Property valuations under FRS 102 and FRS 105

At a recent virtual conference, there were a stream of questions coming through from delegates around the issue of property valuations. Some accountants were querying the accounting treatment for investment property, while others were saying they had received challenges through reviews of financial statements as to the accounting treatment they had applied (including deferred tax aspects) as well as the disclosure requirements and were unsure where the criticism came from.

This article addresses some of the issues concerning property valuations under both FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime.

Investment property classification

One of the most common questions surrounds the classification of investment property and when property should, or should not, be classified as such. The Glossary to FRS 102 provides the definition of investment property which is:

This is quite a broad definition. Investment property can include just land or just a property or both. In practice, where a property generates a rental income stream for the business, the property would fall to be classed as investment property. Similarly, if land is being held for long-term capital appreciation, then that, too, would be classed as investment property. Correct classification is critical because it can affect the subsequent accounting treatment.

Where property meets the definition of investment property, it must be accounted for under FRS 102, Section 16 Investment Property. Micro-entities choosing to report under FRS 105 would apply FRS 105, Section 12 Property, Plant and Equipment and Investment Property.

At initial recognition, the investment property is measured at cost (being its purchase price plus all directly attributable costs, such as legal fees). After initial recognition, FRS 102, Section 16 applies the Fair Value Accounting Rules in company law. This means that at each reporting date, the entity must remeasure investment property to fair value with fair value gains and losses being recorded in profit or loss. A couple of delegates had been taking gains and losses on investment property directly to a revaluation reserve within equity, which is what happened under old UK GAAP. As FRS 102, Section 16 does not use the Alternative Accounting Rules, taking gains and losses to a revaluation reserve is incorrect and invariably will cause the financial statements to be misleading, necessitating a prior period adjustment to correct the error.

Fair value gains and losses on investment property must pass through profit or loss. Once this has happened, they can be ring-fenced into a separate component of equity (e.g. a ‘non-distributable reserve’). Although there is nothing in company law that requires this, it is an efficient means of segregating distributable and non-distributable reserves.

Under FRS 105, the Fair Value Accounting Rules cannot be applied. Everything must be measured at historical cost. This is the way the micro-entities’ legislation was drafted – it was not something the Financial Reporting Council decided to do. Hence, under FRS 105, investment property is measured at cost less depreciation less impairment.

Another delegate questioned the presentation of a ‘revaluation reserve’ on a set of FRS 105 financial statements they had received from an outgoing accountant. Seemingly, on transition to FRS 105, the investment property’s value at the date of transition to FRS 105 had been ‘frozen’ and a revaluation reserve had been presented. FRS 105 does not allow the use of a previous GAAP valuation as ‘deemed cost’ (because revalued amounts are inconsistent with the legislation) hence presenting a revaluation reserve in an FRS 105 balance sheet is inappropriate. Instead, FRS 105, para 28.01(c) provides an optional exemption which, among other things, allows the first-time adopter to simply reverse any revaluation gains and losses previously recognised in equity reserves against the value of the property at the date of transition.

Mixed-use property

One delegate questioned the scenario where a client owns a building and rents out part of that building to a third party and the resulting accounting treatment. In this example, the property would fall to be classed as ‘mixed use property’. This is dealt with under FRS 102, para 16.4. This paragraph states that mixed use property must be separated between investment property and property, plant and equipment if the resulting portions could be sold separately or leased out separately under a finance lease.

If the fair value of the investment property component cannot be measured reliably, the entire property is accounted for under FRS 102, Section 17 Property, Plant and Equipment. Where the investment property component can be measured reliably, Section 16 would apply to that component with the owner-occupied component being measured under Section 17.

Revalued property, plant and equipment

Property, plant and equipment is dealt with in FRS 102, Section 17 and in FRS 105 at Section 12.

The Glossary to FRS 102 defines ‘property, plant and equipment’ as:

In practice, the most common type of tangible asset to be revalued is a building (although other types of assets can also be revalued).

Under FRS 105, no assets can be revalued. Nor can previous revaluation amounts be used as ‘deemed cost’ on first-time adoption of FRS 105.

The revaluation model is contained in FRS 102 at paras 17.15B to 17.15F. The revaluation model in Section 17 applies the Alternative Accounting Rules in company law. These rules require the presentation of a revaluation reserve in the equity section of the entity’s balance sheet.

While the revaluation model may seem attractive on first glance (because an entity can include any appreciation in value of the asset on the balance sheet), there are some important points to note where this model is concerned that a client needs to be aware of:

• All assets within the same asset class must be revalued as well. So, if a client has three buildings, two of which have appreciated in value, it must revalue all three buildings rather than just the two whose fair value has increased. This rule is to prevent entities from deliberately ‘cherry picking’ those assets that have increased in value and leaving out those which may not have.
• Revaluations must be carried out with sufficient regularity to ensure the carrying amount of the asset(s) at the balance sheet date does not differ materially from fair value. There are no timescales in FRS 102, Section 17 as to how often the entity must carry out a revaluation – this will be left to professional judgement.
• Once the entity adopts the revaluation model, it cannot switch back to the cost model. Switching from the cost model to the revaluation model is a change in accounting policy (although not one that has to be applied retrospectively on initial application, unlike other changes of accounting policy per FRS 102, para 10.10A). An entity can only change an accounting policy if a revised policy is required by a change to an FRS; or the revised policy results in the financial statements providing reliable and more relevant information in the accounts. Switching back to the cost model from the revaluation model is highly unlikely to provide such reliable and relevant information.

Revaluation gains and losses are accumulated within the revaluation reserve (i.e. they do not flow through the profit and loss account as fair value gains and losses on investment property do). Revaluation gains only go to profit or loss if they reverse a previously recognised revaluation loss in respect of that asset that had been recorded in profit or loss. Any excess gain is then recorded in the revaluation reserve.

Revaluation losses are also recognised in the revaluation reserve to the extent of a revaluation surplus in respect of that asset. Any excess loss is then recorded in profit or loss – there cannot be a debit balance on the revaluation reserve in respect of a revalued item of property, plant and equipment.

Historical cost comparative disclosures

When an asset is revalued, The Small Companies and Groups (Accounts and Directors’ Report) Regulations 2008 (SI 2008/409) and The Large and Medium-sized Companies and Groups (Accounts and Report) Regulations 2008 (SI 2008/410), Sch 1, para 34 require disclosure of the comparable amounts of the revalued property according to the historical cost accounting rules.

Deferred tax

For micro-entities reporting under FRS 105, deferred tax is prohibited.

Under FRS 102, deferred tax must be brought into account in respect of fair value gains and losses on investment property and revaluation gains and losses on property, plant and equipment. Deferred tax is calculated using the tax rates and laws that have been enacted or substantively enacted by the reporting date.

Deferred tax in respect of investment property will follow its underlying transaction and be recorded in profit or loss. Deferred tax in respect of revalued property, plant and equipment will also follow its underlying transaction and will be recorded in the revaluation reserve.

Currently deferred tax is usually calculated at a rate of 19%, but this may be different for balance sheet dates ending on or after 25 May 2021 as the Finance Bill 2021 had become substantively enacted by this date. The Finance Bill 2021 increases the main rate of corporation tax from 19% to 25% from 1 April 2023 and so this will also affect the calculation of deferred taxes in some cases.

Conclusion

Property valuations can cause an element of confusion for some preparers, particularly as the treatment of fair value and revaluation gains and losses is significantly different depending on the classification of the property. If there are uncertainties as to whether a property should be treated as investment property, it is always advisable to look to the definition in the Glossary to FRS 102 and compare the use of the property to the definition. Alternatively, it would be advisable to seek third party advice to ensure the correct treatment (and subsequent accounting treatment) is appropriate in the circumstances.

Category: Accounting and standards, Audit