Building Analogy Part 2

In my previous month’s article I asked the question: “What if architects thought like accountants?” Here are two further problems for you to consider.

Private Company Owing a House

A private company’s only asset is land with a house thereon. The asset is funded by a bond, a shareholders’ interest free loan and equity. There are no income statement items as the sole shareholder pays the interest, rates and taxes, etc. The shares are held by a trust so conversion to a close corporation is not an option. The only users of the financial statements are the sole shareholder and SARS. The bank has a bond over the property so is not interested in them.

According to Statements of GAAP, this property is an investment property (held for capital appreciation). AC135 provides two options for accounting for the property:

  1. Leave it at cost and depreciate the house over its useful life or
  2. Fair value the property each year to income and provide for deferred tax on the revaluation.

Here is the practitioner’s query (he writes up the books and performs the audit):

If I go the cost/depreciation route:

  1. How do I split the land from the buildings? The property was bought as a unit many years ago.
  2. How do I determine the useful life? Do I base it on the expected life of the sole occupant of the house?
  3. How do I arrive at the residual value of the building? According to AC123 I must estimate what the company could sell the building for without the land today if it were already of the age and in the condition expected at the end of its useful life. I have no idea to what extent the building will be abused between now and then and I have no idea when “then” will be!

If I go the fair value route:

  1. How do I get the fair value of the property? My client refuses to pay for a valuation to be made each year and I have no idea what market values are as there have been few sales in the area and the house is unique.
  2. If I comply with AC421 I am supposed to provide for deferred tax on the revaluation of the building at the company income tax rate and the land at the capital gains tax rate. To do this, I need to split the land from the buildings (back to the first problem in the other method).

What advice do you give to this practitioner, who is subject to practice review and is expected to adhere to Statements of GAAP, which were never intended to apply to this type of entity!

Rightly or wrongly this is the advice that I gave him:

  1. Go the fair value route as it is less costly. If you go the cost/depreciation route you will still have to obtain a value for the property - it is a disclosable item.
  2. The statement does not require an expert to value the property so ask your client to give you a representation letter giving his or her opinion of the value.
  3. Do some reasonability checks on the value, e.g.
  • Find out what land is selling for in the area or close by and get some idea of building costs today and relate these to the value given to you by the shareholder
  • Calculate the annual increase from cost to the value and determine whether you consider it to be fair in relation to actual property inflation over that period in the area
  1. Use the capital gains tax rate for the deferred tax on the revaluation of the land and the building as the company does not earn taxable income so the only tax that will be payable on future economic benefits will be capital gains tax.

Is this not the most pathetic advice you have ever read? The problem is that if I advised him to leave the fixed property at cost and ignore AC135 there could be a disciplinary action against him. I have always loathed the idea of “being seen to be” but I am afraid that we have no choice until someone in authority does something about the situation.

Game “Owned” by a Parks Board

An entity was formed to take over the operations of a national game park. It is governed by the Public Finance Management Act, which requires compliance with Statements of GAAP. The main objective of the entity is to reintroduce and conserve the indigenous fauna and flora in the area and to eradicate exotic species that have been contaminating the environment.

Some of the problems posed were:

  1. Valuing certain animal species without taking into account the contribution of other organisms and other aspects of the ecosystem is not in line with biodiversity conservation principles.
  2. Fauna move from one place to another (birds fly over the fences, fish swim under the fences and buck either go over the fences or under the fences), which makes counting complicated.
  3. The cost of counting and auditing game is extremely expensive. Resources are scarce and should rather be invested in conservation.
  4. The monitoring, measuring and managing of accounting values of fauna and flora add no value to the management of the park.
  5. Sales of game are not motivated by profit but by maintaining the balance of nature and raising money to finance the park’s operations. Profit is not the prime mission of the board.

How do you advise on this one? The simple and correct answer is: “Statements of GAAP only apply to commercial, industrial and business reporting entities (AC000.8) so they clearly do not apply to this type of operation.” The problem is that those who are making the rules do not understand that general purpose accounting systems do not meet the needs of a specialised operation such as a game park. So, to use the building analogy I wrote about last month, we will have to build two buildings: One a castle in the sky to satisfy the building inspectors and one in which the real work takes place. Logic dictates that this is total waste of resources. But if you want to play the game you must play by thesesilly rules. Can we hope that someone on the Company Law committee with the necessary power, understanding, motivation and clarity of thought will look at these rules and start a process to get them changed?

Give five different GAAP “experts” this problem and you will probably get five different answers. The trick is to choose the one that keeps the cost of our castle in the sky as low as possible but will still pass the scrutiny of the inspectors. Here is my contribution with this objective in mind:

  1. This activity does not meet the definition of an agricultural activity as the entity does not manage its operation to sell the biological assets, make biltong from them or increase them (the idea is to get a balance, not to maximise numbers).
  2. The insects, plants, trees and game are an integral part of the land and should be accounted for as part of this asset.
  3. The day to day management of the flora and fauna should be expensed. However, if costs are incurred to improve the land asset by buying flora and fauna and introducing them to the environment, this can be seen as an improvement to the land and should be capitalised to the land.
  4. The land should be left in the books at cost, i.e. not be depreciated. If there is any indication of impairment, e.g. a severe drought or fire that devastates the environment, an impairment loss should be recognised. As the land is rehabilitated, the impairment loss can be reversed.

How does this grab you?