Introduction
Investment property accounting plays a significant role in financial reporting, especially when adhering to the fair value model under IFRS and U.S. GAAP. The fair value model requires companies to record investment properties at their market value rather than historical cost, ensuring that financial statements accurately reflect current economic conditions.
In this article, I will break down the fair value model for investment properties, discuss its implications, illustrate key journal entries, and provide examples with detailed calculations. This guide is designed for investors, accountants, and finance professionals who want to understand how fair value adjustments impact financial statements.
Understanding the Fair Value Model
The fair value model requires entities to remeasure their investment property at fair value at each reporting date. Unlike the cost model, where properties are recorded at cost less accumulated depreciation, the fair value model allows entities to recognize gains or losses directly in profit or loss.
Key Features of the Fair Value Model:
- No Depreciation: Unlike the cost model, depreciation is not recorded.
- Regular Revaluations: Investment properties are revalued at fair market value at each reporting date.
- Impact on Financial Statements: Gains or losses from fair value adjustments are recognized in the income statement.
- Subjectivity in Valuation: Fair value estimates depend on market conditions and professional appraisals.
Journal Entries for Investment Property Under the Fair Value Model
To illustrate journal entries, let’s assume a company owns an investment property initially purchased for $500,000. The fair value of the property changes over time, leading to adjustments in financial records.
Initial Recognition of Investment Property
When acquiring an investment property, it is recorded at cost.
Journal Entry:
\text{Investment Property (Asset)} \quad \text{Dr} \quad 500,000 \text{Cash/Bank (Asset)} \quad \text{Cr} \quad 500,000Annual Fair Value Adjustment (Gain)
Suppose at the end of the year, the market value of the property increases to $550,000. The gain of $50,000 is recorded as follows:
Journal Entry:
\text{Investment Property (Asset)} \quad \text{Dr} \quad 50,000 \text{Fair Value Gain (Income Statement)} \quad \text{Cr} \quad 50,000Annual Fair Value Adjustment (Loss)
If instead the fair value drops to $480,000, a loss of $20,000 must be recognized:
Journal Entry:
\text{Fair Value Loss (Income Statement)} \quad \text{Dr} \quad 20,000 \text{Investment Property (Asset)} \quad \text{Cr} \quad 20,000Sale of Investment Property
If the company sells the property for $600,000, assuming its last fair value recorded was $550,000, the gain of $50,000 is recognized:
Journal Entry:
\text{Cash/Bank (Asset)} \quad \text{Dr} \quad 600,000 \text{Investment Property (Asset)} \quad \text{Cr} \quad 550,000 \text{Gain on Sale of Property (Income Statement)} \quad \text{Cr} \quad 50,000Fair Value vs. Cost Model: A Comparison
| Feature | Fair Value Model | Cost Model |
|---|---|---|
| Basis of Valuation | Market-determined fair value | Historical cost minus depreciation |
| Depreciation Recorded | No | Yes |
| Financial Statement Impact | Gains/losses affect net income | Depreciation expense recorded |
| Market Sensitivity | High | Low |
| Regulatory Preference | Preferred under IFRS | Used under U.S. GAAP for real estate firms |
Advantages and Disadvantages of the Fair Value Model
Advantages:
- Reflects True Market Value: Provides a more accurate financial position.
- No Depreciation Expense: Eliminates the impact of arbitrary depreciation.
- More Relevant for Investors: Investors prefer fair value for decision-making.
Disadvantages:
- Market Volatility: Fluctuations in fair value can distort earnings.
- Valuation Subjectivity: Requires professional judgment and market assumptions.
- Complexity in Reporting: Requires frequent fair value assessments.
Example Calculation of Fair Value Adjustments
Let’s assume the following data for an investment property:
- Initial Purchase Price: $800,000
- Year 1 Fair Value: $850,000
- Year 2 Fair Value: $780,000
- Year 3 Fair Value: $820,000
| Year | Beginning Value | Fair Value | Gain/Loss Recognized |
|---|---|---|---|
| 1 | $800,000 | $850,000 | $50,000 Gain |
| 2 | $850,000 | $780,000 | $70,000 Loss |
| 3 | $780,000 | $820,000 | $40,000 Gain |
The journal entries for these fair value changes would be:
- Year 1:
Year 2:
\text{Fair Value Loss (Income Statement)} \quad \text{Dr} \quad 70,000 \text{Investment Property (Asset)} \quad \text{Cr} \quad 70,000Year 3:
\text{Investment Property (Asset)} \quad \text{Dr} \quad 40,000 \text{Fair Value Gain (Income Statement)} \quad \text{Cr} \quad 40,000Conclusion
Using the fair value model for investment properties provides transparency but introduces volatility. While it eliminates depreciation, it requires constant fair value assessments, which can be subjective. Investors and financial analysts must weigh the pros and cons to determine whether the fair value model aligns with their reporting needs.
