Owned investment property is measured initially at cost plus transaction costs.

‘Cost’ is defined as “the amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised by the specific requirements of other IFRS, for example, IFRS 2”.

Cost is the purchase price, including directly attributable expenditure. Directly attributable expenditure includes transaction costs, such as legal fees and property transfer taxes. If the asset is being constructed, it will also include borrowing costs.

Cost capitalisation (1) Entity D has recently purchased a property. The entity’s in-house lawyer has spent a substantial amount of time drafting the purchase agreement and negotiating legal terms with the seller’s lawyers. Entity D’s management has estimated a share of the lawyer’s annual salary, social security and benefits package of C70,000 and proposes to capitalise this as a cost of the property. The in-house lawyer’s employment-related costs cannot be capitalised, as these are internal costs that relate to ‘general and administrative costs’ and are not directly attributable to the acquisition of the property. These costs would have been incurred by entity D even if the property in question was not acquired. External legal fees in relation to the purchase of an investment property can be capitalised as part of the cost of an investment property. However, they cannot be capitalised as a separate asset.

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Cost capitalisation (2) Entity A acquires a large portfolio of investment properties, and the acquisition is financed through a loan facility. As part of the arrangement, the entity had to repay its existing borrowings and incurred early redemption penalties. These breakage costs cannot be capitalised as part of the cost of the properties, because they are not a directly attributable cost of bringing the investment properties to their working conditions.

Directly attributable costs can be capitalised only until the investment property is “capable of operating in the manner intended by management”. If investment property is purchased or constructed and can operate in that manner immediately, but is not brought into use immediately, further costs incurred cannot be capitalised. This principle is similar to that in IAS 16 for determining costs that are capitalised as part of property, plant and equipment.

Asset under construction Question: When is construction completed and when does capitalisation cease? Answer: Capitalisation of costs ends when construction is complete. “An asset is normally ready for its intended use or sale when the physical construction of the asset is complete even though routine administrative work might still continue …”. There might be considerable costs of letting an investment property incurred after physical completion. These are not part of the initial cost of the property, because they are not costs of completing the construction of the property, but they are costs of letting it.

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Subsequent costs of bringing the asset to a working condition for its intended use A building was physically completed on 31 March, but the local health and safety regulator did not clear the property until 30 June. The delay of three months in receiving health and safety approval is standard for the type and location of the building. Entity M incurred C400,000 for security during this period. The security expenses are capitalised for the expected period of delay. The legal requirement to receive the regulatory clearance means that the building could not be put to its intended use, even though it was physically ready for its intended use on 31 March.

Capitalizable costs exclude:

• Start-up costs, unless they are necessary to bring the property to the condition necessary for it to be capable of operating in the manner intended by management.

• Operating losses incurred before the investment property achieves its planned level of occupancy.

• Abnormal amounts of wasted material, labour or other resources incurred in constructing or developing the property, because they result in no economic benefits.

Costs excluded Entity M develops office buildings for rental. Subsequent to completion of a building, it incurs expenses (such as security, utilities and marketing) that must be incurred before the building has secured a reasonable level of occupancy. The usual time between the building’s completion and securing a reasonable number of tenants is approximately three months. These costs are expensed as incurred and relate to maintaining the building and attracting tenants. They are not necessary to bring the asset in an operational condition.

Incentives granted to lessees to enter into leases are not the cost of construction; they are part of the net consideration agreed with the lessee for use of the leased asset. The lessor treats the cost of incentives as a reduction of total lease payments which are recognised by IFRS 16.

The cost of an investment property is the cash price equivalent at the date when the asset is recognised. An investment property could be acquired on payment terms that are deferred. The cost in those circumstances is the discounted amount. The difference between the discounted amount and the total payments is treated as interest payable throughout credit unless it is capitalised during the period of construction by IAS 23.

An entity might purchase a property (land and building) to demolish the building directly after purchase (or shortly) and replacing it with a new building.

Demolition costs Entity A purchases land with a derelict building for total consideration of C100m. The building is demolished after purchase and a new building will be constructed in its place. The total cost paid to a third party to demolish the building was C1m. Both the land and the new building meet the definition of investment property, and entity A uses the cost model under IAS 40. The fair value of vacant land in the same area is C101m. It is determined that any other market participant acquiring the land would demolish the current building. The derelict building in this specific FAQ does not meet the definition of an asset, because no economic benefits will flow to entity A from the building. [IAS 16 para 7]. The economic rationale behind the purchase was to acquire land rather than land and a building. Therefore, all consideration paid (C100m) should be allocated to the land. The demolition costs incurred of C1m would represent site preparation costs and would be capitalised in line with IAS 16.

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Expenditure to be capitalised as part of the cost of an investment property – example Entity R acquires a building for CU95 million in March 20X1 as an investment property. In June 20X1, Entity R refurbishes entirely the building at a cost of CU5 million to bring it to the condition required by the rental market. Entity R will pay an estate agent two months’ rent if the agent locates a lessee. In December 20X1, Entity R (the lessor) finally rents the property under an operating lease to Entity S (the lessee). When it buys the building, Entity R should recognise the purchase price as the initial cost of the building under IAS 40. The refurbishment costs are necessary to bring the property to a condition suitable for renting out and, therefore, these costs should also be included in the initial cost of the building. The estate agent’s fees are not part of the initial cost of the building but they are considered to be “initial direct costs incurred in negotiating and arranging an operating lease” under IFRS 16. They are, therefore, capitalised as part of the leased building. When the cost model is used, the expenditure should be depreciated over the lease term. When the fair value model is used, the costs should be capitalised and will, therefore, result in a smaller revaluation gain (or larger revaluation loss) when the building is next remeasured to fair value.

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Termination payments by a lessor to a lessee – example Company A owns an office building that it leases to Company B. The lease is classified as an operating lease in accordance with IFRS 16. Company A would like to convert the office building into a block of flats, believing that this will attract significantly higher rental income. First, however, Company A must terminate the lease contract with Company B. Company A applies the cost model as its accounting policy for the measurement of its investment property subsequent to initial recognition. IAS 16 states that the cost of an item of property, plant and equipment includes “any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management”. IAS 16 requires that the cost of an item of property, plant and equipment be recognised as an asset if “it is probable that future economic benefits associated with the item will flow to the entity” and if “the cost of the item can be measured reliably”. Therefore, if Company A’s cost of terminating Company B’s operating lease meets the recognition criteria for property, plant and equipment in IAS 16, Company A should capitalise this cost because it is a directly attributable cost of enabling operation of the asset in the manner intended by management. Company A should also consider whether there is an indicator of impairment and whether any further impairment testing should be performed to ensure that the building is not recognised at a carrying amount higher than its recoverable amount as a result of capitalising the lease termination costs.

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Depreciation of leasehold land during the construction of an investment property – investment property measured using the cost model When an entity constructs a building on leasehold land that is classified as an investment property measured using the cost model, the depreciation of the leasehold land right-of-use asset during the construction period should be incorporated in the cost of the building under construction. The depreciation of the right-of-use asset for the leasehold land is an expenditure that is directly attributable to the construction of the building, and incorporation of such depreciation in the cost of building while under construction is consistent with the principles of IAS 16.

Deferred payments

The cost of an investment property for which payment is deferred is the cash price equivalent of the deferred payments. The difference between the cash price equivalent recognised at initial measurement, and the total payments made, is recognised as an interest expense throughout credit, i.e. the period from the point of receipt of the property until the point of settlement of the related liability.

There is no definition of ‘cash price equivalent’ in IAS 40. It is presumably intended to equate to the present value of the deferred payment but might also encompass a cash price offered by the vendor as an alternative to the deferred payment terms.

Investment property held by a lessee as a right-of-use asset

An investment property held by a lessee as a right-of-use asset should be measured initially at its cost by IFRS 16.

Investment property acquired through the exchange of another asset

When an investment property is exchanged for an asset (assets), whether monetary or non-monetary, IAS 40 prescribes the treatment for such an exchange. The cost of the investment property is measured at fair value unless either:

• the exchange transaction lacks commercial substance, or
• the fair value of neither the asset received nor the asset given up is reliably measurable.

The acquired asset is measured in this way even if an entity cannot derecognise immediately the asset given up. If the acquired asset is not measured at fair value, its cost is measured at the carrying amount of the asset given up.

Whether an exchange transaction has commercial substance is determined by considering the extent to which the future cash flows are expected to change as a result of the transaction. IAS 40 states that a transaction has commercial substance if:

• the configuration (risk, timing and amount) of the cash flows of the asset received differs from the configuration of the cash flows of the transferred asset; or
• the entity-specific value of the portion of the entity’s operations affected by the transaction changes because of the exchange; and
• the difference in either of these is significant relative to the fair value of the assets exchanged.

In determining whether an exchange transaction has commercial substance, the entity-specific value of the portion of the entity’s operations affected by the transaction should reflect post-tax cash flows. The Standard notes that the results of these analyses may be clear without having to perform detailed calculations.

In most instances, it will be readily apparent whether a transaction lacks commercial substance. The reference in IAS 40 to the entity-specific value of the portion of the entity’s operations affected by the transaction is not explained in detail but is intended to indicate that a transaction will have substance when it has a significant effect on the present value of the entity’s future cash flows.

The fair value of the asset is reliably measurable if:

• the variability in the range of reasonable fair value measurements is not significant for the asset; or
• the probabilities of the various estimates within the range can be reasonably assessed and used when measuring fair value.

If the fair value of either the asset received or the asset given up can be measured reliably, then the fair value of the asset given up is used to measure cost unless the fair value of the asset received is more clearly evident.