Entity is engaged in the business of development of a special economic zone and industrial park. For development of SEZ, the Entity has purchased, and Government has awarded large parcels of land to the entity. The Company shall develop the land and shall create infrastructure on such land before selling/ leasing the plots to the other businesses. Thus, some portion of land with the entity will be sold in ordinary course of business and some shall be provided on finance lease. Consequently that land shall be classified and presented as “inventory” as per IAS 2 / Ind AS 2 – Inventories in the books of the entity. Due to some legal issues, there are uncertainties regarding the usage of the land and entity is uncertain about the exact usage of the land i.e., whether it will be sold or given on finance lease or operating lease on the date of reporting. Few queries with respect to the accounting of such property have been raised as below. As a part of this blog, we will analyse the accounting issues raised below with the help of relevant accounting standards under Ind AS and under International Financial Reporting Standards (IFRS) as issued by IASB.
1. Land purchased and developed by an entity can be monetised in one of the following ways:
- Land can be sold out rightly or can be provided on the finance lease to other businesses.
- Land can be provided on the operating lease to other businesses.
However, at the time of recognition of land in the accounting records, there is an uncertainty regarding the way the land will be monetised. Thus, question arises as to how to present land in the statement of financial position in case use of the land is undetermined.
In the first scenario 1(a) above, land will be presented as ‘inventory’ in the balance sheet. However, in case of scenario 1(b), the land will be presented as ‘investment property’.
How is the land required to be presented in the accounting records on its reporting date even if presented as inventory on initial recognition?
2. Entity incurs following costs in acquisition of the land:
- Purchase price of the land,
- Cost for relocation of the people occupying the land,
- Interest costs on funds borrowed to purchase and develop the land and
- Other overheads for land development etc.
Which of the above costs can be capitalised as part of the land cost?
3. What would be the accounting treatment on disposal of land by way of:
- Outright sale
- Finance lease
- Operating lease
Relevant technical guidance under IFRS / Ind AS required:
IAS 40 / Ind AS 40 – Investment property
As per Para 5, Investment property is property (land or a building or part of a building or both) held (by the owner or by the lessee as a right-of-use asset) to earn rentals or for capital appreciation or both, rather than for:
- Use in the production or supply of goods or services or for administrative purposes; or
- Sale in the ordinary course of business
As per Para 8 (b), land held for currently undetermined future use shall be considered as Investment property. (If an entity has not determined that it will use the land as owner-occupied property or for short-term sale in the ordinary course of business).
As per Para 20, an owned investment property shall be measured initially at its cost. Transaction costs shall be included in the initial measurement.
As per Para 21, the cost of a purchased investment property comprises its purchase price and any directly attributable expenditure. Directly attributable expenditure includes, for example, professional fees for legal services, property transfer taxes and other transaction costs. (For additional guidance on ‘directly attributable expenses, one can refer guidance provided under IAS 16 / Ind AS 16 – PPE).
As per Para 57 – An entity shall transfer a property to, or from, investment property when, and only when, there is a change in use. A change in use occurs when the property meets, or ceases to meet, the definition of investment property and there is evidence of the change in 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 include:
- Commencement of owner-occupation, or of development with a view to owner-occupation, for a transfer from investment property to owner-occupied property;
- Commencement of development with a view to sale, for a transfer from investment property to inventories
- End of owner-occupation, for a transfer from owner-occupied property to investment property; and
- Inception of an operating lease to another party, for a transfer from inventories to investment property.
As per Para 58 – When an entity decides to dispose of an investment property without development, it continues to treat the property as an investment property until it is derecognised (eliminated from the statement of financial position) and does not reclassify it as inventory. Similarly, if an entity begins to redevelop an existing investment property for continued future use as investment property, the property remains an investment property and is not reclassified as owner-occupied property during the redevelopment.
IAS 23 / Ind AS 23 – Borrowing costs
As per Para 1, borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense.
As per Para 5, Borrowing costs are interest and other costs that an entity incurs in connection with the borrowing of funds and a qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
As per Para 17, an entity shall begin capitalising borrowing costs as part of the cost of a qualifying asset on the commencement date. The commencement date for capitalisation is the date when the entity first meets all of the following conditions:
- It incurs expenditures for the asset
- It incurs borrowing costs; and
- It undertakes activities that are necessary to prepare the asset for its intended use or sale.
As per Para 19, the activities necessary to prepare the asset for its intended use or sale encompass more than the physical construction of the asset. They include technical and administrative work prior to the commencement of physical construction, such as the activities associated with obtaining permits prior to the commencement of the physical construction. However, such activities exclude the holding of an asset when no production or development that changes the asset’s condition is taking place. For example, borrowing costs incurred while land is under development are capitalised during the period in which activities related to the development are being undertaken. However, borrowing costs incurred while land acquired for building purposes is held without any associated development activity do not qualify for capitalisation.
IAS 16 / Ind AS 16 – Property, plant, and equipment (PPE)
As per Para 17, an item of PPE that qualifies for recognition as an asset shall be measured at its cost.
As per Para 16, the cost of an item of PPE comprises:
- Its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.
- Any costs are 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.
Examples of ‘directly attributable costs are:
- Costs of employee benefits arising directly from the construction or acquisition of the item of PPE;
- Costs of site preparation
- Initial delivery and handling costs
- Installation and assembly costs
- Costs of testing whether the asset is functioning properly
- Professional fees
Analysis and conclusion:
Based on the technical guidance provided under Ind AS 40, Para 5 and Para 8 (b), land purchased by the entity for which usage / the way of monetization is not determined, shall be considered as land with undetermined future use and should be classified and presented as “Investment property” in the balance sheet.
Based on the guidance provided under Ind AS 40, Para 20 and 21 and also the analogy drawn from Ind AS 16 Para 17 and 18, the entity can consider purchase price and land development expenses as a part of the cost of the land. Further, relocation expenses for the affected people occupying the land is one of the necessary expenses required to be incurred in order to acquire the land and thus can also be capitalized as part of the cost of the land being a directly attributable expenditure.
As per the guidance provided under Ind AS 23, Para 1 and Para 5, interest expenditure incurred directly with respect to acquisition or construction of a qualifying assets only can be capitalised as a part of the asset. Other borrowing costs are expensed in the statement of profit and loss. Further, as per guidance provided in Para 17 and 19 of Ind AS 23, it can be interpreted that land may or may not become a qualifying asset. If entity decides to sale or rent out the land as it is without development, it cannot be considered as a qualifying asset and hence interest expense cannot be capitalised as a part of land. However, entity is planning to monetise the land in one of the way mentioned above only after it is developed, then such land can be considered as a qualifying asset. Accordingly, interest expenses can be capitalised as a part of the land.
Accounting treatment upon monetisation of the land will differ depending on the land is proposed to be monetised.
- Outright sale or finance lease – Based on the guidance provided in Para 57 and 58 of Ind AS 40, land which is earlier classified as investment property can be transferred to inventory when the development on land starts. In such case, sale proceeds can be presented as a part of total revenue and inventory can be classified as ‘cost of sale’ in the statement of P&L.
However, if the land is not developed before sale, then transfer to inventory is not allowed and it will be disposed as investment property where gains on disposal will be considered as other income in the statement of profit and loss.
- Operating lease – Accounting for such land will based on Ind AS 16 – Leases, where entity will keep recognising the land in its books as investment property. Lease rental income will be recognised as its revenue on a straight-line basis in the statement of profit and loss and with related expenses recorded in the same period.