Revaluation of Leasehold land
16 August 2010
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We have land on 99 years lease. Unexpired lease is 60 years. we revalued land in 2005 and created revaluation reserve. Same auditor is signing the annual accounts since 2005. This year, auditors say that we have to reverse the reavaluation part saying that as per IFRS, revaluation of leasehold land is not possible
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Is the land classified as investment property (per IAS 40) or not?
Is the lease operating or financial?
BTW, assuming the auditor’s view is justifiable (which it may or may not be), I don’t see how a simple reversal would suffice. As far as I can see, if you applied the revaluation model inappropriately, this is a “mistake in applying accounting policies”, which should be treated as a prior period error (retrospective restatement).
Oh, just for the sake of curiosity, what were you doing the 34 years you had the land prior to 2005?
Unfortunately, because I am sure that you are unhappy with your auditors, I agree that, unless the land can be classified as an investment property, you cannot spply the subsequent measurement models in IAS 16 to an IAS 16 asset.
I also agree with Mladek that you would have an error correction that would require retrospective application.
Another option is to send a question to IFRIC and hope for a different reading of IAS 16.
Finally, unless you had the ability to sell the asset and realize the revaluation reserve, I’m not sure why you believed that the revaluation model provided relevant information to the users of your financial statements, the original opinion of your auditors notwithstanding.
Patricia Walters
Previous owner of the land got the land for 99 years lease. When we bought, the unexpired lease period is 60 years. Though it is said as leasehold, we can carry on business, make use of the land and sell. We have all the rights over the land. Lease rental is very nominal. It’s about USD200/- p.a. For all practical reasons, it is as good as it’s own land. It’s classified as financial lease. Unfortunately, when the original classification and revaluation were done, I’m not present.
Guys, I think you’re looking at the wrong standard. IAS 17 (leases) specifically states that land, being (the only) tangible asset with an indefinite life, is necessarily classified as an operating lease. The size of the rent you’re paying has nothing to do with it. So if you apply IAS 17, that land should never have been put on your balance sheet in the first place, let alone revalued!
However, don’t rush to take it off balance-sheet or reverse anything, because leases (all of them) are under review. The IASB is on the point of issuing a new standard which applies a different logic : termed the ‘right of use’ approach, it means that the lessee must capitalise their right to use an asset, including their right to extend a lease. This would imply that your current treatment is correct, including the revaluation part.
Actually, IAS 17 states: “The land element is normally classified as an operating lease unless title passes to the lessee at the end of the lease term.” But, this text is in the summary of changes (IN9), not the standard itself.
Paragraph 15A states: “When a lease includes both land and buildings elements, an entity assesses the classification of each element as a finance or an operating lease separately in accordance with paragraphs 7–13. In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life.”
Thus, contrary to ifrsexpert’s assertions, having an indefinite life does not preclude land from being recognized as a finance lease. As to derecognizing an asset with a remaining 60-year life or speculating on the transition to standard whose ED hasn’t even been published yet? I’m not even going to go there.
In any event, based on the additional information supplied, it does not seem that IAS 17 was the pertinent standard.
Since the transaction involved the acquisition of an advantageous contractual right (a 99 year lease costing $200 per year), I believe IAS 38 should have been applied.
Maybe the original lessee could have applied IAS 17 (though I doubt it), but for the subsequent buyer of the right? That would not be appropriate.
This also implies that, if IAS 38 is the applicable standard, revaluation not disallowed.
But that is the caveat.
As Patricia correctly pointed out, the revaluation model should be applied only if it provides relevant information to the users. Or, to put another way, it reflects the economic substance of the transaction.
Often, the exact opposite is the case.
Management’s decision to use the revaluation model is occasionally (always in my experience) based on ulterior motives.
Personally, I have only ever seen revaluation at rate-regulated enterprises that use the revalued (and significantly higher) basis to not only to bolster capital, but justify (to their regulator) charging significantly higher rates for their services.
The quality (or the lack thereof) of the methodology used has (always up to now) confirmed this suspicion (at every company I have examined). Also (as an interesting side note), if guaranteed confidentiality, management is usually so please with itself that it will gladly admit to the real reasons for selecting this policy (and one does not even have to get them drunk first).
But that is another issue.
Based on the facts presented, I do not see any strictly standards driven justification for the auditor’s change in judgment.
But, as I stated in my first post, fixing the problem (if there is a problem) won’t involve reversing the gain.
It will involve restating the financial statements.
And this will almost certainly be messy for all involved (especially the auditor who will have to explain why it took him 5 years to realize that his original judgment was mistaken or why, during those five years, he never noticed that the asset was not being revalued “by reference to an active market … with such regularity that at the end of the reporting period the carrying amount of the asset does not differ materially from its fair value”).
[New Post] Revaluation of Leasehold land – http://www.ifrslist.com/2010/08/revaluat...
via Twitoaster
Opps, forgot to check their site yesterday.
In any event, the leasing exposure draft can be downloaded here: eifrs.ifrs.org.
Land cannot be classified as finance lease if the title do not transfers to the lessee at the end of lease term, since considering the infinite life and economic benefits of land, substantive risk and rewards are not transferred from in a period of mere 100 years!, though a few exceptions apply in this regard. therefore, the revaluation of a piece of land held under operating lease is out of question.
Hate to rain on asad’s categorical assertion parade, but IAS 17.10.a-e explicitly states that title transfer is only one of five situations (paragraph 11 also outlines addition indicators) to be considered in evaluating whether an agreement transfers substantially all the risks and rewards incidental to ownership.
Thus, title transfer IS NOT a prerequisite for a lease being classified as a financial lease.
If any question remains (though I do not see how it could), paragraph 15A explicitly instructs one to take into consideration that land normally has an indefinite life, not to base one’s judgment solely on that fact.
BTW, I think the term asad is looking for is unlimited. Only the universe or God’s love for his children is infinite (but only if one believes in that sort of thing). As to land always being unlimited, IAS 16.58 outlines some situations where this is not the case (which is why the word normally appears in paragraph 15A).
As to the implication that the arrangement be treated as an operating lease. That would so thoroughly disregard the economic substance of the transaction, that it is not even worth commenting on.
But I digress.
And I am not defending revaluation. As I stated above, I am firmly against revaluing assets (except financial instruments and possibly, depending on the circumstances, investment property).
But revaluation is not the issue.
The issue is whether an auditor is justified (five years after the fact) to make a 180 degree turn in judgment.
The secondary issue is, if the change is justified, whether the auditor can simply (by reversing it) sweep it under the rug or whether he (by making a restatement) has to hang it out there for all to see (sorry about the mixed metaphor).
Why do I even bring this up?
In my experience, companies are simply too tolerant of their auditor’s whims, mood swings and plain sloppy work. Why let them off easy?
Sure, a restatement is never fun for any comapny. But, it tends to be even less fun for the auditor (the licensed accounting expert) who signed off on the erroneous report.
I remember one time when I was working at a (at the time) big-eight firm. One of our partners signed of on such a report. Her punishment? She had to retake the CPA exam. How did she do? I have no idea. Since clients prefer auditors without suspended licenses, she did not stay with the firm long enough for me to find out.
IAS 17.14-1 and IAS 40.33-1 – Accounting for land-use rights
Issue
How should long-term land-use rights (leases of land) be accounted for?
Fact Pattern
On 1 January 2004 Entity A acquires a long-term land-use right for an amount of CU 100. The lease term is 50 years. An independent valuer assesses the fair value of the long-term land-use right as CU 105 as at 31 December 2004.
Scenario 1:The land-use right is acquired with the intention of holding it to earn rentals and for capital appreciation.
Scenario 2:The land-use right is acquired with the intention of constructing a building on the land for own use.
Conclusion
Scenario 1:
Under scenario 1 the accounting treatments depends on whether:
• Entity A chooses to apply the cost model
• Entity A chooses to apply the fair value model under IAS 40 Investment Property.
If the entity chooses to apply the cost model, the payments made on entering into or acquiring the land-use right represent prepaid lease payments that are amortised over the lease term in accordance with the expected pattern of consumption of the economic benefits embodied in the land-use right. In this example, on 1 January 2004 CU 100 would be recognised as a prepaid operating lease expense to be classified as a non-current asset under a separate heading such as “prepaid lease expenses” and thereafter amortised over 50 years. Subsequent to initial recognition such prepaid lease payments are not revalued.
If an entity applies the fair value model under IAS 40 (IAS 40 and IAS 17 Leases explicitly allow a property interest held under an operating lease to be classified as an investment property subject to specific requirements), the payments made on entering into or acquiring a land-use right are capitalised as part of the cost of the investment property and the land-use right is subsequently measured at fair value. In this example, on 1 January 2004 Entity A recognises an asset under investment properties at CU 100. At 31 December 2004 the value of this asset has increased by CU 5, resulting in a gain of CU 5 to be recognised in profit or loss for 2004.
Scenario 2:
Under scenario 2 the land-use right would be scoped out of IAS 40. Accordingly, the payments made on entering into or acquiring the land-use right represent prepaid lease payments that are amortised over the lease term in accordance with the expected pattern of consumption of the economic benefits embodied in the land-use right. In this example, on 1 January 2004 CU 100 would be recognised as a prepaid operating lease expense to be classified as a non-current asset under a separate heading such as “prepaid lease expenses” and thereafter amortised over 50 years.
Reasons for Conclusion
Scenario 1:
An entity applies the cost model
Long-term land-use rights are leases under paragraph 4 of IAS 17. If the long-term land-use right does not provide for the transfer of title by the end of the end of its term, the lessee normally does not receive substantially all of the risks and rewards incidental to ownership and therefore the contract is deemed to be an operating lease as set out in paragraph 14 of IAS 17.
Paragraph 6 of IAS 40 allows a property interest held by a lessee under an operating lease to be classified and accounted for as investment property if, and only if, the property would otherwise meet the definition of an investment property and the lessee uses the fair value model, i.e. where a property interest held by a lessee under an operating lease is classified as investment property the application of the fair model is mandatory (paragraph 34 of IAS 40). As the fair value model is not applied, the accounting treatment set out in IAS 17 has to be followed.
Paragraph 33 of IAS 17 states that:
“Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.”
If certain costs arise at the inception of the lease that are necessary to consummate the agreement and enable a lessee to exercise its rights under the lease agreement, these costs are incurred as a direct result of the land-use right (lease). Therefore, it is appropriate to consider these as lease-related costs that should be subject to the same accounting treatment as prepaid lease payments. A premium paid for a leasehold represents pre-paid lease payments that are amortised over the lease term in accordance with the pattern of benefits obtained.
As paragraph 14 of IAS 17 states that “a payment made on entering into or acquiring a leasehold that is accounted for as an operating lease represents prepaid lease payments […]” it is appropriate to classify the land-use right as a non-current asset under a separate heading such as “prepaid lease expenses”. This accounting treatment is supported by paragraph 57 of IAS 1 Presentation of Financial Statements (which rules that all assets which are not realised within twelve months after the balance sheet date shall be classified as non-current).
Some might argue that a land-use right meets the definition of an intangible asset as defined in paragraph 8 of IAS 38 Intangible Assets (“an identifiable non-monetary asset without physical substance”) and should therefore be classified as such in the balance sheet. However, in our view this accounting treatment is not appropriate as leases are scoped out of IAS 38 (paragraph 3 c).
Some argue that a land-use right can be considered as a separate item of property, plant & equipment and should therefore be classified as such in the balance sheet. However, in our view this accounting treatment is not appropriate as a land-use right is not a tangible asset and does therefore not meet the definition of an item of property, plant and equipment as defined in paragraph 6 of IAS 16 Property, Plant and Equipment.
An entity applies the fair value model under IAS 40
The lessee is able to classify and account for the operating lease as investment property as permitted by paragraph 6 of IAS 40 since the property would otherwise meet the definition of an investment property and the lessee uses the fair value model. On initial recognition the investment property is recognised at cost (paragraph 20 of IAS 40). Fair value measurement after initial recognition is discussed in paragraph 33 ff. of IAS 40.
Scenario 2:
A land-use-right for own use does not meet the definition of an investment property and is scoped out of IAS 40 (see paragraph 9 (c) of IAS 40). Hence, the accounting treatment set out in IAS 17 as discussed above in relation to the application of the cost model in scenario 1 has to be followed.
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