The demand for fair value

Joseph Alfred reports from Singapore on the new FRS 40 and its implications for the investment properties market

A number of property companies regularly report the fair value of their property portfolios outside their financial statements and estimates of fair values of property portfolios are also attempted by various analysts and the media. There is no doubt that investors clearly appreciate and have utilised this fair value information in evaluating the investment quality and financial strength of these companies. The Council on Corporate Disclosure and Governance (CCDG) recently issued the financial reporting standard, FRS 40, Investment Properties, which allows investment properties to be carried at fair value on a company's balance sheet when the fair value model is used. Increases and decreases in fair values are reported in the P&L and the properties are not depreciated. This is a significant development from current practice.

Currently, where investment properties are carried at valuation (rather than cost), changes in market value generally do not affect each period's earnings. As valuation increases or decreases are recognised in a revaluation reserve, they affect only the balance sheet. A decline in value would hit earnings only if the amount exceeds previous valuation increases. The 'fair value model' under FRS 40 is therefore quite different from the 'revaluation model' which is used by many companies in Singapore applying FRS 16, Property, Plant and Equipment. Under FRS 40, companies can choose to value their investment properties using the 'fair value model' or the 'cost model', except in cases relating to properties held under operating leases which will be discussed later. Under the cost model, investment properties will be stated at cost less depreciation (less any impairment losses). The standard implies that once the fair value model is selected, a company generally would not be expected to revert back to the cost model, betraying a preference for the fair value model.

The new FRS will become effective for annual periods beginning on or after 1 January 2007. This allows for an unusual two-year familiarisation period to allow companies more time to review their business models and valuation methods; and also provides more time for the investing community to understand better the impact of FRS 40 on the operating results of companies. Companies, however, can choose to apply FRS 40 before the effective date of the standard. FRS 40 supersedes FRS 25, Accounting for Investments, in matters relating to investment properties and is equivalent to the revised IAS 40 which became effective on 1 January 2005.

Investment properties, under the standard, include:

• land held for long term capital appreciation
• land held for undecided future use
• building leased out under an operating lease, and
• vacant building held to be leased out under an operating lease.

Properties that are under construction or development for future use as investment properties, and properties leased out under finance leases, are not investment properties under the standard.

Pros and cons of the fair value model

Investment properties are interests in land and/or buildings that are held for their investment potential, rather than for consumption in business operations. As such, it is argued that the current value of these investments and changes in current value are of prime importance rather than a calculation of systematic annual depreciation. Some financial statement users, however, question the reliability of fair value estimates. The standard does not require the use of independent valuers to determine the fair value and, even if independent valuers are used, management (if it chooses) can still 'shop around' for an appropriate value to 'manage' the company's profits. Accounting costs are also expected to increase when using the fair value model. According to the standard, the fair value of an investment property must reflect market conditions at the balance sheet date. Hence, more frequent valuations may be required under the fair value model.

Furthermore, the standard requires all changes in the value of investment properties to be recognised in the P&L. This will make the earnings of companies that hold investment properties more volatile, reflecting the upturns and downturns of the property market, and blurs the assessment of operating performance (particularly for non-property companies such as manufacturing or trading companies). The use of the fair value model is expected to introduce a degree of volatility into the results of companies not seen before. Some companies may then be tempted to hold investment properties at cost. However, these companies should not celebrate too soon as the standard still requires management to determine and disclose the fair value of an investment property when the cost model is adopted. Here again, the standard betrays a preference for the fair value model.

The observation that there are economic similarities between investment properties and financial instruments, however, supports the fair value model. For example, cash flow effects of both investment properties and financial instruments can be identified with specific assets. Unlike assets held for use in manufacturing or service processes, investment properties generate cash flows largely independent of other assets held by the entity. This indicates that the most relevant measure of the financial performance of investment properties and financial instruments includes changes during a period of their fair values.

Properties held under operating leases

When IAS 40 was first issued in 2000, the initial cost of a property interest held under an operating lease could not be recognised as an investment property. Although an equivalent exposure draft was issued in Singapore, it never took off. Many were opposed to IAS 40 (2000) because a large number of leases of interests in properties in Singapore and other land-scarce cities like Hong Kong are operating leases which are often entered into for capital gains by property companies. An amortisation policy which ate mechanically into the value of these interests would adversely affect bottom-lines of (particularly) property companies and not reflect economic reality. This 'impediment' in IAS 40 (2000) has been removed under the revised IAS 40 (and the equivalent FRS 40) in response to feedback on the initial standard.

One of the more interesting aspects of the standard is that it requires the initial cost of a property interest held under an operating lease, and classified as an investment property, to be accounted for as a finance lease - whatever its classification under FRS 17, Leases. In this case, FRS 40 overrides FRS 17. In other words, even if the property is held under a lease which fulfils the definition of an operating lease under FRS 17, it will be accounted for as a finance lease under FRS 40 if it is classified as an investment property. As a result, the interest in land and buildings held under operating leases can now be considered investment properties which need not be depreciated. However, they need to be fair-valued at each balance sheet date. This is because the choice between the cost and fair value models is not available to a lessee accounting for a property interest held under an operating lease that it has elected to classify and account for as an investment property. The standard requires that such an investment property be measured using the fair value model. Companies which own these types of properties must brace themselves for extra accounting work in the next two to three years.

In Singapore, many companies pay a 'leasehold premium' under operating leases with Jurong Town Corporation (JTC) and other landlords. Under the standard, any premium paid for a lease is treated as part of the minimum lease payments and is therefore included in the cost of the asset. If a property interest held under a lease is classified as investment property, the item accounted for at fair value is that interest and not the underlying property.

Conclusion

While there is no doubt that FRS 40 will entail more work for companies, there is also no doubt that it will improve corporate transparency and satisfy demand for fair value information from investors and others. Management must now start studying this lengthy standard and set up procedures to cope with its requirements.

Joseph Alfred is technical manager, ACCA Singapore.