Transfers from inventory
In 2011, an entity purchased land with the intent to construct an apartment building on the land and sell the apartments to private customers. Accordingly, the land was classified as inventory. During 2011, the prices for residential properties decreased and at the beginning of 2012 the entity decided to change its original business plans. Instead of constructing an apartment building and selling the apartments, the entity decided to construct an office building that it would lease out to tenants. The entity holds and manages other investment property as well.
During the first half of 2012, the entity obtained permission from the relevant authorities to commence the construction and hired an architect to design the office building. The physical construction of the office building began in August 2012. No operating leases had been agreed, nor commenced, with other parties for the lease of office space. However, negotiations had been held with potential tenants.
We would generally conclude that there is sufficient evidence for a change in use from inventory to investment property if the following criteria are met:
- The entity has prepared a business plan that reflects the future rental income generated by the property and this is supported with evidence that there is demand for rental space.
- The entity can demonstrate that it has the resources, including the necessary financing or capital, to hold and manage an investment property.
- The change in use is legally permissible. That is, the entity has obtained permission from relevant authorities for the change in use. In cases where the approval of the change in use is merely perfunctory, the entity”s request for permission may be sufficient evidence.
- If the property must be further developed for the change in use, development has commenced.
For the scenario described in the fact pattern, the entity met the above criteria at the point in time when it obtained permission from the relevant authorities to change the use of the property and commenced development of the property by hiring an architect. At that time, the land would be transferred from inventory to investment property.
The question of when an inventory can be reclassified as investment property was the subject of a restatement of financial statements required by the United Kingdom regulator, the Financial Reporting Review Panel (the ‘Panel’).
The Panel reviewed the report and accounts of Grainger Trust plc for the year ended 30 September 2006. The Panel reported that during the period in question, the company transferred properties held as inventory with a carrying amount, at cost, of £43.5m to a Jersey Property Unit Trust (the ‘JPUT’), a wholly-owned subsidiary, at 30 September 2006. On transfer, the properties were reclassified as investment properties and a gain on revaluation to market value of £23.5m was recognised in the income statement.
The directors of Grainger agreed that the transfer did not comply with the requirements of IAS 40 as it did not provide evidence of the required change in use. However, the final outcome was that of a different type of prior year adjustment – the directors concluded that the properties transferred to the JPUT were originally acquired for the purpose of long term capital appreciation and rental growth and, consequently, should always have been shown as investment property rather than inventory.