Written by Richard Spence, a Director within Deloitte’s Real Estate’s Valuation, Assurance and Professional Advisory Team
FOLLOWING the introduction of the ‘new’ UK GAAP/FRS 102 (applicable in the UK and Republic of Ireland) and adaptions to and reinterpretations of IFRS in from 2015, the umbrella term of fair value has become far more prevalent in preparing property asset valuations for an organisation’s financial statements. This has brought a large number of practical issues into sharp focus which needs to be addressed by both the valuer and the client and preferably with input from a pro-active auditor experienced in real estate issues.
Previously, the valuer would primarily rely on guidance prepared by the Royal Institution of Chartered Surveyors (RICS) in their Valuation – Professional Standards, commonly referred to as the ‘Red Book’ when preparing valuations for accounts. However, the valuer is now increasingly required to have a detailed understanding of the requisite Accounting Standards, Statement of Recommended Practices (SORPs), Manuals and specific regulations applicable to the particular organisation whose assets are being valued. Even when the valuer gets to grips with this plethora of standards, codes, manuals, and guidelines, issues often arise as the applicable accounting treatments, valuation regulations and guidelines are not always fully aligned, clear or entirely consistent.
It is therefore increasingly important that the valuer liaises with both the client and auditor throughout the valuation process to ensure that the asset valuations are being prepared adopting the correct approach and that all relevant matters are considered and taken into account.
Both as a practitioner, preparing asset valuations for clients and also acting in the capacity as a real estate specialist for our audit teams across the UK, reviewing a significant number of asset valuations, I am aware of the challenges and issues that often arise in preparing fair value accounts valuations. Often these issues can occur at the very outset, i.e. the commissioning of the asset valuation. In most cases the onus in commissioning an asset valuation falls to an organisation’s finance team who may not be fully au fait with all the matters which the valuer needs to address in preparing fair values. This can often result in clients setting a scope that is, at best, vague or even misdirected. The instructed valuer has an obligation to question the client and where appropriate challenge the approach that is being advocated. Accordingly it is essential that at this stage there is a detailed dialogue between the client and the valuer to agree the exact scope and output of the valuations. The client’s auditor can assist in this process, particularly those auditors who have in-house real estate specialists, as ultimately the valuations need to be correctly based for audit sign off to be achieved.
Chances are that if there are issues with valuations of property assets many of the problems will originate with valuations being commissioned on either an incorrect or unclear basis.
Accordingly, in order to ensure that there will be no fundamental issues with the asset valuations at year-end, the commissioning of an asset valuation should involve a three way dialogue between client, valuer and auditor. Auditors with real estate expertise can often provide the requisite guidance on various valuation issues and can provide input, ensuring that the scope is sufficiently clear so that client and valuer understand their respective roles, that the valuation methodology is appropriate, and that the output produced provides sufficient detail allowing the client and auditor to be satisfied that the appropriate issues have been addressed. If the auditor is sufficiently experienced in undertaking reviews of real estate assets they can also provide practical solutions to issues faced during the valuation process.
So what does commissioning a valuation have to do with fair value? Well in the past the valuer only really had to determine a valuation of a property on a Market Value basis, the definition of which is well understood and established following years of practical application. Fair value however offers a number of different ways in which an asset can be valued and, even when the appropriate valuation basis and methodology is applied there are often other nuanced but ultimately essential issues to be considered by both the valuer and the client.
The number of issues that need to be addressed can appear overwhelming but if the client and valuer determine a ‘route map’ for each stage then the relevant and correct considerations should be covered.
Clearly the first stage is to understand under which accounting standard the client reports, i.e. in the UK most commonly either UK GAAP (FRS 102) or IFRS, and whether there are any other accounting/reporting regulations/guidelines applicable for the particular organisation (i.e. SORPs, CIPFA, NHS Manuals etc.). If there is any uncertainty over what policies should apply then the valuer should verify this with the client or the client’s auditor and thereafter review the appropriate standards, regulations and guidelines. In some cases these may prescribe a particular approach which might differ from standards/statements set out in RICS’ Red Book. It is therefore particularly important that the valuer is aware of these before undertaking the valuations. It is also advisable that the valuer makes reference to these in both their terms of engagement and their valuation report as this will provide the client and the auditor with a degree of assurance that the valuations will be or have been prepared adopting the correct accounting and valuation ‘framework’.
The next stage is determining or reviewing the categorisation for each property asset as this should assist in shaping the valuation approach to be adopted for each asset. Typically asset categorisations will include; Property, Plant & Equipment (PPE) (Specialised Operational, Non-Specialised Operational, Non Operational Surplus or Assets under Construction); Investment Property and Non-Current Assets Held for Sale. A number of other categories may exist which are specific to the organisation including Heritage Assets.
It is critically important that the client and the valuer discuss the categorisation of the assets to ensure that the assets are correctly allocated and ultimately this will depend upon the actual use and type of the asset, which can change
The valuation approach to be adopted will largely be governed by various Accounting Standards, namely International Accounting Standards (IAS), International Financial Reporting Standards (IFRS) and Financial Reporting Standard (FRS) 102. Although it should be noted that FRS 102 has been derived from IFRS it is far less detailed. IFRS 13 Fair Value Measurement sets out how to measure fair value where fair value is required by other standards. Other standards relevant to property include (IAS) 16 Property, Plant and Equipment (PPE); IAS 17 Leases (albeit this will shortly be replaced by IFRS 16); IAS 40 Investment Property, IFRS 5 Non-Current Assets held for Sale and Discontinued Operations and IAS 36 Impairment of Assets.
The valuer and client should also be aware that there are other standards which might be used for property related reporting, for example IAS 28 Investments in Associated and Joint Ventures and IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Care should be taken at this stage to ensure that elements that make up a valuation are not included, or ‘double counted’ in more than one accounting treatment. This can happen in areas such as contamination clean-up costs which could be factored into the valuation of an asset under IAS 16 (PPE) and but provision for the cost could also be included in IAS 37 (Provisions, Contingent Liabilities and Contingent Assets).
The above standards prescribe the accounting treatment for properties including the recognition of the assets, the determination of their carrying amounts and the depreciation charges and impairment losses that should be recognised. Whilst the valuer needs to fully understand what is being prescribed in these various standards it has to be appreciated that these are principally accounting documents written by accounting authorities and are not restricted to the valuation of property assets. Therefore the valuer needs to review these in conjunction with the relevant sections of the RICS Red Book to formulate the key principals in preparing the valuations of particular categories of assets. This is where both the client and auditor can play a key role as it is all too easy for the valuer to misinterpret the relevant Standard and prepare valuations adopting a basis that will not be consistent with financial reporting.
If the valuer adopts the wrong valuation approach then at best they might be viewed as incorrectly founded but perhaps not material to the accounts. In such cases the real estate audit specialist should provide assistance to the client in determining the materiality of the error and advice on how the valuations could be corrected or provide guidance on how the valuation should be prepared in the future. If the issue is more critical, then, in certain cases the assets will either need to be revalued or in the worst case, the accounts will need to be qualified which highlights the fact that the property valuation cannot be relied upon.
In qualifying an organisation’s accounts there are significant implications for all parties that have a stake in the process in preparing and reviewing the accounts. Having reviewed a significant number of valuations prepared for just about every conceivable type of client, and on an extensive range of property types, common issues regularly arise, and a number of these are highlighted in the table below. These clearly highlight that it is essential for there to be a three way dialogue between the client, valuer and auditor throughout the valuation process, starting at the initial stages of commissioning an asset valuation.
Therefore in conclusion it is critical that:
- Valuers fully understand and keep abreast of all the guidance if they are providing this sort of asset valuation work. They also have a responsibility to help guide their clients and to ask the right questions when the client is commissioning a valuation;
- There needs to be consultation between valuer, client and auditor. This is important particularly when the situation is complex and whilst this may mean that the whole process takes a bit longer, getting it right first time it can save time in the long run; and
- In the long term we all hope that the guidance will become better understood, more universal and consolidated and straightforward.
|Potential Issue, Impact or Where Clarification Should be Sought from Client and Auditor|
|Adoption of incorrect Accounting Standard or lack of awareness of relevant policies applicable to the organisation.||Incorrectly based valuations including issues such as:
· The application of Market Value instead of Fair Value; and
· Use of valuation methodology which is not appropriate for the relevant organisation.
|Incorrect Categorisation of Assets.||Incorrect valuation methodology used i.e. (non-specialised assets valued on a specialised (depreciated replacement cost (DRC) basis) or specialised assets valued adopting a market comparable approach.|
|How to treat acquisition and disposal costs applicable in the valuation of specific categories of assets.||Valuer should consider the treatment of such costs and make it clear in the advice provided, for example:
· Deduct disposal costs in ‘market based’ valuations i.e. Investment Assets & Assets Held for Sale?
· Exclude (report gross values) for Operational Assets?
|Highest and best value- to what extent does the valuer need to consider alternative uses?||The valuer needs to consider and discuss the following issues with the client and auditor:
· To what extent the valuer can assess the value of an asset based on existing use?
· How easy is alternative use to determine?
· Additional costs in providing valuations determined on a completely different valuation basis requiring detailed research.
· Too many assumptions to be made (requiring the use of Special Assumptions)?
· Planning uncertainty?
· Will the highest & best value be ultimately be used for financial reporting?
· Consider the need to provide general commentary that Fair Value is unlikely to be higher if examined on an alternative use basis and in many cases alternative use would be considerable lower than Fair Value for specialised assets (i.e. valued on a DRC basis)?
· Option for Public Sector assets to be valued on a Current Value approach only (i.e. Existing Use value)?
|The application of the ‘instant build’ assumption and the exclusion of finance charges.||Only applicable to certain organisations and depends upon specific prescribed accounting regulations and guidelines. The valuer should make it clear what assumptions have been made on finance costs and assumed build period.|
|VAT- the potential addition of VAT to the adopted build costs for specialised operational subjects.||This issue shouldn’t be ignored- valuer should seek guidance from the client – VAT treatment may be organisation or even asset specific.|
|Modern Equivalent Asset (MEA) Considerations.||Critical issue when preparing valuations of specialised assets on a depreciated replacement cost basis as the client and valuer needs to consider:
· Modern equivalent build costs;
· Service potential of the existing and modern replacement asset;
· Appropriate building sizes and functions of modern replacement asset;
· Site sizes applicable to the MEA;
· Alternatively located asset, reflecting the organisation’s requirements and least cost to replace considerations.
Assumptions adopted must be realistic, supported by research and analysis undertaken by the client and valuer and findings outlined in the report.
|Should the valuations of the assets be subject to componentisation to more accurately account for depreciation and how should this be done?||The relevant organisation should have a componentisation policy in place dealing with this specific issue and this should be reviewed regularly to ensure an appropriate process is employed to account for depreciation of certain assets. The valuer and auditor can assist in defining the scope for the componentisation of the assets.|
|Fair Value vs Market Value- to what extent can Fair Value can reflect:||· Enhanced value achieved by a sale/purchase by specific market participants including special purchasers;
· Premium value if all or part of a portfolio was to be marketed simultaneously, either in lots or as a whole (albeit often the total reported value reflect the aggregate value based on an assumption of the sale of individual assets as opposed to specific lots or whole portfolios as this commonly produces the highest value. The approach should be clearly stated in the valuer’s report);
· Additional value of specialist facilities which should be reflected in the assessment of Fair Value, but it should be noted that these may detract from value if appraised on a Market Value basis.
|How to reflect legal issues restricting alternative use of a property asset?||For example if legal issue does not impact on the current use of an asset but restrictive title conditions can impact on alternative use.|
|The application of Special Assumptions.||Generally not appropriate for financial reporting as actual reality not reflected, i.e. adopting an assumption that planning permission in place.|
|Impact of determination of asset value on a specific valuation date.||For example asset valuations based on a total of individual land plot sales – the valuation should reflect the realisable value as at the valuation date i.e. either reflecting a discount for a single sale of all the plots or adopting a phased sale using a discounted cash flow approach.|
|Obsolescence allowances reflecting unrealistic future expenditure on the assets (i.e. nominal or excessive capex)||Can lead to unrealistically high or low valuations.|
|Use of valuations prepared for other purposes i.e. loan security and adopting different valuation date from that needed for financial reporting.||Valuation prepared for different purposes other than financial reporting may not adopt the correct valuation basis and a different valuation date brings into question how relevant valuations are, particularly if there are factors which might lead to the valuations needing to be reviewed if a different valuation date is adopted.|
|Frequency of Asset Valuations.||
Fundamental principle is that the value of assets must be materially accurate at a specific date. Therefore assets which are more likely to see changes in value should be revalued more regularly (i.e. commonly Investment Properties, Surplus, and Assets Held for Sale). If a rolling programme of asset valuations is being undertaken then advice should be provided on the value movement of assets not subject to the valuation in a particular year.
Craig Maxwell joins the audit and assurance team in Scotland
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