level of profit will continue for the foreseeable future. The fair value gain will be recorded in Sunnie’s profit and loss account as follows:
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Deferred tax
FRS 102, para 29.16 states:
‘Deferred tax related to investment property that is measured at fair value in accordance with Section 16 Investment Property shall be measured using the tax rates and allowances that apply to the sale of the asset, except for investment property that has a limited useful life and is held within a business model whose objective is to consume substantially all of the economic benefits embodied in the property over time.’
Investment property is a non-monetary asset that is subject to revaluation and hence falls under the scope of deferred tax in FRS 102, Section 29 Income Tax.
In the spring 2021 Budget, the chancellor announced that the rate of corporation tax in the UK would increase from 19% to 25% on 1 April 2023 for companies making taxable profits in excess of £250,000. However, the rate of corporation tax will remain at 19% for companies making taxable profits of £50,000 or less.
There is an added complexity at the present time for preparers of financial statements under UK GAAP because of this increase. FRS 102, Section 29 requires deferred tax to be calculated using the tax rates and laws that have been enacted or substantively enacted by the reporting date and which are expected to apply to the reversal of the timing difference.
The 25% tax rate was codified in Finance (No. 2) Bill which became substantively enacted on 24 May 2021. Consequently, for balance sheet dates ending on or after 24 May 2021 deferred tax in respect of timing differences which are expected to reverse on or after 1 April 2023 will need to be remeasured at 25% where taxable profits are expected to exceed £250,000; or at the marginal rate if taxable profits are expected to fall between £50,000 and £250,000.
| Example – Deferred tax on fair value gain
Continuing with the example of Sunnie Ltd above. The fair value gain was £35,000 and the company expects to make profits around £500,000 hence will be taxed at 25% from 1 April 2023, even though profits will be taxed at 19% in the tax computation for the year ended 31 December 2021. The financial year ended on 31 December 2021 and so deferred tax is calculated at a rate of 25% because this rate is the rate that is expected to apply to the reversal of the timing difference. Consequently, a deferred tax liability on the fair value gain of £8,750 (£35,000 x 25%) arises and will be recorded as:
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Gains on fair value fluctuations of investment property are not distributable to the shareholders. This is because profits must be ‘realised’ to be classed as distributable which, in essence, means that they have been converted into cash or can be readily converted into known amounts of cash. There is no guarantee that an investment property can be sold instantly and so any net gains recorded in profit or loss will be classed as non-distributable. Hence, in the example of Sunnie Ltd above, the net gain of £26,250 (£35,000 – £8,750) is non-distributable.
It may be advisable to keep a record of the value of reserves which are not distributable to the shareholders either within the accounting records themselves or by ring-fencing them in a ‘non-distributable reserve’ within equity. There is nothing in company law that requires non-distributable profits to be ring-fenced in a separate component of equity, but it is an efficient means of keeping track of profits which cannot be distributed to the shareholders.
Revaluations of owner-occupied property
Owner-occupied property (e.g. a freehold building) is measured under the provisions of FRS 102, Section 17 Property, Plant and Equipment (or FRS 105, Section 12 Property, Plant and Equipment and Investment Property).
Initial recognition
On initial recognition, the property is measured at cost. Cost can include several components including purchase price and directly attributable costs. FRS 102, para 17.10 provides a list of the elements of cost which include legal fees, irrecoverable purchase taxes and costs of site preparation.
Subsequent measurement
After initial recognition at cost, there are two possible subsequent measurement bases available under FRS 102:
- Cost model
- Revaluation model
Cost model
Under the cost model, an entity measures an item of property, plant and equipment (PPE) at cost less depreciation less accumulated impairment losses.
Revaluation model
FRS 102, para 17.15B states that under the revaluation model, an item of PPE whose fair value can be measured reliably is carried at a revaluation amount, being its fair value at the date of revaluation, less any subsequent accumulated depreciation and subsequent accumulated impairment losses.
It must be emphasised that all assets within the same asset class must be subject to revaluation.
FRS 102 defines ‘class of assets’ as:
‘A grouping of assets of a similar nature and use in an entity’s operations.’
For example, if an entity has four properties, then all four properties must be subject to the revaluation model; the entity cannot just ‘cherry pick’ those assets which have appreciated in value and ignore the others.
The revaluation exercise must be carried out with sufficient regularity to ensure that the carrying amount of the revalued asset at the reporting date does not differ materially from that which would be determined using fair value at the reporting date. This, of course, will require professional judgement as FRS 102 does not specify timescales as to how frequently the revaluation exercise must be undertaken.
The revaluation model in FRS 102, Section 17 applies the Alternative Accounting Rules in company law. This means that any gains on revaluation are taken to a revaluation reserve in the equity section of the entity’s balance sheet and are reported as other comprehensive income. The Alternative Accounting Rules also require disclosure of the equivalent historical cost figures had the revaluation not taken place.
| Example – Revaluation gains and losses
Dexter Co has an asset with a carrying value of £140,000. On 31 July 2020, the asset was revalued upwards to £160,000 (note deferred tax implications are ignored for the purposes of this example). The entries in the books to reflect this revaluation gain are:
On 31 July 2021, the asset’s value had decreased to £130,000. The entries in the books to reflect this revaluation loss are:
If it is assumed that on 31 July 2022, the asset increases in value to £150,000, the revaluation gain is recorded as follows:
In the 31 July 2022 financial statements, the previous revaluation loss of £10,000 has been reversed as the asset’s value as increased. Hence, rather than take the whole revaluation increase of £20,000 to the revaluation reserve, £10,000 is recognised in profit and loss to reverse the previous revaluation loss as at 31 July 2021. |
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Deferred tax
PPE measured under the revaluation model are non-monetary assets subject to revaluation and fall within the scope of deferred tax.
Deferred tax in respect of PPE will follow its underlying transaction in the financial statements. Hence, for revaluation gains, a deferred tax liability (or movement therein) will be taken to the revaluation reserve. A reduction in a deferred tax liability for a revaluation loss will also be taken to the revaluation reserve. Where any element of gain or loss passes through profit or loss (due to part or all of the revaluation gain reversing a previous revaluation loss, or an excess loss being recorded in profit or loss), the associated deferred tax element will need to be split pro-rata between other comprehensive income and profit or loss.
Conclusion
Confusion often surrounds the accounting treatment of investment property and owner-occupied property. It is important to keep in mind the relevant company law rules that are being applied to ensure the correct accounting treatment is applied (investment property is measured under the Fair Value Accounting Rules; owner-occupied revalued property is measured under the Alternative Accounting Rules). Also, keep in mind the requirement to bring deferred tax into account which poses its own difficulties at the present time due to marginal rates being brought back.
Category: Accounting and standards, Audit
