1.0 Introduction: The Accountant's Dilemma - How Should We Value Assets?

At the heart of accounting lies a fundamental challenge: how should a company value its assets on its financial statements? If a company buys a building for $1 million, that price is a fact. But ten years later, is the building still worth $1 million? The market might say it's now worth $3 million. This simple question reveals two competing philosophies in accounting.

The first, historical cost, values an asset at its original purchase price. It is objective, verifiable, and grounded in a real transaction. The second, fair value, values an asset at its current market worth. It is timely and reflects the asset's present economic reality. This is the classic accounting trade-off between reliability (the verifiable nature of historical cost) and relevance (the timeliness of fair value).

International Accounting Standard 40 (IAS 40), which governs the accounting for Investment Property, provides a perfect real-world case study for understanding this debate. It allows companies to choose between these two approaches, making it an ideal lens through which to explore one of accounting's most enduring dilemmas.

2.0 What is an Investment Property? Setting the Stage with IAS 40

Before we can explore the valuation debate, we must first understand what qualifies as an investment property under IAS 40.

2.1 The Official Definition

According to IAS 40.5, an Investment Property is defined as:

property (land or a building—or part of a building—or both) held to earn rentals or for capital appreciation or both.

The key characteristic of an investment property is that it generates cash flows that are "largely independently of the other assets an entity holds." This distinguishes it from property used in a company's day-to-day operations.

2.2 What Qualifies as Investment Property?

IAS 40 provides several examples of what is considered an investment property.

  • Land for Long-Term Gain: Land held for long-term capital appreciation rather than for short-term sale in the ordinary course of business.
  • Land with an Undetermined Future: Land held where the future use has not yet been decided. If the company hasn't determined whether it will use the land for its own operations or for short-term sale, it is considered held for capital appreciation.
  • Leased-Out Buildings: A building owned by the entity and leased out to others under one or more operating leases.
  • Vacant Buildings Held for Lease: A building that is currently empty but is held with the intention of being leased out under one or more operating leases.
  • Property Under Construction: Property that is being constructed or developed for future use as an investment property.

2.3 What is NOT Investment Property?

The standard also clearly outlines what does not qualify as an investment property. These assets are covered by other accounting standards.

  • Owner-Occupied Property (IAS 16): This includes property used by the company in its own operations, such as for the production or supply of goods/services, or for administrative purposes. This is accounted for under IAS 16, Property, Plant and Equipment.
  • Property for Sale in Business (IAS 2): Property held for sale in the ordinary course of business. For example, a real estate developer building homes to sell would classify this property as inventory under IAS 2, Inventories.
  • Property Leased Under a Finance Lease (IFRS 16): Property that is leased to another entity under a finance lease is covered by IFRS 16, Leases.

2.4 Addressing the Gray Areas: Common Classification Challenges

While the lists above seem straightforward, real-world situations can be more complex. An expert accountant must know how to navigate the "gray areas" where classification isn't immediately obvious.

  • Dual-Use Properties: What if a company owns a building where it uses some floors for its own administrative offices and leases the remaining floors to other businesses? IAS 40.10 provides the rule: if the portions can be sold or leased out separately, they must be accounted for separately (the offices as IAS 16 PPE, the leased floors as IAS 40 Investment Property). If the portions cannot be sold separately, the entire property qualifies as investment property only if the owner-occupied portion is "insignificant." While the standard doesn't define "insignificant," a practical rule of thumb often used is less than five percent of the total property.
  • Ancillary Services: Classification can also depend on the level of services provided to a property's occupants. If the services are "insignificant" to the overall arrangement, the property can be classified as an investment property. The classic example is an office building where the owner provides security and maintenance services; these are considered insignificant ancillary services. In contrast, an owner-managed hotel provides significant services (cleaning, reception, room service), making it an owner-occupied property under IAS 16, not an investment property.

Now that we know how to identify an investment property, let's explore the two different ways a company can choose to account for it after its initial purchase.

3.0 The Big Choice: Accounting for Investment Property After Purchase

When an investment property is first acquired, it is always recorded at its cost, which includes the purchase price plus any directly attributable transaction costs (like legal fees). However, this cost does not include start-up expenses (unless essential to get the property ready for use), initial operating losses, or abnormal amounts of wasted material or labor during construction. After this initial recognition, a company must make an important accounting policy choice for how it will measure the property going forward. It can choose either the cost model or the fair value model. Crucially, this choice must be applied consistently to all of its investment properties.

3.1 Path #1: The Cost Model (The Path of Reliability)

Under the cost model, the investment property is measured at its cost less any accumulated depreciation and any accumulated impairment losses. This treatment is prescribed by IAS 16, Property, Plant and Equipment.

Two key points define this model:

  1. The property's value on the balance sheet is systematically reduced over its useful life through an annual expense called depreciation.
  2. The carrying amount on the balance sheet does not reflect any changes (up or down) in the property's market value.

A critical requirement exists even for companies choosing this path: they must still determine and disclose the fair value of the investment property in the notes to the financial statements.

3.2 Path #2: The Fair Value Model (The Path of Relevance)

The fair value model is fundamentally different from the cost model and has two crucial consequences for the financial statements:

  1. Revaluation to Market Value: The property is re-measured to its fair value at the end of each reporting period. Fair value is 'the price that would be received to sell an asset...in an orderly transaction between market participants at the measurement date' (IFRS 13).
  2. Impact on Income: Any gain or loss arising from this change in fair value is recognized directly in the company's profit or loss for that period.

Under the fair value model, no depreciation is charged. This is a logical consequence of the model; since the asset is already stated at its current market value at the end of each year, charging depreciation would be redundant. This approach provides more relevant information to investors but can also lead to more volatility in a company's reported earnings from year to year.

IAS 40 includes a "rebuttable presumption" that an entity can reliably determine the fair value of an investment property on a continuing basis. This shows the standard's strong preference for the fair value model. Only in exceptional cases—such as when the market for comparable properties is inactive and alternative reliable estimates are unavailable—can an entity conclude that fair value cannot be reliably determined and must therefore use the cost model.

These two models have very different impacts on a company's financial statements, which can be best understood with a direct comparison.

4.0 At a Glance: Cost Model vs. Fair Value Model

This table provides a side-by-side comparison of the two models for investment property.

Feature

Cost Model (IAS 40)

Fair Value Model (IAS 40)

Balance Sheet Value

Carried at historical cost less accumulated depreciation and impairment losses.

Re-measured to fair value at each reporting date.

Depreciation

Depreciation is charged annually over the asset's useful life.

Depreciation is not charged.

Changes in Value

Unrealized changes in market value are not recognized on the balance sheet (but fair value is disclosed in the notes).

Gains or losses from fair value changes are recognized directly in profit or loss.

Primary Benefit / Drawback

Primary Benefit: Reliability and objectivity. Key Drawback: Becomes less relevant as market values change over time.

Primary Benefit: Relevance to current market conditions. Key Drawback: Can introduce earnings volatility and relies on estimates.

5.0 Clearing Up a Common Confusion: Fair Value Model vs. Revaluation Model

Learners often confuse the fair value model under IAS 40 with the revaluation model under IAS 16 for Property, Plant, and Equipment (PPE). While both involve revaluing assets to fair value, their accounting treatment is fundamentally different and applies to different types of assets.

Feature

Fair Value Model (IAS 40)

Revaluation Model (IAS 16)

Applies to

Investment Property (e.g., a building held for rental income).

Property, Plant, and Equipment (PPE) (e.g., a company's own headquarters).

Valuation Frequency

At each reporting date (e.g., annually).

Periodically (when fair value differs materially from the carrying amount, not necessarily every year).

Gains/Losses Go To...

Recognized in Profit or Loss.

Recognized in Other Comprehensive Income (OCI) and held in a revaluation surplus within equity.

Depreciation

No depreciation is charged.

Depreciation continues to be charged on the revalued amount.

Consistency Rule

Apply consistently to all investment property within the same class (e.g., office buildings could use a different model than retail buildings).

Apply consistently to the entire class of assets (e.g., all buildings, regardless of use, must use the same model).

Understanding these measurement rules is key, but it's also important to know when a property can switch between classifications.

6.0 When Things Change: Transfers To and From Investment Property

Under IAS 40, a property's classification can be changed only when there is a change in its use. In isolation, a change in management’s intentions for the use of a property does not provide evidence of a change in use.

Examples of evidence of a "change in use" that would trigger a transfer include:

  • Commencement of owner-occupation (transfer from investment property to owner-occupied property).
  • End of owner-occupation (transfer from owner-occupied property to investment property).
  • Commencement of development with a view to sale (transfer from investment property to inventories).

The accounting for these transfers depends on the models used. For example:

If an owner-occupied property (accounted for under IAS 16) becomes an investment property that will be carried at fair value, the company applies IAS 16 up to the date of the change. On that date, any difference between the property's carrying amount and its fair value is treated like a revaluation under IAS 16. This means any gain is recognized in Other Comprehensive Income (OCI).

7.0 Conclusion: The Enduring Trade-Off Between Relevance and Reliability

The choice between the cost and fair value models for investment property under IAS 40 is a practical demonstration of one of accounting's core challenges. It highlights the constant tension between providing information that is easy to verify and information that is most useful for decision-making today.

  • The Fair Value Model champions relevance, providing a real-time snapshot of the property's worth. The price for this relevance is potential earnings volatility and a reliance on valuation estimates.
  • The Cost Model champions reliability, anchoring the property's value to a verifiable historical transaction. The trade-off is that this value can become stale and less relevant over time, potentially hiding the asset's true economic value.

Ultimately, IAS 40 does not declare one model superior to the other. Instead, it provides a framework that forces companies to make a choice, and in doing so, reveals the timeless accounting trade-off between relevance and reliability.