FV Measurements IFRS 13 for Real Estate Industry (PwC 2011)

A practical guide to IFRS – Fair value measurement 1

Practical guide to IFRS Fair value measurement: implications of IFRS 13 for the real estate industry

At a glanceThe International Accounting Standards Board (IASB) issued IFRS 13, ‘Fair value measurement’, in May 2011 as a common framework on how to measure the fair value when its determination is required or permitted by another IFRS. The new framework defines fair value and provides a single source of guidance for measuring fair value. It also eliminates various – and sometimes differing – provisions in the existing frameworks and requires additional disclosures about fair value measurements.

IFRS 13 defines the fair value of an asset as an ‘exit price’, hence “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.

The effect of IFRS 13 on different industries may vary. This publication focuses on the implications for the real estate industry. IFRS 13 predominantly brings into a single standard the fair value concepts that were in other standards, but it also clarifies various requirements with regard to the appropriate measurement and disclosure of the fair value and its underlying inputs − for example:• Fornon-financialassets,‘highestand

best use’ is the use to be assumed by market participants that maximises the value of an asset.

• Thefairvaluemeasurementassumesthat the hypothetical sale of the asset – or ‘exit transaction’ – takes place in the ‘principal market’ with the greatest volume and highest level of activity for the asset or liability. Alternatively, in the absence of such a principal market, the transaction should take place

in the ‘most advantageous market’; management will therefore need to identify the relevant market.

• Disclosurerequirementshavebeensignificantly expanded to provide users of financial statements with detailed quantitative and qualitative information about assumptions made and processes used when measuring the fair value.

• Thethree-levelfairvaluehierarchyprioritises the inputs to be used in determining the fair value using certain valuation techniques.

For real estate entities, the new standard may result in the requirement to redefine processes and procedures; it will especially impact the following areas:• Investment property carried at fair value:

how investment properties are measured and the requirement for additional disclosures;

• Investment properties carried at amortised cost: how to determine fair value less costs to sell for IAS 36, ‘Impairment ofassets’,andIFRS5,‘Non-currentassets held for sale and discontinued operations’, and fair value for disclosure under IAS 40, ‘Investment property’;

• Fair value for property, plant and equipment: how to measure fair value under the revaluation model according to IAS 16, ‘Property, plant and equipment’;

• Fair value in a business combination: how to estimate fair value in a business combination according to IFRS 3, ‘Business combinations’.

IFRS 13 applies prospectively for annual periods beginning on or after 1 January 2013; earlier application is permitted.

September 2011

ContentsAt a glance 1

Background: 2 the need for new guidance

How does 2 IFRS 13 affect the real estate industry?

Definition of 2fair value

Fair value 3 hierarchy

Valuation 4 techniques

Valuation 5 premise

Highest and 6 best use

Disclosure 8 requirements

Outlook 9

pwc.com/ifrs

2 A practical guide to IFRS – Fair value measurement

Background: the need for new guidance

The IASB issued IFRS 13, ‘Fair value measurement’, on 12 May 2011. This new IFRS has been developed as a joint project with the FASB, which at the same time published an update to Topic 820 in the FASB’s Accounting

Standards Codification® (formerly referred to as SFAS 157).

The new standard has been developed since September 2005. The key milestones of the project are shown below..

Up until now, definitions and guidance on measuring fair value have been dispersed across many IFRSs and have not always been consistent. Existing guidance is not always able to provide a clear measurement objective or a robust measurement framework. The new standard is intended to establish a single source of guidance and codification for all fair value measurements. The Boards also intended to achieve international harmonisation of fair value measurements and corresponding disclosure requirements; a further important step towards convergence between IFRS and US GAAP.

The Boards have seen the need for enhanced disclosures on fair value measurements in response to the latest financial crisis. So in order to improve and align fair value measurement and disclosure requirements, the Boards decided to establish a single source of guidance for all fair value measurements.

IFRS 13 does not say when to use fair value as the measurement basis, nor does it extend the scope of fair value measurements. It only provides guidance on how the concept of fair value should be applied where its use is already required or permitted by other standards

Fair value measurement project milestones

IASB added project to agenda September 2005

Discussion paper November 2006

Exposure draft, ‘Fair value measurement’, May 2009

Exposure draft, ‘Measurement uncertainty analysis

disclosure for fair value measurements’, June 2010

‘Fair value measurement IFRS 13’, published May 2011

Effective date: January 2013

(earlier application permitted)

How does IFRS 13 affect the real estate industry?

Definition of fair value

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 the measurement date”. [IFRS 13 paragraph 9]

The definition is similar to the former fair value definition (for example, importance of an orderly transaction – that is, not values derived from distressed sales), but there is the notion of an exit price to be considered in the new definition. The IASB intends to clarify with the new definition that fair

valueisamarket-basedmeasurement,notanentity-specificmeasurement,andthatfairvalue reflects current market conditions. In the Board’s view, both definitions articulate ‘essentially the same concepts’.

From a real estate industry perspective, in most cases there won’t be substantial change in the estimation of fair value due to the amended definition, as the exit price will often be equal or almost equal to the ‘exchange value’. In the current standard, the estimation of the relevant price should always be based on a market participant’s view.


Under IFRS 13, a fair value measurement takes into account the characteristics of the asset. Applying this to real estate, those characteristics could be – as in the current IAS 40 – the condition and location of the asset and restrictions on its use.

Theconceptoffairvalueasamarket-based estimation remains unchanged; management should be aware of this when referring to appraisals that are based on other sources of guidance that use different definitions of fair value.1

Fair value hierarchy

One of the major changes in IFRS 13 compared to IAS 40 is the change in the fair value hierarchy. IAS 40 defines a fair value hierarchy based on valuation techniques; IFRS 13 uses a different approach.

In IFRS 13, fair value measurements are categorisedintoathree-levelhierarchybased on the type of inputs and no longer based on the valuation method. The new hierarchy is defined as follows:

(1) Level 1 inputs are unadjusted quoted prices in active markets for items

identical to the asset being measured. Consistent with existing guidance, if there is a quoted price in an active market (that is, a Level 1 input), an entity uses that price without adjustment when measuring fair value;

(2) Level 2 inputs are inputs other than quoted prices in active markets included within Level 1 that are directly or indirectly observable; and

(3) Level 3 inputs are unobservable inputs that are usually determined based on management’s assumptions. However, Level 3 inputs have to reflect the assumptions that market participants would use when determining an appropriate price for the asset.

The entity is not free to choose which level of inputs to use: “An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs.” [IFRS 13.61]

1 The IVSC is currently reviewing the valuation standards to develop the new IVS. IFRS 13 might be taken into account in the due process of the new IVS guidance.

Fair value hierarchy

IFRS 13 allows the application of the following valuation techniques: market approach, income approach or cost approach.

Fair value measurement project milestones

Level 1 inputs• Quoted prices (unadjusted) for identical assets in an active market

Level 2 inputs• Quoted prices for similar assets or liabilities in active markets• Quoted prices for identical or similar assets or liabilities in

markets that are not active• Inputs other than quoted prices that are observable for the asset

or liability (for example, market observable interest rates)• Inputs that are derived principally from or corroborated by

observable market data by correlation or other means

Level 3 inputs• Unobservable inputs

In some cases the inputs used to measure fair value may be categorised within different levels of the fair value hierarchy. In such instances, the fair value measurement

is categorised in its entirety based on the lowest level input that is significant to the measurement.


Fair value measurement – valuation inputs

Input level Input (example)

2 • Sale prices per sqm for similar properties in similar locations

• Observable market rent per sqm for similar flats

• Property yields derived from latest transactions

3 • Yields based on the management estimation

• Significant yield adjustments based on management’s assumptions about uncertainty/risk

• Assumptions about future development of parameters (for example, vacancy, rent) that are not derived from the market

• Cash flow forecast using the entity’s own data

Duetothenatureofrealestateassets−which are often unique and not traded on a regular basis − and the subsequent lack of observable input data for identical assets, fair value measurements of real estate will be categorised as Level 2 or Level 3 valuations. All observable market data (that is, transaction prices) are given

a higher priority and should be preferred over unobservable inputs, even if the market is inactive and transactions of comparable assets are rare.

The table below gives examples of inputs to real estate valuations and their typical categorisation in the fair value hierarchy.

Management should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. The use of unobservable inputs is a complex and judgmental area where IFRS 13 provides certain guidance: “An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. In developing unobservable inputs, an entity may begin with its own data, but it shall adjust those data if reasonably available information indicates that other market participants would use different data or there is something particular to the entity that is not available to other market participants (eg an entity-specific synergy). An entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, an entity shall take into account all information about market participant assumptions that is reasonably available. Unobservable inputs developed in the manner described above are considered market participant assumptions and meet the objective of a fair value measurement.” [IFRS 13.89]

Unobservable inputs should therefore still be adjusted for market participant assumptions, but the information gathered to determine market participant assumptions should be limited to the extent that is reasonably available.

Valuation techniques

In contrast to the fair value hierarchy in IAS 40 and IAS 16, IFRS 13 does not prefer a specific valuation technique. The fair value hierarchy in existing IFRS guidance prioritised the application of a market approach (or a comparable sales method) over the income approach (that is, a valuation technique based on discounted cash flows) and – for the valuation of property plant and equipment – the cost approach. However, the fair value hierarchy in IFRS 13 is based on valuation inputs by maximising the use of relevant observable inputs and minimising the use of unobservable inputs rather than the valuation techniques themselves.

According to IFRS 13, there are generally three approaches that can be used to derive fair value: the market approach, the income approach and the cost approach. To measure fair value, management should use valuation techniques consistent with one or more of these approaches. It should use valuation techniques that are appropriate in the circumstances and for which sufficient data is available, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. Valuation techniques should be applied consistently. However, ‘a change in the valuation technique or its application’ can be


appropriate if the result is ‘equally or more representative of fair value’.

IFRS 13 does not exclude the application of a cost approach in the fair value measurement of investment property under IAS 40. Nevertheless, the practical impact of this change will be limited, as IFRS 13 requires an entity to choose those valuation techniques that are appropriate to the specific circumstances and maximises the use of observable inputs. As market participants would usually estimate the price of an investment property based on their expectations about future income, an income approach or a market approach will often be more suitable to measure fair value in this case. A market or income approach will therefore usually be more appropriate in these circumstances, even if the application of a cost approach is permitted and possible due to the availability of sufficient data. The challenge in using the cost approach is to consider whether or not an adjustment to the actual building costs (for example, change in materials, change in floor usage, etc.) is necessary. The valuation has to be based on the specifications that are considered necessary to reflect the market participants highest and best use of the property. As a result, specifications that include no added value to the market participants are not considered in the valuation.

IFRS 13 encourages an entity to apply multiple valuation techniques (market approach, income approach and cost approach), if appropriate. In this case, the results (that is, the respective indications of fair value) should be evaluated considering the reasonableness of the range of values indicated by those results.

The fair value measurement is the point within that range that is most representative of fair value in the circumstances.

This approach obviously requires significant judgement, and the results of the multiple valuation techniques should be evaluated carefully.

Valuation premise: principal market and unit of account

IFRS 13 requires management to identify the relevant market in which a typical transaction of the asset would take place. A fair value measurement assumes that the transaction to sell an asset takes place in the principal market for the asset or, in the absence of a principal market, in the most advantageous market for the asset. The principal market is the market with the greatest volume and level of activity for the asset or liability that can be accessed by the entity.

In the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market or, in the absence of a principal market, the most advantageous market. However, management does not need to continuously monitor different markets to identify the most advantageous market at the measurement date.

The identification of the principal market requires first the identification of the unit of account, which is subject to transactions in this market. IFRS 13 refers to the unit of account as it is defined by the respective IFRS that requires or permits fair value measurement:

Fair value measurement – unit of account

Unit of account for investment properties is defined according to IAS 40

“Whether the asset or liability is a stand-alone asset or liability, a group of assets, a group of liabilities or a group of assets and liabilities for recognition or disclosure purpose depends on its unit of account. The Unit of account for the asset or liability shall be determined in accordance with the IFRS that requires or permits the fair value measurement, except as provided in this IFRS.” [IFRS 13.14]

The principal market for the asset – sold onitsownattheunit-of-accountlevel–should in most cases be determinable by knowledgeable market participants. IFRS 13 states that “the fair value of a non-financial asset assumes that the asset is sold

consistently with the unit of account specified in other IFRSs (which may be an individual asset)”. According to IAS 40.5 “investment property is property (land or building – or part of a building or both) held (by the owner or by a lessee under a finance lease) to earn


rentals or for capital appreciation or both”. The unit of account – the single property (for example, land and building) – is the relevant level to measure an investment property at fair value according to IAS 40 and IFRS 13.

However, the valuation principles in IFRS 13 have implications that management should take in to account. The standard discusses some valuation principles to be applied when considering how to determinefairvalueofanon-financial asset used in combination with other assets as a group. The fair value might be the same whethertheassetisusedonastand-alonebasis or in combination with other assets. This conclusion is based on the assumption that the use of the assets as a group in an ongoing business would generate synergies that would be available to market participants. As a result, market participants would judge the synergies onastand-alonebasisaswellasinanasset group on the same basis. However, for real estate assets, the valuation of the investment property is generally on a stand-alonebasis.

Only in rare circumstances “the entity might measure the asset at an amount that approximates its fair value when allocating the fair value of the asset group to the individual assets of the group” [IFRS 13.B3]

lit. e]. There may be the following rule/exception ratio for the real estate industry: • valuationonastand-alonebasis,

considering synergies only to the extent they are available to typical market participants; and

• onlyinlimitedsituations(exception),allocating the fair value of the asset group to the individual asset (considering the unit of account).

Highest and best use

IFRS 13 defines the concept of highest and best use. The absence of a definition of this concept in existing guidance on fair value accounting has given rise to varying interpretations in the past. This is especially true for real estate valuations, as land values depend significantly on the assumptions about the land’s (potential) use.

According to IFRS 13 paragraph 27, a fair valuemeasurementofanon-financialassettakes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use. The ‘highest and best use’ takes into account the use of the asset that is physically possible, legally permissible and financially feasible.

Fair value measurement

Physically possible Legally permissible

Takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (for example, the location or size of a property).

A fair value measurement of a non-financial asset takes into account a market perticipant’s ability to generate economic benefits by using the assets in its highest and best use or by selling it to another market perticipant that would use the asset in its highest and best use.

Financialy feasible

Takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (for example, the zoning regulations applicable to a property).

Takes into account whether a use of the asset generates adequate income or cash flows (taking into consideration the costs of converting the asset to that use) to produce an investment return that market participants would require from an imvestment in that asset put to that use.


Highest and best use’ is determined from the perspective of market participants. IFRS 13 includes some guidance on how to understand the highest and best use concept on real estate, which is shown below.

Example

A piece of land being developed for industrial use as a site for a factory could be developedasasiteforhigh-riseapartmentbuildings if there is a future change in legislation − for example, a new zoning. How should management estimate the highest and best use?

According to IFRS 13 BC 69: “a fair value measurement can assume a different zoning if market participants would do so (incorporating the cost to convert the asset and obtain that different zoning permission, including the risk that such permission would not be granted).” In this case, there would need to be appropriate supporting evidencethatthepotentialre-zoningwouldbe considered by market participants when determining the fair value. Furthermore, the use of the asset must be physically possible and financially feasible.

However,anentity’scurrentuseofanon-financial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximise the value of the asset.

In cases where the current use differs from the highest and best use, IFRS 13 requires management to estimate a fair value based on the hypothetical exit price assuming the asset’s highest and best use by market participants. This issue will arise from time to time in the real estate industry, as the way an entity uses land sometimes differs from the use of surrounding land.

According to IFRS 13, when determining thehighestandbestuseofanon-financialasset, management should take into account two possibilities: the highest and best use

of the asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, a business).

If the highest and best use of the asset is to use the asset in combination with other assets or with other assets and liabilities, the fair value of the asset is the price that would be received in a current transaction to sell the asset, assuming that the asset would be used with other assets or with other assets and liabilities and that those assets and liabilities (that is, its complementary assets and the associated liabilities) would be available to market participants.

However, the fair value measurement of a non-financialassetassumesthattheassetis sold consistently with the unit of account specified in other IFRSs (which may be an individual asset). This is the case even when the fair value measurement assumes that the highest and best use of the asset is to use it in combination with other assets or with other assets and liabilities.

The estimation of the exit price is not based on a transaction including the complementary asset and liabilities; it assumes that the market participant already holds the complementary assets and the associated liabilities.

To illustrate this, take a look at the following example: An undeveloped plot of land – without street access – has to be valued. In front of the plot there are industrial sites with street access. There are three companies located next to the undeveloped plot, which are strongly in need of additional storage space. For those three market participants, the undeveloped plot – although hinterland – is very valuable, whereas for all others it is all but worthless. Following the definition in IFRS 13, the value of the plot would be the exit price that one of the industrial companies would be willing to pay.


Disclosure requirements

The Board has included significantly enhanced disclosure requirements into the new standard, in order to provide users of financial statements with better information about the measurement uncertainty inherent in fair value measurements and to strengthen market participants’ confidence in fair value measurements after the latest financial crisis. The required disclosures include: • informationaboutassetsmeasuredatfair

value that are used in a way that differs from their highest and best use;

• informationaboutthehierarchylevelintowhich fair value measurements fall;

• transfersbetweenLevels1,2and3;and

• methodsandinputstothefairvaluemeasurements and changes in valuation techniques.

Fair value measurements categorised within Level 3 of the fair value hierarchy are more subjective than those derived from observable market prices, so IFRS 13 requires additional disclosures for Level 3 measurements. These include a reconciliation of opening and closing balances, quantitative information about unobservable inputs and assumptions used, and a description of the valuation processes in place.

The table below gives an overview of the most important disclosure requirements for non-financialassetsunderIFRS13.

FV Measurement Disclosure requirement

All • Fair value measurement at the end of the reporting period

• Level of the fair value hierarchy

All non-recurring • The reason for the measurement

All recurring • Amounts of transfers between Level 1, 2 and 3

• The entity’s policy for determining when transfers between levels are deemed to have occured

Level 1 • Transfers from and into Level 1

Level 2 • Description of the valuation technique(s) and the inputs used in the fair value measurement

• Changes in valuation techniques and reasons for making those changes

Level 3 • Description of the valuation technique(s) and the inputs used in the fair value measurement

• Changes in valuation techniques and reasons for making those changes

• Quantative information about the significant unobservable inputs used in the fair value measurement if reasonably available

• Description of valuation processes, policies and procedures

• If the highest and best use differs from its current use, an entity should disclose the fact and why the non-financial asset is being used in a manner that differs from its highest and best use

• Narrative description of sensitivity of the fair value measurement to significant changes in unobservable inputs (recurring only)

If there is evidence that users of financial statements need additional information to evaluate the quantitative information disclosed, the entity should disclose additional information necessary to meet this objective.

Duetothelackofactivemarketsforidentical assets, preparers of fair value measurements for real estate often will have to rely on Level 2 or Level 3 inputs; this could result in considerably more work for reporting entities in the real estate industry.


Market value should not change due to a new fair value definition, and the concepts in IFRS 13 are in line with the current practice in general, so the measurement results should be quite similar – in most circumstances – under the new standard as under IAS 40.

Nevertheless, the new valuation premises and the new principles may have an impact on the real estate industry. Real estate entities should consider what kind of (limited) situations will require a redefinition of the rules and procedures to fulfil the regulations of the new fair value measurement standard. At the same time, all real estate entities will face with a lot

more disclosure requirements as a result of the new regulations. Management may need to reconsider some of the valuation procedures in place to minimise the impact as far as possible.

Regarding the valuation principles and the valuations under IFRS 13, there may be a new challenge for management to make judgments and to explain their decisions and their resulting influence on thevaluationresults.Duringthenextfewmonths, management, valuation experts and auditors will become familiar with the IFRS 13 and will face new questions, especially when presented with scenarios to be considered in future valuations.

Outlook


Contacts

Australia IFRS specialist: JamesDunning [email protected] Valuation specialist: Peter Power [email protected]

Austria Valuation specialist: Wolfgang Vejdovsky [email protected]

Belgium IFRS specialist: Ann Smolders [email protected] Valuation specialist: Jean-PaulDucarme [email protected]

Bulgaria Valuation specialist: Vanya Assenova [email protected]

Canada IFRS specialist: Frank Magliocco [email protected] Valuation specialist: Michael Chung [email protected]

Channel Islands IFRS specialist: Karl Hairon [email protected]

China Valuation specialist: Nova Chan [email protected]

Cyprus & Global ACS Leader IFRS specialist: Tasos Nolas [email protected]

Czech Republic Valuation specialist: Jan Hadrava [email protected]

Denmark IFRS specialist: Henrik Steffensen [email protected]

France IFRS specialist: DanielFesson [email protected] Valuation specialist: Geoffroy Schmitt [email protected]

Germany IFRS specialists: AnitaDietrich [email protected] DanielRanker [email protected] Valuation specialist: DirkHennig [email protected]

Hong Kong IFRS specialist: Alan Ho [email protected] Valuation specialist: Christopher Chan [email protected]

Hungary Valuation specialist: Nora Sarlos [email protected]

Italy IFRS specialist: Elisabetta Caldirola [email protected] Valuation specialist: Margherita Biancheri [email protected]

Japan IFRS specialist: Takeshi Shimizu [email protected] Steve Sloman [email protected]

Luxembourg IFRS specialist: Kees Hage [email protected] Kenneth Iek [email protected] Valuation specialist: Philipp Koch [email protected]

Norway IFRS specialist: Ola Anfinsen [email protected]

Poland IFRS specialist: MalgorzataSzymanek-Wilk [email protected] Valuation specialist: GrazynaWiejak-Roy [email protected]

Portugal Valuation specialist: Teresa Santos [email protected]

Romania Valuation specialist: Razvan Penescu [email protected]

Russia Valuation specialist: Mark Hannye [email protected]

Singapore IFRS specialist: Eng Beng Choo [email protected] Valuation specialist: Kok Keong Lie [email protected]

Spain IFRS specialist: Gonzalo Sanjurjo Pose [email protected]

Sweden IFRS specialist: Johan Ericsson [email protected] Valuation specialist: Per-ErikWaller [email protected]

Switzerland IFRS specialist: Markus Schmid [email protected] Valuation specialist: Marie Seiler [email protected]

(continued)


The Netherlands IFRS specialist: Sidney Herwig [email protected] Valuation specialist: Jens Osinga [email protected]

Turkey Valuation specialist: Orhan Cem [email protected]

United Kingdom IFRS specialist: SandraDowling [email protected] Valuation specialist: Nick Croft [email protected]

United States IFRS specialist: Tom Wilkin [email protected] Valuation specialist: DavidSeaman [email protected]

Contacts (continued)

FV Measurements IFRS 13 for Real Estate Industry (PwC 2011)

Documents

Transcript of FV Measurements IFRS 13 for Real Estate Industry (PwC 2011)