Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate, April 2010
On January 1, 2011, Canadian Generally Accepted Accounting Principles (GAAP) will be replaced by the International Financial Reporting Standards (IFRS) as the financial reporting standard required for Canadian businesses that are "publicly accountable enterprises." The IFRS system of reporting is used around the world and is widely regarded as a single set of high-quality, understandable and enforceable global standards. The transition to IFRS promises enhanced comparability and transparency of the financial health of companies.
Landlords that are publicly accountable enterprises (e.g., publicly traded real estate companies and REITs, as well as many insurance companies and pension funds) are included in the group of businesses that will be required to move to IFRS. Landlords that do not fall within this group (e.g., family-run or closely held landlord companies) have the option of adopting either IFRS or new private enterprise standards that are in accordance with Canadian GAAP for private enterprises.
IFRS and Treatment of Investment Properties
The specific IFRS reporting standards applicable to investment properties (e.g., shopping centres and office towers) are known as IAS 40 – Investment Property (IAS stands for International Accounting Standards). Under current Canadian GAAP rules, a landlord of an investment property must record and carry the property on its books on a historic cost basis in each year deducting any accumulated depreciated value of the property. Under the IFRS standard, a landlord must initially record the investment property at cost but, following initial recognition, has the choice to record the property using either: (a) a fair value model (being fair market value of the property as at the last day of the then-current accounting period), with any changes in the value of the property being recognized as a profit or loss during the accounting period in which it arises; or (b) a cost model that contemplates the deduction of accumulated depreciation from the original cost (in a manner generally similar to current GAAP). The ability to report property using the fair value model represents the biggest change for investment properties over current GAAP.
IFRS Operating Cost Recoverability Issues
In determining the carrying amount of investment property under the fair value model, a landlord is not permitted to double-count assets or liabilities that could be recognized as separate assets or liabilities. Accordingly, if a piece of equipment or a particular facility (e.g., an HVAC unit or roof) forms an integral part of a property, then that value must be included in the fair value of the property, instead of being separately recognized. On the other hand, the cost model requires a landlord to utilize what is called a "component" approach to recognition of parts of an asset that will likely be replaced sooner than, and separately from, the rest of the asset (for many properties, the above-noted examples of an HVAC unit and roof would qualify as separate components). Under the cost model, each separate component is recorded and depreciated separately.
In light of the foregoing, leases that simply link the calculation and recovery of operating costs to IFRS (such as through the use of statements like "operating costs will be calculated in accordance with IFRS" or "capital costs will be amortized in accordance with IFRS") could lead to unfavourable results for both landlords and tenants. This is because there is, in effect, no recognition of amortization or depreciation under the IFRS fair value model. For example, if a shopping centre replaces its roof at a cost of C$2-million dollars, there would be no amortization of the cost under the fair value model (i.e., the cost could be expensed in the year incurred); instead, the value of the building at the end of the accounting period would simply be compared to the fair value at the start of the period and any change would be recognized as a profit or loss. Under the cost model, the roof would likely be recorded and carried as a separate item on a depreciated basis. A tenant that sought to have capital costs amortized "in accordance with IFRS" might be in for a surprise later on down the road if the landlord adopted or took the position that the fair value model of IFRS applied because such capital cost could then be expensed in the year incurred.
Simply making reference to IFRS without further detail could also lead to unfavourable results for landlords who seek to recover the original cost of big-ticket items on a "sinking fund" or "depreciated basis." For example, a tenant could argue that, since the lease requires operating costs to be calculated "in accordance with IFRS," the landlord is not entitled to continue to pass through the amortization or depreciation of costs incurred prior to the tenant's lease commencement date item, as the fair value model of IFRS dictates that the cost of the item should be reflected in the fair value of property and cannot be carried as a separate item on a depreciated basis.
Lease Drafting Recommendations
From both a landlord's and tenant's perspective, simple references to GAAP and IFRS as a means of providing guidance in relation to the recoverability of certain pass-through operating costs should be avoided as this could lead to confusion and unintended consequences. As noted above, making reference to IFRS without further amplification could also lead to unintended consequences given that the treatment of capital expenditures is quite different depending on whether the fair value or cost model is adopted. Additional confusion and unintended consequences could also arise where the original landlord may utilize one model, but its successor (i.e., a purchaser) may utilize a different model. In addition, unless the lease expressly recognizes that the parties have turned their attention to the differences between GAAP and IFRS, making reference to GAAP could be subsequently interpreted by a court to mean IFRS, particularly where the landlord is required to report using IFRS standards.
In light of these and other problems, both landlords and tenants would be wise to expressly articulate in their leases their intent as to how and which capital or bigticket items may be recovered through operating costs. This should be accomplished not by making reference to GAAP, IFRS or any other accounting standard but rather by explicit and precise language that clearly captures the full intent of the parties. Possible approaches could be:
- including a detailed list of what original (as opposed to repairs or replacements) equipment and facilities capital costs could be recovered on a depreciated/ sinking fund basis
- including a detailed list of what repair/replacement items would be considered a capital cost or deeming repair/replacement costs for specified items in excess of a stated amount to be capital in nature
- expressly articulating the amortization period for recovery of big-ticket items, such as over a set number of years or over the useful life of the item in question
- expressly setting out the interest rate applicable to any depreciation/amortization
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.