Question 1 Under IAS 40 companies can either use the cost model or the fair value model for investment property. Investment property is held to earn rentals or for capital appreciation or both of them. Next I will summarize main differences between the value models. If the company has chosen the cost model it can change it to the fair value model later. If the fair value model has chosen it is impossible to move back the cost model in practice. It is very hard to find any good reason how the cost value model will enhance the quality of financial reporting if the company has used the fair value method before. In that case if the company has chosen the fair value model the company has to use it in the future. The company has to take account of this issue. The cost model: The depreciation method is used and based on the useful lifetime or depreciation rate. The depreciation time is based on time how long the investment will turn a profit. The company has to report current value taken off accumulated depreciation on the balance sheet. Depreciations are reported on the income statement. If the company has chosen to use the cost model the fair value also has to be reported in the notes to the financial statement. The fair value model: Fair value of property is based on the market value. It is the price which independent player would pay for the property on the market. The company should use an expert who will confirm the fair value. The fair value has to be defined every accounting period. Fair values of investment properties are reported in the balance sheet and the changes in fair are reported in the profit and losses. The depreciations are not used in the fail value model. The choice of accounting method affects company´s solvency. When the company has made a choice to use the fair value method the total sum of balance sheet will change on the market prices. However company´s liabilities do not change. If the estate´s value decreases the company´s gearing ratio will also decrease. This is the situation when solvency has been measured by gearing ratio. I think this is a better way because balance sheet is more indicative now. If the cost model is used solvency does not change when the market prices are changing. The choice of value method affects also on company´s ROE. If the level of rent is rising it means that profit is also going up. When company uses the fair value method ROE will be almost same as before. Profits go up and shareholder´s equity also rises. In the situation where the cost value method is used value of estates do not change when the
level of rents rise. So the fair value method is more indicative in case of real return on equity. Silic Inc. has used the cost model as they have valuated their investment properties. Their ROA was 3.41 % in 2004. If they had chosen the fair value method ROA would have been 2.94%.
Question 2 In the Exhibit 10 according to Investment Property Industry fair value seems to give better information about real estate companies because of the nature of the industry. One negative side of the fair value model, however, was the difficulty to make comparisons with historical accounting data. There are few paragraphs in IASB conceptual framework which deal with the performance and changes in financial position. It is important that the users of financial statements can make their economic decisions and predict future profits based on reliable information. One of the qualitative characteristics of financial statements is comparability (paragraphs 39-42) which means that the financial statements of an entity should be comparable through time. According to these views the negative side of the fair value model mentioned earlier would not be in line with the IASB conceptual framework. On the other hand the comparison between other entities might be easier when there are no mistakes or misevaluation in the financial statements. Among International Accounting Firms and...
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