JANUARY 2002 FEATURES The Hong Kong 28 ACCOUNTANT I nternational Accounting Standard (IAS) 40 “Investment Property” is effective for accounting periods beginning on or after 1 January 2001. This standard prescribes radical changes to the existing generally accepted practices for accounting of investment properties. In a nutshell, two main accounting concepts were introduced by this standard: • After initial recognition at cost, a company can choose to measure its investment properties at fair value or depreciated cost, referred to as the “fair value model” or the “cost model”. Whichever policy is chosen, it should be applied consistently for all investment properties; • If a company chooses to adopt the CHANGES IN ACCOUNTING OF INVESTMENT PROPERTIES? I S H O N G K O N G R E A D Y F O R fair value model, changes in fair values of investment properties from one balance sheet date to the next are taken to the profit and loss account as an operating item. These concepts seem quite simple and easy to digest, but there is more. The Far and Wider Implications Taking fair value changes through the profit and loss account Under Hong Kong Generally Accepted Accounting Practices (GAAP), fair value changes of investment properties are taken to a revaluation reserve, unless the total of this reserve is insufficient to cover a deficit on a portfolio basis. In this case the amount of deficit not covered by the revaluation reserve is charged to the profit and loss account. Since all fair value changes must go through the profit and loss account under the newly introduced IAS, whether the accounting of fair value changes is on a portfolio basis or individual property basis is no longer relevant. In regions such as Hong Kong, where the property cycle is typically characterised by substantial peak to trough swings, taking all fair value changes through the profit and loss account as an operating item would result in substantial volatility of reported profit year on year. For many companies, the holding of investment properties is a medium to long-term business. Once year on year changes in asset values of investment properties are included in the profit and loss account, using reported profit as a yardstick to measure a company’s performance would be simplistic and
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JANUARY 2002
FEATURES
The Hong Kong28 ACCOUNTANT
I nternational Accounting Standard(IAS) 40 “Investment Property” iseffective for accounting periods
beginning on or after 1 January 2001.This standard prescribes radicalchanges to the existing generallyaccepted practices for accounting ofinvestment properties. In a nutshell,two main accounting concepts wereintroduced by this standard:
• After initial recognition at cost, acompany can choose to measure itsinvestment properties at fair valueor depreciated cost, referred to asthe “fair value model” or the “costmodel”. Whichever policy ischosen, it should be appliedconsistently for all investmentproperties;
• If a company chooses to adopt the
CHANGES IN ACCOUNTING OF INVESTMENT PROPERTIES?IS HONG KONG READY FOR
fair value model, changes in fairvalues of investment properties fromone balance sheet date to the nextare taken to the profit and lossaccount as an operating item.
These concepts seem quite simpleand easy to digest, but there is more.
The Far and Wider ImplicationsTaking fair value changes through theprofit and loss account
Under Hong Kong GenerallyAccepted Accounting Practices (GAAP),fair value changes of investmentproperties are taken to a revaluationreserve, unless the total of this reserveis insufficient to cover a deficit on aportfolio basis. In this case the amountof deficit not covered by the revaluationreserve is charged to the profit and lossaccount. Since all fair value changes must
go through the profit and loss accountunder the newly introduced IAS, whetherthe accounting of fair value changes ison a portfolio basis or individual propertybasis is no longer relevant.
In regions such as Hong Kong, wherethe property cycle is typicallycharacterised by substantial peak totrough swings, taking all fair valuechanges through the profit and lossaccount as an operating item wouldresult in substantial volatility ofreported profit year on year. For manycompanies, the holding of investmentproperties is a medium to long-termbusiness. Once year on year changes inasset values of investment propertiesare included in the profit and lossaccount, using reported profit as ayardstick to measure a company’sperformance would be simplistic and
JANUARY 2002
FEATURES
The Hong Kong30 ACCOUNTANT
possibly misleading. To address this,property companies may need toconsider separate line disclosure of thefair value changes on the face of theprofit and loss account and/or to considerother disclosure notes to enhance theclarity and transparency of reportedfinancial information. In any event, theongoing controversy surrounding whatare performance measurements andwhether a one-performance statementshould be used to measure all gains andlosses will continue to be debated. Thisissue only accentuates the need tobroaden the context of corporatereporting and improve financialdisclosures so as to move away fromthe previous focus on short-termearnings.
Investment Properties underRedevelopment
The new international standard alsoaddress cases where an investmentproperty is redeveloped for continuedfuture use as an investment property.Under existing HK GAAP, this wouldresult in a transfer of the property frominvestment property to property underredevelopment, with the correspondingrevaluation reserve frozen upon thereclassification. Conversely, IAS 40requires such property to remain as aninvestment property and does notrequire reclassification into owner-occupied proper ty dur ing theredevelopment. On completion, anydifference in fair value between thedate of completion and that at the timeredevelopment commenced is thenrecognised in the profit and lossaccount. This rule only applies toinvestment properties which are beingredeveloped and any property which isconstructed or developed for the firsttime into an investment property wouldbe accounted for under the normal rulesfor properties covered by IAS 16“Property, Plant and Equipment” or theHK GAAP equivalent SSAP 17, of thesame title, respectively.
How to Account for Interests inLeasehold Land
Perhaps the most challenging partof IAS 40 is its clarification of theInternational Accounting StandardsBoard (“IASB”) views on the treatmentof land leases under IAS 17 “Leases.”
IAS 40 does not permit leaseholdinterests in land to be classified as partof investment properties since IAS 17explicitly states that all interests liein leasehold land. Regardless of theeconomic substance of the lease, theseshould be classified as operating leases.
Operating leases are required to bestated at cost less amortisation in thebalance sheet and cannot be revalued.
This has momentous implications onthe accounting treatment of leaseholdland interests, particularly in Asianregions such as Hong Kong, Singaporeand Mainland China, where themajority of interests in land are grantedby the Government on a leasehold basisand typically involves the payment ofsignificant premiums. A strictapplication of IAS 40 for companieswith investment properties in thisregion (assuming that a fair value modelis adopted) would mean that leaseholdland payments are measured at cost lessamortisation while separate fair valuesfor the building portions (independentof the leasehold land) would have to beobtained.
The practicalities of ascribingseparate fair values for the buildingportions should also be carefullyconsidered. In Hong Kong, there areno market transactions for the sale ofa building independent of the landelement. This begs the question as towhether reliable estimates of fair valuecan be made in view of the lack ofcomparable market transactions - and,if reliable estimates cannot beobtained, the remaining option mightbe to measure the building portion atcost less depreciation.
Reverting to a cost model to accountfor investment properties may not be aviable or ideal solution to many realestate companies in Hong Kong.Imagine how your balance sheet wouldlook if your investment properties arestated at cost, not to mention the annual
depreciation charge on building andamortisation of the land premiumpayment that would go through theprofit and loss account? For companiesgoing from the fair value model to thecost model to measure investmentproperties, the drop in net asset value
may be very substantial. What wouldhappen to financial covenants on bankloans that may be based on balancesheet numbers? Will shareholders seethe true performance of a real estatecompany if its properties are stated atdepreciated cost? For companies usingIAS to prepare financial statements,these are just some of the questionswhich are being considered right now.
The Debate Goes onThe application of IAS 40 has already
drawn substantial interest around thereal estate industry globally. To resolvethese debates, the immediate issue goingforward is not a debate on howinvestment properties are accounted for,but how leases are accounted for.Additionally, a definitive policy forperformance measurement is requiredwhether or not all gains and losses arerecorded on one performance statement.In light of the practical implicationswhich property companies haveexperienced in 2001, the first year IAS40 is effective, the issue of leaseaccounting and performance reportingare fundamental and urgent and mustbe further addressed by the IASC andother global standard setters.
Here in Hong Kong, we understandthe HKSA is considering the accountingtreatment of investment properties inlight of IAS 40. No matter what theoutcome is, this debate will certainlychange the way we account forinvestment properties in Hong Kong inthe future.
Reverting to a cost model to account forinvestment properties may not be anideal solution to real estate companies
By Robert Gazzi and Ming TsePricewaterhouseCoopers
HKA
The Hong Kong32 ACCOUNTANT JANUARY 2002
FEATURES
Whither E-commercein Hong Kong?
the power to bring pressure to bear onPCCW to engage in open competitionin the telecoms market, but it does notuse that power to the full which in turnharms the development of the market.They may have a point.
But it is not all bad. The governmentsuccessfully established the legalframework necessary to turn HongKong into an e-commerce society. TheElectronic Transactions Ordinance(ETO) came into force in April 2000and adopted most of UNCITRAL’sModel Law on the subject. This meant,inter alia, that contracts that weresigned digitally (for example, B2Bcontracts concluded on-line, used lessin the B2C market) would be given thesame force in law as contracts thatwere signed in the normal way.
The ETO also made provision forthe establishment of certificationauthorities (CAs) which would governthe administration of digital signatures.The first of these authorities, HongkongPost, attempted to position itself as thede-fact standard in digital signaturesand certificates with a view to doingaway with the problems oftenassociated with on-line contracts – lackof certainty concerning the identity ofthe other party, concerns aboutattempts to repudiate the contract bythe other side and tampering orcorruption with contracts. The use ofdigital signatures and certificates inHong Kong has in fact been furtheredby the recent appointment of Digi-Signas a CA, which is the first privatecompany to be so appointed, as well asHongkong Post’s announcement thatthey are working on provide mobilecommerce certification services for theburgeoning cellular telephone market.
Despite the investment, however,
Hong Kong continues to lag behindother Asian nations when it comes tothe use of the internet for conductingbus ine s s ( pa r t i c u l a r l y r e t a i ltransactions). This has prompted arecent government initiative called TryIt Online, which took place inDecember to encourage the growth ofthe consumer e-commerce market. Itis being supported by a number of localbusinesses and industry groups,including the Hong Kong Society ofAccountants, to encourage consumersto use e-services. Next year will marka shift in focus for the initiative moretowards online business services.
So Hong Kong arguably has theright business and legal environmentto be a hotbed of e-commerce.However it remains to be seen howsuccessful these initiatives will be asa means of jumpstarting the e-economy.One factor that may prove to elude thepush towards e-commerce could be thesimple fact that Hong Kong’sconsumers prefer to shop in person thanonline. If that is the case, the industrywill need to rethink the direction ofits efforts. In any event, 2002 shouldbe an interesting year.
The bursting of the tech bubble overthe course of the last two yearsheralded the global economy’s
slide into recession. “Dotcom” has becomea dirty word and consumer confidence istaking a pounding. But it wasn’t alwaysthis way.
Back in the good old days of 1998,Hong Kong looked across the Pacificand saw an economy surfing high onthe crest of the “new paradigm”. TheSAR government, not wanting to be leftbehind by its second biggest tradingpartner, decided something needed tobe done. The Digital 21 initiative waslaunched in November 1998 (restatedin May 2001) with the explicit goal ofpromoting electronic commerce inHong Kong on a number of fronts.These initiatives have met with somesuccess and some failure.
Take, for example, the investmentneeded in the SAR’s telecomsinfrastructure to promote the take-upof broadband data communications.The groundwork had been done for thisby the deregulation of the local fixed-line telecoms system (or FLTS, whichis used to deliver ADSL and otherbroadband technologies) in 1993, butin 2000 the incumbent PCCW stillenjoyed upwards of a 70% market sharein the broadband market.
Despite its licence containing auniversal service obligation to providegood, continuous and efficient basicservice and to open its network ofbroadband cables to its competitors byway of co-location arrangements, manyof the other FLTS licensees complainthat PCCW drags its feet in an anti-competitive manner when it comes toa g r e e i n g t h e s e c o - l o c a t i o narrangements. These licensees arguethat the telecoms authority OFTA has
Whither E-commercein Hong Kong?
By Derek Roth-BeisterIT PracticeMasons
HKA
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