Audit and Technical Partner Leavitt Walmsley Associates Ltd
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FRS 105 step by step: Investment property

11th Aug 2015
Audit and Technical Partner Leavitt Walmsley Associates Ltd
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FRS 105 ‘The Financial Reporting Standard applicable to the Micro-entities Regime’ becomes mandatory for micro-entities choosing to report under the micro-entities’ regime for accounting periods commencing on or after 1 January 2016 (earlier adoption is permissible).

The standard has to be applied retrospectively to the date of transition.  The ‘date of transition’ is the start date of the earliest period reported in the financial statements (in other words the start date of the comparative period).

The regime is currently receiving mixed responses. Some accountants like the standard because it simplifies certain areas (eg prohibiting micro-entities from recognising deferred tax); while others remain firmly unsupportive of the standard, questioning how such financial statements give a true and fair view given the sheer amount of disclosure reductions.

Micro-entities can choose to make additional voluntary disclosures if they so wish. But because of the presumption in legislation that the financial statements give a true and fair view if the micro-entity’s financial statements have been prepared to the legally required minimum provisions, the directors are not obliged to consider any additional disclosure requirements to achieve a true and fair view.

A notable aspect of the micro-entities’ legislation is that it does not recognise any of the alternative accounting rules or fair value accounting rules.  This is going to potentially present problems for micro-entities who currently have assets carried at revaluation; notably investment property and must be carefully considered when choosing the appropriate financial reporting framework.

Accounting for investment property

Under the FRSSE, investment property is measured at open market value, with changes in market value passing through the revaluation reserve in equity and reported via the statement of total recognised gains and losses.

This accounting treatment is not permitted in FRS 105 because the legislation does not recognise any provision of the alternative accounting rules. The alternative accounting rules are currently applied by companies when they revalue certain assets and because these rules are prohibited, assets must be carried at historical cost.

It will not be possible to use a previous revaluation amount as deemed cost and then apply the cost model from the date of transition as this would be inconsistent with the legal framework and hence no transitional exemption was provided for in FRS 105 in this respect.

In drafting FRS 105, the Financial Reporting Council (FRC) have included an optional exemption relating to investment property in paragraph 28.10(c).  This optional exemption says:

“A first-time adopter is not required to retrospectively apply paragraph 12.15 to determine the depreciated cost of each of the major components of an investment property at the date of transition to this FRS.  If this exemption is applied, a first-time adopter shall:

(i)            Determine the total cost of the investment property including all of its components.  Where no depreciation had been charged under the micro-entity’s previous financial reporting framework, this can be calculated by reversing any revaluation gains or losses previously recorded in equity reserves.

(ii)           The cost of land, if any, shall be separated from buildings.

(iii)          Estimate the total depreciated cost of the investment property (excluding land) at the date of transition to this FRS, by recognising accumulated depreciation since the date of initial acquisition calculated on the basis of the useful life of the most significant component of the item of investment property (eg the main structural elements of the building).

(iv)         A portion of the estimated total depreciated cost calculated in paragraph (iii) shall then be allocated to each of the other major components (ie excluding the most significant component identified above) to determine their depreciated cost.  The allocation should be made on a reasonable and consistent basis.  For example, a possible basis of allocation is to multiply the current cost to replace the component by the ratio of its remaining useful life to the expected useful life of a replacement component.

(v)          Any amount of the total depreciated cost not allocated under paragraph (iv) shall be allocated to the most significant component of the investment property.’

Example – Investment property on transition

Company A Ltd is a micro-entity applying FRS 105 for the first time for the year-ended 31 December 2016.  The opening balance sheet as at 1 January 2015 has an investment property carried at open market value of £100,000 and a revaluation surplus of £20,000.  The investment property was purchased on 1 January 2012 and the value of the land was £25,000.

Step 1

The transitional provision in paragraph 28.10(c)(i) can be applied.  The revaluation surplus of £20,000 can be reversed against the cost of the investment property and hence at the date of transition the investment property will have a cost for FRS 105 purposes of £80,000 (£100k less £20k). 

Step 2

Once the cost has been established, the value of the land is taken into consideration and accounted for separately because land does not depreciate.  This will then allow the depreciable amount of the asset to be calculated as follows:

     

£

Cost

   

80,000

Less land element

 

(25,000)

Depreciable amount

55,000

Step 3

Once the depreciable amount has been calculated paragraph 28.10(c)(iii) requires depreciation to be calculated since the date of initial acquisition on the basis of the property’s useful life of the most significant component of the property (i.e. the main structural element).  If this is considered to be 50 years from the acquisition date, the depreciation charge since the date of acquisition is calculated as follows:

Date of purchase:            1 January 2012

Depreciable amount:     £55,000

Depreciation:                     (£55,000 x 2%) x 3 years (i.e. to 1 January 2015) = £3,300

At the date of transition (1 January 2015) an adjustment will be required as follows:

£
DR accumulated profit and loss 3,300
CR accumulated depreciation (investment property) 3,300
Being three years’ depreciation from the date of acquisition to the date of transition

Step 4

On the date of transition, the investment property has a total depreciated cost of £51,700 (£55,000 less £3,300).  This depreciated cost then needs to be allocated to each of the other major components (i.e. excluding the most significant component) to determine their depreciated cost.

The director has identified that the central heating system will need replacing in three years’ time from 1 January 2015.  The current cost to replace the central heating system is £10,000. 

In this example the central heating system has a considerably shorter life than the main structure of the investment property and hence should be depreciated separately from the remainder of the property.  The depreciation charge in the 2015 comparative year is as follows:

   

Investment property

Central heating

Total

   

£

£

£

Depreciable amount

41,700

10,000

51,700

Depreciation charge

834*

3,333**

4,167

         

*£41,700 x 2%

       

**£10,000 / 3 years

     

Conclusion

The prohibition of fair values and revaluation amounts in the micro-entities’ legislation will mean that all revaluation amounts will have to be removed on transition. This could have a big impact on an entity’s balance sheet position and therefore should be taken into consideration when establishing the most appropriate financial reporting framework to report under.

FRS 105 is optional and if a micro-entity wants to continue recognising its investment property (and any other assets) at revaluation, then it must apply FRS 102 with reduced disclosures as a minimum. 

The transitional exemption allowing to treat the investment property at the date of transition as a single asset for the purposes of estimating accumulated depreciation has been introduced to provide an exemption for micro-entities from having to determine the historical cost of each component that has been replaced in the past and the depreciation charge that would have been charged since their initial recognition.

Many accountants are concerned about the prohibition of applying the alternative accounting rules and this concern is shared by the Accounting Council of the FRC who believe that investment property should always (where practicable) be measured at fair value on the grounds that this will provide more relevant information to users of the financial statements; however this is not possible under the legal framework. 

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Replies (16)

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By Jas28
11th Aug 2015 20:55

It is ridiculous to depreciate an investment property

I don't have a problem with showing investment properties at their historical cost, for the sake of simplicity, but I do have a problem with depreciating them. It is quite ridiculous to charge depreciation on an asset which is appreciating in value.

Also, for many properties is will be impossible to separate the cost of the land from the cost of the building. And how do you determine the estimated useful life of a building which is already over 100 years old? 

We have an investment property which was bought in 1962 for about £16,000 and is now worth over £200,000. I am happy to accept, for simplicity, that it should just be shown at its original cost of £16,000. But I'd just have to guess how much of the cost related to the building. And if I then calculated depreciation at 2% per year, the written down value of the building would be nil.

Is is possible to justify an argument that the depreciation of the building should be nil, because its estimated useful life is more than 50 years, and its estimated residual value is more than cost?

Thanks (1)
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By Ayesha Bham
11th Aug 2015 21:12

Agreed it's nonsensical
Last week I attended a free local seminar on all of this. I did think common sense had prevailed as the speaker told us that the decision to withdraw the revaluation method for investment properties had been reversed and a previous valuation could be used on transition. She did not say where this information was but I've looked at FRS 105and it seems not to be the case so I think she was wrong - moreso judging by this article.

Personally I think this micros regime is a disaster waiting to happen.

Thanks (1)
Teignmouth
By Paul Scholes
11th Aug 2015 22:52

What % of micro companies are property investment?

It's accepted by the standard setters that ME accounts format won't suit all situations, so the grief expressed above is self imposed, FRS102 suits far better, so use it.

For my trading ME companies the new standard is a godsend, making the stat accounts the equivalent of a VAT return, with management accounts providing value in running the business.

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By Jas28
12th Aug 2015 10:08

FRS 102 does not suit better. The property investment company I am referring to is a very small family company, and its accounts are very simple, and FRS105 would be ideal apart from the need to do the contrived depreciation calculations described above.

The company also has interest-free loans from the directors, and FRS102 would require some complicated calculations of the "present value of future cash flows", which would just confuse the shareholders (see http://www.icaew.com/en/members/practice-resources/icaew-practice-suppor...).

FRS105 would be far more suitable, and I intend to use it, as it will avoid the need to keep revaluing the properties and calculating deferred taxation, and it will allow me to just show the interest-free loans at the amount outstanding on the loan.

However, there is a very real practical problem with the depreciation calculations on the properties, and if the standard setters want to simplify the accounts, it would be better to allow freehold investment properties to just be stated at cost, without any depreciation, provided that they have an estimated useful life in excess of 50 years, and provided that their net realisable value is greater than the cost.

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By Bonzai900
12th Aug 2015 11:53

Investment property depreciation

What is the life of an investment property? We all opt for 50 years, but the simple fact of the matter is that buildings do not fall down when they reach their 50th birthday. It is more likely that the building will still be standing and will still be marketable and, in all probability, at a price higher than its original cost. As depreciation is applied to write tangible fixed assets down to their recoverable amount, where that recoverable amount is higher then there will be no depreciation.

I suspect that this will be one of the very few instances where FRS 105 may prove advantageous.

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By Sandyhatter1988
12th Aug 2015 12:56

Residual Value

I am not sure if I am missing something but from a depreciation point of view nothing appears to have changed for fixed assets.

Therefore depreciation is calculated as cost, less residual value and then spread across the useful life. Certainly looking at FRS105 this does not appear to have changed. If your investment property has a residual value equal to its cost then the depreciation amount charged is zero.

Obviously the cost is still reduced because revaluations are not allowed but surely what I have stated above allows some scope to avoid depreciation charges.

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By Bonzai900
12th Aug 2015 14:53

Residual value

Precisely. In this scenario there will be no depreciation charge.

Thanks (1)
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By Ayesha Bham
12th Aug 2015 15:41

Hmmm
Not sure it's as easy as that in honesty. What if property prices are lower when you come to sell. You'd need a fairly accurate residual value each year I think based on property values which to me is more costly in itself! No thank you.

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By AndrewV12
13th Aug 2015 08:04

Reading the above ....

I have a feeling its going to end up in a right mess, and amendments will have to be made to FRS 105, who fancies preparing a set of accounts under FRS 105 first.

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By trecar
17th Aug 2015 18:15

Useful life!

Interesting that the examples quoted regarding freehold property refer to a useful life example of 50 years. The company that owns the freehold of the property I live in acquired it in the early 1980s and has carried it at cost all that time. The amount is pretty insignificant at just over one and a half thousand pounds. The building has been in existence for 160 years and has leaseholds with just under 60 years to run and the lessees can extend for as long as they wish. The insurance value for replacement and attendant costs exceeds £1 million. So just where does one allocate a fair value to the land as a proportion of the purchase cost? It seems to me that the standard has tried to be too clever with regard to land and buildings. Factories may be demolished or extensively renovated but that is an unusual proposition for residential buildings. To be honest I haven't the faintest idea of the land value and as the house is listed any voluntary changes such as rebuilding would be robustly resisted. So I think I will just continue to carry the original cost with a covering note. I'm fairly sure anyway that the cost of the land exceeds the carrying cost. As for premiums on leases I'm not even going to go there.

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By kiwilondon99
03rd Nov 2015 09:41

FRS 105 + Shares

 

small SME for which FRS105 would suit - similarly has a smal share 'listed co' share portfolio which it writes down diminution in value   ie CR BalSheet provision on listed equity holdings  DR P&L

 

so- what woud happen in adopting FRS 105 -?? 

would the full provision need to be reversed on transiton [ restate 2015 accounts  comparative for year end 2016 stats ]  If so the ASSET of portfolio stocks would / could be materially overstated

nb- holding a small share portfolio is not the main business activity

 

so reverse or not under FRS 105?

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By mdoyle
25th May 2016 15:45

I've just seen this article when I searched for this exact question - FRS 105 applying depreciation to investment properties when residual value will be the same if not higher than cost. Has anyone prepared their first set of accounts under FRS 105 with Investment Properties yet? And if so, did you depreciation or do you think non depreciation is an option with a disclosure as to the reason?

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By Bonzai900
16th Jun 2017 10:41

Don't lose sight of the fact that it is only the building that is depreciated. It is often the case that the land value escalates leaving the building with a much lower residual value. Hmmm, food for further thought.

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By kiwilondon99
18th Jun 2017 09:39

Steve - with IFRS15 on revenue recogition wef 1/1/18 etc - how does this now apply - if @ all [to frs105 investment companies] who may be offering rent free/ reduced rent but requiremnt to carry out 'refurb' etc and other issues on recognition ?

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By Gone Sailing
28th Jul 2017 19:00

Accounts in progress (FRS 105 - Balance Sheet criteria ok due to mortgage) with a leasehold buy-to-let portfolio which has recently seen a market value reduction.

Would have agreed with no depreciation because the residual value would not be lower than purchase price - but it looks like we're going the impairment route anyway.

Obviously no land value to factor in.

A revaluation reserve will be removed also - but do we keep prior year as is and adjust this year, or restate prior year?

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By pcerqu10
16th Jun 2018 19:10

Hi, did anyone come to a conclusion on this discussion and create micro accounts for any property investment company?

Did people just use cost at time of purchase and then depreciated the amount. Freehold would be 2% and leasehold would be life of the lease?

Plus when directors invested money into company to purchase property as investments you just pushed this as a loan (any interest added?) Or provided shares.

Any other issues anyone is aware of as no revaluation allowed.

Thanks (0)
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By pcerqu10
16th Jun 2018 19:10

Hi, did anyone come to a conclusion on this discussion and create micro accounts for any property investment company?

Did people just use cost at time of purchase and then depreciated the amount. Freehold would be 2% and leasehold would be life of the lease?

Plus when directors invested money into company to purchase property as investments you just pushed this as a loan (any interest added?) Or provided shares.

Any other issues anyone is aware of as no revaluation allowed.

Thanks (0)