Realtor Inc is a company that owns five large office
Realtor Inc. is a company that owns five large office buildings that are leased out to tenants. Most of the leases are for 10 years or more with renewal clauses for an additional 5 years. Currently, the company is a private company that follows ASPE. Recently Rita Mendoza was hired as a new controller. Ms. Mendoza has suggested to Habib Ganem, the owner and sole shareholder of the company, that perhaps the company should consider switching to IFRS. She explained that under ASPE, the buildings are recorded at cost and then depreciated and tested for impairment when events occur. However, under IFRS, she explained, the buildings could be classified as investment properties and adjusted to fair value every year. In addition, there is no impact on the income statement since no depreciation is recorded on the investment properties. Finally, Ms. Mendoza stated that there is no impairment testing required for investment properties under IFRS so there would never be any impairment losses to be recognized.
Mr. Ganem was intrigued with this idea. He had just been looking at the calculation of the bank loan covenants and had found that the company's debt to asset ratio was very close to the maximum that would be allowed. He wanted to take this year's annual financial statement, once completed, to the bank and ask for revisions on the covenants, since he was also looking at some new properties to possibly purchase. He particularly liked the idea of no depreciation having to be recorded on these assets, which would also improve the company's times interest earned ratio (calculated as Earnings before taxes and interest 1 Interest expense). Mr. Ganem decided he might call his banker to discuss this change and get her thoughts.
You are the loans officer at the bank. What comments would you make to Mr. Ganem about the controller's suggestions? In particular, explain the impact on the balance sheet and the income statement under both the cost model and the fair value model and the resulting impact on the existing covenants. From a banker’s point of view, which method for reporting the investment properties would be most useful? Make a final recommendation to Mr. Ganem.
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