IAS 40 Investment Property: The Cost Model Does Not Save You the Valuation

Two entities buy the same office building for £2,000,000 and let it to the same tenant on the same terms. By the end of year one, one reports a £300,000 credit in profit or loss and the other a £30,000 depreciation charge. A £330,000 swing on identical cash flows and an identical asset, decided entirely by an accounting policy choice.

And here is the part that surprises people: the entity that chose the cost model, to avoid exactly that volatility, still has to obtain the fair value. It just discloses it instead of recognising it.

What is and is not investment property

Paragraph 5 of IAS 40 defines investment property as property, being land or a building or part of a building or both, held by the owner or by the lessee as a right-of-use asset, to earn rentals or for capital appreciation or both, rather than for use in the production or supply of goods or services or for administrative purposes, or for sale in the ordinary course of business.

Paragraph 7 gives the rationale: an investment property generates cash flows largely independently of the other assets held by an entity, and that is what distinguishes it from owner-occupied property.

The express exclusions in paragraph 4 are unusually short, covering only biological assets related to agricultural activity and mineral rights and reserves. Almost everything else meeting the definition is in scope.

Paragraph 9 then lists what is not investment property, and it functions as the real scope limit: property held for sale in the ordinary course of business; owner-occupied property, including property held for future use as owner-occupied, property occupied by employees whether or not they pay market rent, and owner-occupied property awaiting disposal; and property leased to another entity under a finance lease, which is derecognised and replaced by a net investment in the lease.

Paragraph 8 gives a useful positive case that catches people out. Land held for a currently undetermined future use is investment property: if the entity has not determined that it will use the land as owner-occupied property or for short-term sale in the ordinary course of business, the land is regarded as held for capital appreciation. The default is investment property, not property, plant and equipment.

The part-let, part-occupied building

Paragraph 10 handles mixed use, and the test is capability rather than intention. If the portions could be sold separately, or leased out separately under a finance lease, the entity accounts for them separately. If they could not be sold separately, the property is investment property only if an insignificant portion is held for own use.

Take a six-floor building where the entity occupies one floor and lets five. If each floor is separately saleable, five sixths is investment property and one sixth is property, plant and equipment. If the floors could not be sold separately, a one-sixth owner-occupied portion is not insignificant, so the entire building becomes property, plant and equipment under IAS 16.

Note the asymmetry that creates. An eleven per cent owner-occupied portion that cannot be separated taints the whole building, while a one per cent portion probably would not. IAS 40 deliberately sets no percentage, and the Basis for Conclusions explains why. Paragraph 14 requires the entity to develop criteria and apply them consistently, and paragraph 75(c) requires those criteria to be disclosed where classification is difficult.

Ancillary services follow a similar logic. Under paragraph 11 the property remains investment property if the services are insignificant to the arrangement as a whole, security and maintenance for office tenants being the example. Paragraph 12 draws the line: an owner-managed hotel is owner-occupied property, rather than investment property.

The group accounts trap

Paragraph 15 produces a result that catches out UK group reporters every year. Where an entity owns property leased to and occupied by its parent or another subsidiary, the property does not qualify as investment property in the consolidated financial statements, because it is owner-occupied from the perspective of the group. But from the perspective of the entity that owns it, the property is investment property if it meets the definition, so the lessor treats it as investment property in its individual financial statements.

Two different measurement bases for one building, and a consolidation adjustment every year. This is also the point at which FRS 102 diverges most usefully, as set out below.

The policy choice, and what it does not save you

Paragraph 30 requires the entity to choose either the fair value model or the cost model and apply that policy to all of its investment property. Paragraph 31 adds a warning about going backwards: it is highly unlikely that a change from the fair value model to the cost model will result in a more relevant presentation.

There are two carve-outs from the all-or-nothing rule. Paragraph 32A permits a separate choice for investment property backing liabilities that pay a return linked directly to the fair value of, or returns from, specified assets including that property, with a separate choice for everything else. And paragraph 53 compels the cost model for an individual property whose fair value is not reliably measurable on a continuing basis, while paragraph 54 keeps all other property at fair value.

Paragraph 32 is the one that undercuts the usual reason for choosing the cost model: this standard requires all entities to measure the fair value of investment property, for the purpose of either measurement, if the entity uses the fair value model, or disclosure, if it uses the cost model. An independent valuer is encouraged but not required. Under paragraph 79(e) the cost model requires the fair value of investment property to be disclosed in any event.

So the cost model does not save the valuation fee. It saves the profit or loss volatility, and it costs you a depreciation charge. That is the real trade-off, and it is rarely how the choice gets framed.

Fair value movements go to profit or loss, with one exception

Paragraph 35 is unambiguous: a gain or loss arising from a change in the fair value of investment property shall be recognised in profit or loss for the period in which it arises. Routing it through other comprehensive income, or a revaluation surplus, is the single most common error on this standard, and the instinct comes from the IAS 16 revaluation model, which looks superficially similar and does use other comprehensive income. For that contrast see our guide to IAS 16 property, plant and equipment.

There is no depreciation requirement anywhere in the fair value model, which is an absence rather than a stated prohibition: the property is remeasured to fair value at each reporting date, so there is nothing left to depreciate.

But other comprehensive income does appear in IAS 40 once, and it is worth knowing where, because it explains the instinct. On a transfer in from owner-occupation under paragraph 62(b), the uplift is treated in the same way as a revaluation under IAS 16: an increase goes to profit or loss to the extent it reverses a previous impairment loss, and any remaining part of the increase is recognised in other comprehensive income and increases the revaluation surplus within equity. A decrease goes to profit or loss except to the extent of an existing revaluation surplus for that property.

Worked example

On 1 January 20X1 Entity A buys a freehold office for £2,000,000, comprising land of £500,000 and a building of £1,500,000 with a fifty-year life and nil residual value, and lets it to a third party under an operating lease. Fair value at 31 December 20X1 is £2,300,000.

Under the fair value model there is no depreciation. The gain of £300,000 goes to profit or loss and the carrying amount is £2,300,000.

Under the cost model, depreciation is £1,500,000 over fifty years, or £30,000, with land not depreciated. The carrying amount is £1,970,000 — and the entity still discloses fair value of £2,300,000.

The effect on profit before tax is £330,000, being a £300,000 credit against a £30,000 charge.

Transfers out

On 1 July 20X2 Entity A begins to occupy the building itself. Fair value at that date is £2,400,000, so the property is remeasured immediately before transfer, giving a further £100,000 gain to profit or loss. Under paragraph 60 the deemed cost for subsequent IAS 16 accounting is that fair value of £2,400,000. Depreciation then begins on the £1,900,000 building element over the remaining 48.5 years, giving £39,175 a year, or £19,588 for the six months to 31 December 20X2.

Transfers in, and the contrast that decides exam questions

Separately, Entity A has a warehouse it has always occupied, carried under the IAS 16 cost model at £1,800,000 with no revaluation surplus and no prior impairment. On 1 October 20X3 it ceases occupation and lets it out. Fair value is £2,100,000.

Depreciate up to the date of change in use, then treat the £300,000 uplift as an IAS 16 revaluation. With no prior impairment to reverse, the whole £300,000 goes to other comprehensive income and increases the revaluation surplus. Thereafter all movements go to profit or loss under paragraph 35.

Now change one fact. Had the warehouse been transferred from inventories at the same figures, paragraph 63 would send the £300,000 to profit or loss. Same uplift, same direction of transfer, different destination, decided by where the property came from. That is the discriminating question in most sittings.

A change of mind is not a change of use

Paragraph 57 requires a transfer when, and only when, there is a change in use, and states plainly that in isolation, a change in management intentions for the use of a property does not provide evidence of a change in use. The evidence required is commencement of owner-occupation or of development with a view to owner-occupation, commencement of development with a view to sale, the end of owner-occupation, or the inception of an operating lease to another party.

A board minute is not enough. That was the entire point of the Transfers of Investment Property amendments of December 2016, effective 1 January 2018. Related, and routinely missed: under paragraph 58 a decision to dispose of investment property without development does not move it to inventories; it continues to be treated as investment property until derecognised.

Under the cost model, by contrast, paragraph 59 provides that transfers do not change the carrying amount of the property transferred and do not change its cost for measurement or disclosure purposes. Paragraphs 60 to 65 apply only under the fair value model.

Leased investment property

Since IFRS 16 the definition covers both owned investment property and property held by a lessee as a right-of-use asset. Paragraph 40A sets the mechanic students most often get wrong: where a lessee uses the fair value model, it measures the right-of-use asset, and not the underlying property, at fair value. Fair-valuing the freehold is the error.

Paragraph 41 follows from that. Where lease payments are at market rates, the fair value of investment property held as a right-of-use asset at acquisition, net of all expected lease payments including those relating to recognised lease liabilities, should be zero, so remeasuring from IFRS 16 cost to fair value should not give rise to any initial gain or loss. And under paragraph 50(d), where a valuation is net of all payments expected to be made, any recognised lease liability must be added back to arrive at the carrying amount.

Paragraph 50 also warns against double counting more generally: lifts and air conditioning are generally within the property fair value rather than separate property, plant and equipment, and fair value excludes prepaid or accrued operating lease income because that is a separate asset or liability.

Under the cost model, paragraph 56 measures a property held for sale under IFRS 5, a lessee right-of-use asset under IFRS 16, and everything else under the IAS 16 cost model, with impairment under IAS 36.

What is changing, and why FRS 102 is the opposite of what most people assume

Nothing of substance changes in IAS 40 in 2025 or 2026. The only pending amendment is consequential on IFRS 18, amending paragraph 31 as a cross-reference change when IFRS 18 is applied, for periods beginning on or after 1 January 2027. The last substantive amendment was the 2016 transfers amendment. That stability is itself worth knowing.

FRS 102 Section 16 is where the real surprise sits, and it runs against the usual assumption that UK GAAP is the softer option. Paragraph 16.7 requires investment property to be measured at fair value at each reporting date with changes in fair value recognised in profit or loss. There is no general cost model option at all: the undue cost or effort exemption that used to permit one was removed by the Triennial Review 2017. Fair value through profit or loss is mandatory.

One policy choice does survive, and it is precisely the intra-group case that IAS 40 paragraph 15 makes awkward. Under 16.4A an entity renting investment property to another group entity may choose either fair value through profit or loss, or transfer to property, plant and equipment, or to right-of-use assets, applying the cost model. An entity taking the cost option gives the relevant section disclosures other than those related to fair value measurement — so unlike IAS 40 paragraph 79(e), a UK entity taking the intra-group cost option does not disclose fair value at all. The FRC reasoning is that the cost of obtaining a fair value for property rented to another group entity far outweighs the benefit, since it would be treated as property, plant and equipment in the consolidated accounts anyway.

Two further UK-specific points. Under 16.3A, property held primarily for the provision of social benefits, such as social housing held by a public benefit entity, is not classified as investment property, which has no IAS 40 equivalent and matters for housing associations. And on mixed use, 16.4 applies the same capability test as IAS 40 but falls back to property, plant and equipment where the fair value of the investment property component cannot be measured reliably, rather than on the basis of whether the owner-occupied portion is insignificant. Genuinely different triggers for the same question.

The periodic review amendments, effective for periods beginning on or after 1 January 2026, moved Section 16 towards IAS 40 on one axis: the new on-balance-sheet lease model removed the lessee finance and operating lease distinction, and consequential amendments bring all leases for which right-of-use assets are recognised into the scope of Section 16 where the other criteria are met. The FRC describes that as similar to the approach taken in IAS 40. So the direction of travel is convergence on leased investment property while FRS 102 stays more restrictive than IAS 40 on the measurement model. Our guide to the FRS 102 periodic review covers the lease changes themselves.