Fair valuation standard in real estate

By Cyril Jasmin B. Valencia

First Published in Business World (6/17/ 2013)

In May 2011, the International Accounting Standards Board (IASB) issued International Financial Reporting Standards (IFRS) 13, Fair Value Measurement, which the Philippine Securities and Exchange Commission (SEC) adopted as Philippine Financial Reporting Standards (PFRS) No. 13, Fair Value Measurement effective on 1 January 2013. The SEC, however, granted an extension and allowed entities required to submit interim financial statements to present the prescribed information and to recognize the impact of PFRS 13 starting with the quarter ending 30 June 2013, instead of 31 March 2013.

The new standard establishes a single framework for measuring fair value. It introduces the new concept of ‘highest and best use’ in determining fair values of the properties, and expands the disclosure requirements.

PFRS 13 may affect real estate companies in various aspects of their business, such as:
• Fair valuation of investment properties
• Impairment testing of properties
• Fair valuation for the purpose of purchase price allocation in business combination/s
• Compiling and disclosing information on the fair values of Investment properties

Investment property can be land or buildings or both, which are held for rental or for capital appreciation. Examples are malls, land and buildings for rent, or idle land waiting for management to decide its ultimate use. Under PFRS, companies are allowed to reflect such property in the financial statements either at cost or at fair value. If at cost, PFRS still requires a disclosure of the fair value of the property; and if at fair value, the fair value must be updated every reporting period with movements directly recorded in profit or loss.

PFRS requires that the cost of assets reflected on the balance sheet should not be higher than their recoverable value. In case recoverable value is lower than cost, an impairment loss will be booked. Recoverable value is the higher of fair value less cost to sell, or value in use (the amount that an entity can recover through continued use of the asset instead of selling the asset).

Since determining fair value is a critical process in impairment testing, proper application of this standard is important because the result will have a direct impact on the company’s bottom line.
Some real estate companies are expanding their portfolio by buying businesses. For financial reporting, it is critical to reliably determine the fair values of the identifiable assets and liabilities of the acquired entity, and compare the aggregate of these fair values with the purchase price. Such comparison may result in goodwill recorded in the books as an asset (this is the premium paid over and above the fair value of identifiable net assets acquired), or negative goodwill (similar to a bargain purchase) which is recorded immediately as income at business combination date.

The IASB significantly expanded the required fair value measurement disclosures to enable users of financial statements to understand the valuation techniques and inputs used to develop fair value measurements.

Under PFRS 13, fair value is defined as “the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants, at measurement date.” It indicates that this is an exit price or the price that the seller will get, not the price that a buyer can offer. This was not explicit prior to PFRS 13. Since real estate companies are both sellers and buyers of properties at the same time, it is important to remember that the value should be determined from the seller’s perspective. An entity is not required to sell the asset or transfer the liability as of balance sheet date but must be able to access the market as of that date.

It must be emphasized that, for financial reporting purposes, there is a conceptual difference between the definition of fair value under this new standard and that of the International Valuation Standards (IVS), which is a set of generally accepted standards for professional appraisal practice in valuing real estate internationally. Generally, PFRS 13 requires any advantage that would not be available to market participants to be disregarded in the valuation, which is different from IVS. Since most real estate companies hire the services of appraisers for various purposes – such as to determine the appraised values for insurance policy take-out, bank loans, sale or purchase of assets, among others — management needs to be aware of this conceptual difference because the values used for financial reporting may be different from the values for these other purposes.

PFRS 13 also introduced the concept of highest and best use of the asset in determining fair value. This should take into account the fact that the use of the asset is (1) physically possible; (2) legally permissible; and, (3) financially feasible. Let’s illustrate this concept:

• Physical feasibility should consider the size or location of the property. Thus, if a locator allows only a maximum gross leasable area, anything beyond that physical limit cannot be assumed by the management. Also, in most instances, locators have strict requirements for minimum set-backs for the construction of the building on all sides of the land/property; thus, the company will have to consider such strict requirements as significant assumptions.

• Management will have to consider any legal restrictions on the use of the asset, such as zoning regulations. For example, if the government restricts a residential development in a government protected area, then such use of the property cannot be an assumption in the valuation.

• Financial feasibility takes into account the use of the asset that is physically possible and legally permissible and whether it generates adequate income or cash flow (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset.

In determining the highest and best use, the standard requires that there should be an assessment if the asset’s value is maximized together with the use of other assets of the company. This is relevant because of the increasing number of mixed-use properties, e.g., developments which combine residential, office and retail space. If the aggregate fair value of the mixed-use property interest is higher to market participants compared to the total of the fair value of the individual property interests, then fair value is determined for the mixed-use property interest as a whole. The difference in values could come from synergies and complementary cash flows of the mixed use of the assets.

Given these points, management should be able to implement the new standard properly. Management will have to coordinate closely with their appraisers on the requirements of this standard, highlighting that there is a difference between IVS and PFRS 13 for financial reporting purposes. In addition, although it is generally assumed that the current use of the asset is the use that maximizes the value of the investment, management will have to reassess if the current use is the highest and best use of the asset. There is also a need to review the processes and procedures in preparing the more extensive disclosure requirements in the financial statements.

After all, while engaging the services of external appraisers is a common practice, management should always remember that the ultimate responsibility for fair value measurements and disclosures in the financial statements is theirs alone.

Cyril Jasmin B. Valencia is a Partner of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.