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.