The research register for this journal is available at http://www.mcbup.com/research_registers/jpif.asp The current issue and full text archive of this journal is available at http://www.emerald-library.com JPIF 212 CONFERENCE PAPERS Financial reporting standards: is market value for the existing use now obsolete? International valuation standards put into practice John Dunckley Darroch Ltd, Dunedin, New Zealand Keywords Standards, Valuation, Financial reporting Abstract This paper backgrounds the recent changes to international financial reporting standards and some possible impacts on current valuation practices. Specifically, it debates issues surrounding the existing use principle and its ability to provide the required information for financial reporting. Also discussed is the role that interaction and debate between international bodies, such as IVSC and IASC, has in the resolution of such issues. Journal of Property Investment & Finance, Vol. 18 No. 2, 2000, pp. 212-224. # MCB University Press, 1463-578X 1.0 Introduction International valuation standards require that, when valuing property for financial reporting purposes, property be categorised by use and valued accordingly: (1) Property held for continuing use. be valued at market value for the existing use (MVEU) where there is a market; or. depreciated replacement cost (DRC) where there is no market. (2) All other property is to be valued at net market value. International debate has heightened since the removal of the MVEU concept from international accounting standard (IAS) 16. This raises a number of questions, and challenges existing international practice. The background documentation currently available on this change is:. IVSC Commentary No 1998/1, ``Removal of market value for the existing use concept in IAS'', which explores the principle of MVEU as historically set out in both the accounting and valuation standards.. IAS 16, ``Property, plant and equipment'', dated September 1998, deletes all reference to MVEU and also to the recoverable amount test.. IAS 36, ``Impairment of assets'', which picks up the recoverable amount test.
. IAS 22, ``Business combinations'', was revised and approved in 1998 requiring that identifiable assets and liabilities be measured at fair value. Why has the debate over MVEU arisen now? The answer may not be to do with the MVEU concept itself, but rests in the very reason for the internationalisation of standards. Jack Boorman, writing in the International Herald Tribune, 20 January 1999, comments (on the Asian economic crisis): The crisis also points to the need for creditors to have better information so that they can do a better job of managing risk. This concern is reflected in current international efforts to improve economic data, make budgets and monetary policy more transparent and built on internationally agreed standards in accounting, disclosure, bankruptcy codes and other areas critical to the functioning of private markets. The functioning of the modern financial market relies on consistent information and better information. Values recorded in financial reports form an integral part of this information, comprising a requirement to report asset values. The reported values of real property, land buildings, plant and equipment, is the main concern of this paper. So, in light of the requirements of today's international investor, how can we provide better information on the asset values of real property? Will this require the abandonment of the existing use concept? In 1997, the US Securities and Exchange Commission reported to the US Congress on the IAS/IOSCO core standards project. It commented on IAS 16, ``Property, plant and equipment'', and I quote as follows: Another issue is the seemingly inconsistent guidance provided by IAS 16 for the determination of Fair Value for the revaluation under the allowable alternative treatment. In paragraphs 31 and 32, IAS 16 states that the Fair Value is usually the Market Value. Thus, Fair Value should be determined based on Market Value. However, paragraph 33 states that the Fair Value of an item of property, plant and equipment be determined based on its existing use. The latter is a value in use notion. That notion recognises that property, plant and equipment is generally not for sale, and would not ordinarily be affected by market fluctuations. Yet paragraph 33 proposes that the frequency of revaluations should depend on the volatility of the market. That suggestion conflicts with the notion of value in use contained within paragraph 33. Thus, IAS 16 discusses determining Fair Value on the basis of existing use, but does not reconcile the notion of Fair Value as a current market value to the notion of existing use (or intended use, as mentioned in paragraph 33) on a continuing use basis. Nor does IAS 16 reconcile the notion of Fair Value as a current market value of the investment as an entity makes in property, plant and equipment to realise a return. IAS also does not provide specific guidance for determining Fair Value amounts, as it does not mention anything about the reliability of the Fair Value measurement. All these issues may lead to inconsistent application of the standard in practice. The current phenomenon of economic globalisation is a common theme and globalisation cannot be achieved without international standards which are widely accepted whereby compliance can be monitored. Misconceptions are highlighted by referring to MVEU as being a value in use notion. It is not. IVSC is committed to improving communication and understanding of financial reporting standards through international co-operation. Conference papers: Reporting standards 213
JPIF 214 2.0 The standard setting process Valuers and financial reporters are bound by their professional bodies to work within the standards which apply in their jurisdiction. Standard setting is a dynamic international process which involves most countries. The IASC is responsible for the development of the accountancy standards from which most national standards evolve (Figure 1). The function of the valuation standard is to guide members in sound practice in a manner which will ensure compliance within the financial reporting regulatory background. It is the valuation standard setters' role to debate technical and conceptual issues, both within the valuation industry and more widely within the financial industry. At this point, we have an international financial accounting standard, which, if adopted by our member countries, our valuers could not comply with if they applied the current international valuation standard. Figure 1.
3.0 Amendments to IAS 16 IAS 16 has been changed in the following way and the new wording with amendments is shown. Key: deletion to standard; addition to standard Conference papers: Reporting standards Benchmark treatment 28 29 Subsequent to initial recognition as an asset, an item of property, plant and equipment should be carried at its cost less any accumulated depreciation and any accumulated impairment losses, subject to the requirement in paragraph 56 to write an asset down to its recoverable amount. 215 Allowed alternative treatment 29 30 Subsequent to initial recognition as an asset, an item of property, plant and equipment should be carried at a revalued amount, being its fair value at the date of revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Revaluations should be made with sufficient regularity such that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date. Revaluations 30 31 The fair value of land and buildings is usually its market value for existing use which presupposes continued use of the asset in the same or a similar business. This value is determined by appraisal normally undertaken by professionally qualified valuers. 33 In determining fair value, an item of property, plant and equipment is valued on the basis of its existing use. However, an asset for which a change in use is probable is valued on the same basis as other similar assets held for the same intended use. For example, it is inappropriate to value a factory and the equipment within it at their value in use, while valuing the factory site at the open market value of the land for redevelopment as a shopping centre. MVEU has been removed from international accounting standards and the principle is under international review. 4.0 Market value existing use What is market value for the existing use? And, why have the standard setters removed it from IAS 16? How does it differ from market value? This term is defined as: The Market Value of an asset based on continuation of its existing use, assuming the asset could be sold in the open market for its existing use, and otherwise in keeping with the Market Value definition regardless of whether or not the existing use represents the highest and best use of the asset[1].
JPIF 216 Existing use principle The normal market valuation principle does not apply to valuations for financial reporting as the highest and best use principle is put aside. The IVSC standards set the existing use valuation policy as follows: IVSC 3-7 4.1 Generally, the need for asset valuations conducted in conjunction with the preparation of financial statements and related accounts implicitly requires that owner-occupied assets be valued in accordance with their existing use and in consideration of the enterprise continuing in operation. If they are declared by the directors as surplus to the needs of the enterprise, such assets would be valued at their highest and best use rather than under the existing use concept. Similarly, assets owned by the enterprise ordinarily classified as investments are valued at their highest and best use rather than for their existing use[2]. The directors, in undertaking a valuation for financial reporting, are required to categorise property. Surplus and investment property is to be valued at market value, while owner occupied (continuing use) property is to be valued at MVEU. The valuer may assist in this process. 4.4 The rationale for distinguishing existing use assets from other assets in the valuation process is that a business cannot, as a practical matter, sell assets which are necessary to its operation and still be productive. The sale of such assets would be inconsistent with continuation of the business. By contrast, estimating the Market Value of existing use assets correctly represents the market-based contribution of those assets and is consistent with Market Value methods applied in valuing other assets. Financial reporting relates to all of the assets of an entity, not one or two in isolation. 4.5 Continuation of the business is fundamental to accountancy and to the valuation presumption that the particular enterprise will continue in operation for the foreseeable future... 6.1.4... Existing use contemplates continued use of the asset for its same application as of the date of valuation having regard to the asset's capacity to continue contributing to the value of the enterprise, but not considering alternative, more probable uses, if sold. MVEU allows an assessment of value for financial reporting purposes at less than the market value vacant for an alternative use. There is debate about the market value for the existing use above market value, although it is generally considered that the value reasonably closely approximates the market value as if occupied by the entity subject to normal leasing criteria. The graph in Figure 2 diagrammatically shows the movement of value over time in real terms. 5.0 Fair value Fair value is defined as:... the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction. In removing market value for the existing use, Sir Brian Carsberg, Secretary General of the International Accounting Standards Committee, commented:
Conference papers: Reporting standards 217 MV Market Value (Alternative Use) RC Replacement Cost (Modern Equivalent Asset) MVEU Key Assumptions: 1. A Market exists for the current use. 2. The reporting entity holds the property for its own use. 3. It is not an investment property. 4. The enterprise will continue to operate the property in its existing use. 5. The highest and best use concept is set aside. 6. MVEU is subject to the recoverable amount test. Figure 2. MVEU graph In developing its proposal for revising IAS 22, the Board came to the conclusion that references to existing or expected use were inconsistent with the definition of Fair Value, and should not override that definition. The defined concept of Fair Value refers to a transaction price. In an efficient market, transaction prices cannot necessarily be said to reflect purely existing use or purely an alternative use because different market participants may well take different views. The interrelationship between IAS 22 (Business Combinations) and IAS 16 is considered to be critical by the IASC board. IAS 22 provides direction for establishing an entity's opening book values. IAS 16 provides direction on revaluation. This is an area of ongoing discussion. The consequence of the change promotes fair value, but: Does fair value equate market value subject to the entity's occupancy? I presume it does when greater than market value alternative use, as this is a rational market decision, but the standards are now unclear (Figure 3). 6.0 Specialised assets How does all this relate to specialised assets? Once a valuer has determined an asset fits into the ``specialised asset'' category then the methodology is contained within the IVSC standards. They require a depreciated replacement cost approach where there is no market.
JPIF 218 Fair Value Assumptions: 1. Assume owner occupancy status. 2. Definable Highest & Best Use. Figure 3. Fair value graph 3. Synonymous with Market Value (less disposal costs) in all other respects. 4. Balance sheet Impairment Test when above NMV alternative use. Depreciated replacement cost (DRC) DRC is a method of valuation which is based on an estimate of the current Market Value of land for its existing use plus the current gross replacement (or reproduction) costs of improvements less allowances for physical deterioration and all relevant forms of obsolescence and optimisation. The result, which is non-market Value, is referred to as the Depreciated Replacement Cost estimate. This result is subject to the adequate potential profitability or service potential of the entity[5]. This estimate is sometimes referred to as optimised depreciated replacement cost (ODRC). The key phrases are:... market value of land for its existing use. Gross replacement cost, less deterioration, obsolescence, and all forms of optimisation. Subject to adequate potential profitability or service potential... There are two issues which arise from this, one being the basis of land value, which international standards direct should be at MVEU, and second, the assumption that the existing use has a special value which is able to be recognised by the cost of asset, which is seemingly inconsistent with the fact that all assets must be recognised at fair value (meaning, of course, market value in this instance). The DRC assessment is merely a surrogate figure produced in the absence of an identifiable market. It does not purport to be a value. To achieve more accurate means of determining the figure is a challenge to our profession.
IAS 16 There is no guidance within IAS 16 (1998) as to the valuation of specialised property, where there is no market, although there is a paragraph which refers to plant and equipment: The Fair Value of items of plant and equipment is usually their market value determined by appraisal. When there is no evidence of Market Value because of the specialised nature of the plant and equipment and because these items are rarely sold, except as a part of a continuing business, they are valued at their depreciated replacement cost. On Figure 4 the DRC line shows the movement of value over time from new to below net market value. 7.0 Depreciation The extent to which an asset is used, or expired, is referred to as depreciation. Market depreciation vs physical depreciation Market depreciation is the reduction in rent and/or the increase in investor risk (capitalisation rate) as the asset progresses through its economic life. Although the value of improvements decreases in real terms, the land value usually follows the surrounding land value trends. Physical depreciation is unrelated to market trends and may be faster or slower than the above example. There are two perspectives to depreciation: (1) The amount of the asset used: i.e. what has been consumed. (2) The service potential remaining to the asset: i.e. what use is left to be consumed. Conference papers: Reporting standards 219 Depreciated Replacement Cost Basis 1. Apply where no market exists. 2. Calculate according to existing use fully optimised. 3. Land value is at MVEU. 4. Subject to adequate profitability or trading potential. Balance sheet impairment test. Figure 4. DRC graph
JPIF 220 Accounting for depreciation IAS 16, Para 41 41 The depreciable amount of an item of property, plant and equipment should be allocated on a systematic basis over its useful life. The depreciation method used should reflect the pattern in which the asset's economic benefits are consumed by the enterprise. The depreciation charge for each period should be recognised as an expense unless it is included in the carrying amount of another asset. Depreciation in the accounting sense is the using up of an asset. All the ``costs'' associated with the purchase, installation and ultimately the removal on sale of the asset are required to be allocated to the enterprise. There are two issues: (1) Accounting for the asset's consumption. The asset's consumption is not necessarily either a function of the market or related to cost, as it is entity specific. (2) Accurately recording the entity's asset values. The benchmark check for impairment is value in use which is also a non-market concept. The test does not challenge asset values, which may be understated. 8.0 IAS 36 Impairment of assets Recoverable amount This standard applies to all balance sheet assets whether carried at cost, or at the revalued amount (fair value) under the International Accounting Standards. Recoverable amount is the higher of an asset's net selling price and its value in use... WHERE Value in use is the present value of estimated cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life... AND Net selling price is the amount obtainable from the sale of an asset in an arms length transaction between knowledgeable, willing parties, less the costs of disposal[7]. The recoverable amount ``test'' is applied if there is any indication of impairment to the carrying amount to ensure that the fair value disclosed in the accounts does not exceed the likely cash inflows from the asset. The standard requires that enterprise assess the position at each balance sheet date[8]. IAS 36 has numerous references to fair value, where it is defined as something other than market value. This inconsistency is confusing and has led to confusion within the industry. It is especially so within Appendix B, where at B 28 under the example, fair value is to reported at something other than market value. In assessing market value for the existing use, the valuer is not required to apply the recoverable amount test. The ``impairment test'' is entity specific, and is applied to the revalued amount when the values are transferred to the balance sheet. The valuer reports, in effect, the ``revalued amount'', and if the directors are satisfied the revalued amount is less than the recoverable amount then the MVEU figure is adopted as the ``fair value''. Where the directors suspect that an asset is impaired then assessment of the value in use and the net selling price is required.
Value in use The value in use is an entity specific, non-market assessment which ensures the value and/or service potential of an asset is recoverable by the entity over the life of the asset (Figure 5). If the asset value (carrying amount) is at net selling price (NSP) or below the asset value is accepted. The current practice of capitalising rentals for owner occupied premises as the primary basis of valuation may provide the directors of an entity with information necessary to complete the value in use assessment. Valuers may also need to consider the allocation of cash flows to ``specialised'' assets, which are currently assessed at DRC. Why not vacant possession? Value in use takes into account all costs of occupancy and the ultimate disposal of the asset. It assumes continued occupancy and to assume vacant possession when assessing MVEU is to understate the asset, so long as the figure is less than the recoverable amount. Conference papers: Reporting standards 221 1. Directors apply the balance sheet impairment test. 2. Estimating Value in use involves: (a) estimating the future cash inflows and outflows to be derived from the continuing use of the asset and from its ultimate disposal; and (b) applying the appropriate discount rate to these future cash flows. 3. The cashflows are entity specific. 4. The discount rate is a pre-tax market related rate. Figure 5. Recoverable amount graph
JPIF 222 9.0 Conclusion First, in the tangled web of standards it is very easy become confused by detail and the words. Within the original IAS 16, the value reported in effect was the lower of MVEU and the recoverable amount, where the recoverable amount was the amount which the enterprise expects to recover from the future use of an asset, including its residual value on disposal. The current position is that the value reported is the lower of the fair value and the recoverable amount, where the recoverable amount is the higher of an asset's net selling price and its value in use. The move from market value for the existing use to fair value is critical. It is assumed that net selling price and fair value are synonymous and as such cannot be below what we know as net realisable value. Second, there is no guidance or direction to assess any value above the net selling price, whether it be on a depreciated replacement cost basis or some other basis. From a valuation perspective, net selling price is a simple concept when viewed on a vacant possession or alternative use basis. However, it does not provide the reporting entity with any information about the asset which it holds and does not provide a basis for the logical depreciation of the asset as its service potential is consumed. IAS 16 has no reference to depreciated replacement post which is widely accepted as being the basis of value for specialised assets. The land value at market value for the existing use is more difficult to determine and is frequently assessed on a pure market value basis. In order to assess the value in use the valuers may be asked to assign revenues to assets, based on their replacement cost. Greater clarification is required for valuation of assets that have considerable remaining service potential. In theory, valuers should be able to assess a depreciated replacement cost value which is consistent with MVEU where a market exists. If fair value as contained in the revised IAS 16 means this, then we will be able to move forward. Third, the accounting standards and standard setters send a confused message to valuers regarding the importance of value to an entity. MVEU is not entity specific, but is industry specific, being a concept which requires the so-called average efficient operator test to applied in terms of the assets employed. What would the market pay for this asset within this industry group, with this service potential? It is not necessarily what that asset is worth to the entity which is a value-in-use concept. The recoverable amount test, however, is a combination of entity and industry. It asks of the entity: can you financially justify the performance of this asset within your current production line? If yes, adopt value in use. If no, then the rational decision is sell; that is, net selling price. When an asset is viewed from an industry perspective, if its service potential can be obtained from a cheaper location, then the industry should relocate to the cheaper location. Is this what the change in IAS 16 signals? (Table I). Boorman highlights uncertainty as a cardinal sin and international standards as a critical factor in the global economy, that better information is the key to avoiding crisis.
Asset charges Market check Value in use check (cost of an asset) Depreciation charge Rental Revaluation basis Mode Asset recorded Basis Lease from third party Cost of adoption Cost N/A Yes Tenant fitout Purchase Land MV MVEU None Buildings (capitalised rent) Yes Yes Yes Fitout Yes Design/built and leaseback ± ± None Yes Desing/build market Land Cost MVEU None Yes Yes Buildings Cost MVEU Yes Fitout Cost MVEU/none Yes Design/build no market Land Cost MVEU None No Yes Buildings Cost DRC Yes Fitout Cost Yes Conference papers: Reporting standards 223 Table I. Alternative methods of obtaining use of assets required by an entity
JPIF 224 Notes 1. IVSC Standards 1997, IVS 3-6. 2. International Valuation Standards: Principles, Standards and Applications and Performance Guidance, International Valuation Standards Committee, 1997, IVS 3-7. 3. International Valuation Standards: Principles, Standards and Applications and Performance Guidance, International Valuation Standards Committee, 1997, IVS 3-7. 4. IAS 16 (1998) Definitions. 5. IVSC Valuation Standards 1997 Revision, IVS 2-6. 6. IAS 16 Para 31, ``Revaluations''. 7. IAS 36, June 1998, Section 5, Definitions. 8. IAS 36, June 1998, Paragraph 8.