A new basis

November 23, 2009

Following best practice in the private sector, local government together with other parts of the UK public sector, is implementing the switch to financial reporting in accordance with the International Financial Reporting Standards (IFRS) for the financial year 2010/11. Peter Hill outlines the implications for property asset managers at local authorities.

For the initial year to year comparison, the change to financial reporting in accordance with the International Financial Reporting Standards (IFRS) will involve restating certain information as at 1 April 2009 (the start of 2009/10) according to the IFRS format. Property Asset Managers will be required to provide certain information for this, and all subsequent years, which was not required under the previous financial reporting system based on UK GAAP (UK Generally Accepted Accounting Practice).

The main changes affecting Property Assets relate to the treatment of leases, for which more detail will appear in financial statements, intended to provide a more accurate picture of both cost and value. The changes will also affect properties held for sale, and will clarify the proper treatment of PFI assets. The changes will affect both reporting of income/expenses and reporting of fixed assets. It is in respect of fixed assets, in particular leases and properties held for sale, that Property Asset Managers will be required to adapt their record systems to generate the additional information required.

The IFRS Hierarchy of Guidance

Under IFRS, there is a hierarchy of guidance comprising:

- IFRS – International Financial Reporting Standards

- IAS – International Accounting Standards

- IFRIC – Interpretations issued by the IFR Interpretations Committee and

- SIC – Interpretations issued by the Standing Interpretations Committee

These must be adopted in priority to any national guidance, but where they do not deal with a particular issue, national guidance can fill the gap.

For property leases, the key provisions appear in IAS 17 Leases, which must be followed together with IAS 16 Property Plant and Equipment. Lessor interests are dealt with in IAS 40 Investment Property. Property Asset Managers may also find useful IFRIC 4 Determining whether an arrangement contains a Lease. For those dealing with PFI schemes, where the risk allocation inherent in the PFI concept is non-traditional, reference should also be made to IFRIC 12 Service Concession Agreements. Properties held for sale are dealt with in IFRS 5 Non-Current Assets held for Sale and Discontinued Operations.

Changes to the financial reporting of Leases

In a Statement of Financial Position (which replaces a balance sheet), there are two significant changes to the way in which financial reporting of property leases needs to be made.

First, a lease is to be reported as both an asset (if it has value) and as a liability. Secondly, each of land, buildings and significant elements of plant & equipment are to be separately reported according to their anticipated economic life. The detailed requirements for plant and equipment appear in IAS 16 Property, Plant & Equipment.

Significant elements within an office building might be the boiler and heating system, and (as a separate element) the lift. In a leisure centre, the swimming pool filters and pumps and a flume are unlikely to have the same economic life (i.e. the period until replacement is expected to be required) as the foundations, walls and roof. Property asset records will need to record the initial cost (including acquisition expenses) and anticipated economic life for each significant element. Year by year financial reporting will show the remaining economic life of each element.

Where a lease is held, for financial reporting purposes, the land will normally be held on an operating lease but the building may be held on either an operating lease or a finance lease. A finance lease is a lease which transfers to the lessee substantially all of the risks (e.g. payment of outgoings, insurance, repair) and rewards (e.g. use and enjoyment, receipt of underletting income) incidental to ownership. The test of this is the substance, not the form, of the document; naming the document a “lease” is not by itself sufficient.

In contrast, an operating lease is any lease which is not a finance lease – they are mutually exclusive definitions. If the lease payments (i.e. premium or rent paid by the lessee to the lessor) cannot be reliably allocated between the land and the building, the entire lease will be classified as a finance lease unless it is clear that the arrangements for both land and buildings are operating leases. The allocation is a matter for the professional judgement of a valuer and guidance on this is available from the RICS in VIP 09.

Where the land value is immaterial (which is common for open market rent leases which often demise only a building and its footprint), land and buildings may be treated as a single unit for financial reporting. If so, the economic life of the building is regarded as being the economic life of the whole asset. Note that while a lessor may report the holding of a reversion subject to an occupational lease as an investment property, the same occupational lease may be reported by the lessee as an operating lease or a finance lease or perhaps as both when distinguishing between land and buildings.

Disclosure Requirements for Leases

Disclosure requirements in financial reporting for both operating leases and finance leases are set out in IFRS 7 Financial Instruments: Disclosures. These include as at the end of the reporting period:

(a) Lease payments falling due:-
- within 1 year
- between 1 and 5 years
- after 5 years

(b) Total future contracted underlease income

(d) Any lessee significant leasing arrangements including

(i) the basis of determination of any contingent rent (e.g. a turnover rent)
(ii) options for renewal/purchase
(iii) escalation clauses (e.g. rent reviews)
(iv) material restrictions imposed by lease arrangements (e.g. a prohibition against underletting).

In the case of finance leases, certain additional information must be disclosed.

Properties held for Disposal

According to IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations, assets held for sale or other disposal must be recognized as a separate category of asset for financial reporting. Assets intended for disposal as group in a single transaction (e.g. a portfolio of properties surplus to a Council’s operational requirements) must be identified as a “disposal group”.

Whereas formerly the change in accounting status was as at the date of the contract for sale, under IFRS this is now as at the date of the decision to sell. Assets in this category are to be reported at the lower of the “carrying amount” (in summary, the ongoing costs expected to be incurred in holding the asset) and fair value less costs to sell.

Peter Hill is an associate director of TPP Law Limited
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