Strategy & Operations » Financial Reporting » Fair play: how to report on fair value

The top 10 largest companies in the Fortune Global 500, by annual revenue, report property assets on their balance sheet worth more than $100bn. However, current accounting practice means that the figures being reported may be significantly different to what is achievable should the property be sold.

There is growing pressure and focus on corporates and their auditors to provide greater transparency around their accounts, with shareholders increasingly interrogating firms accounting procedures. For many corporates owned real estate amounts to a large proportion of their balance sheet and significantly impacts their operational business strategy.

Despite this, standard practice is to hold these assets at a figure which does not reflect what they are truly worth therefore misleading investors and restricting their business operations.

Current practice

Accounting guidelines allow companies to account for their owned real estate assets at either fair value or at cost. Occupiers typically account at cost, this may be the price that they either bought or built the property for, this figure is then depreciated down to a residual land value over a period of 30 to 50 years.

This method of accounting ensures that there is no significant variance to the annual accounts caused by swings in property values and is also a more cost-effective approach negating the requirement for annual asset valuations. However, while this method may be appropriate for other items of a balance sheet, where there is a limited usable life and little to no secondary market, real estate does not operate in the same manner.

Real estate funds and real estate investment trusts value their properties annually or more frequently and account for their properties at fair value in accordance with IFRS. Fair value is recognised as being in line with the International Valuation Standards Council and Royal Institute of Chartered Surveyors’ definitions of market value, which estimates the actual price a property would sell for on the market. As a result, funds hold their property on their accounts at a “real value”.

Real estate has an established market, where properties are traded on a regular basis as well as being used as collateral for finance. Real estate prices can move significantly in time and the price that third party purchasers are willing to pay does not relate to the cost of construction.

There are active markets for the majority of real estate assets and therefore property can be valued reflecting what “the market” would be prepared to pay for it. There is an argument therefore that periodic assessments of “fair value” would be a more prudent approach to financial reporting than that of cost. Through a periodic, professional review of assets this risk can be managed and priced, as incorrect reporting of both assets and liabilities clearly does not provide shareholders with a clear picture of a company’s financial health.

Risks

The largest owners of commercial real estate across the world are global corporates. They own a vast number of office, industrial, logistics and retail properties. The value of these properties is in the trillions of dollars, though by accounting for their real estate at cost there is a significant danger that companies are not showing their real value on the balance sheets. The fundamental principle that cost does not equal value is not being considered nor is the volatile nature of the property market.

The real estate market operates in a cyclical manner, values can change distinctly and by not reflecting these, organisations could be at risk of either grossly under or over assessing the worth of their assets. This can be especially true when considering land, land is a finite resource and amendments to planning policy over time can result in drastic fluctuations in value. Cities across the globe have changed dramatically over the years. There are numerous examples of industrial sites owned by manufacturing companies across the Globe which now have higher and better uses, in these instances corporates could be sitting on real estate with values significantly higher than what is being reported.

A considerable number of companies are publicly listed on stock exchanges and traded for and on behalf of institutional and private investors. The decision to invest in these companies is made based on the information corporates provide, particularly their accounts. When the balance sheet does not reflect the true value of real estate by showing a value either higher or lower, there is a danger that investors are being misled and companies are either over or under valued.

The same applies to financial institutions who provide finance to corporate businesses. While they will of course consider a number of elements before making their decision, one element of this is their reported real estate value. It is taken for granted that the audited accounts are accurate but if the real estate is not being considered in line with the market, are they?

Best practice

A small number of corporate occupiers have begun to recognise that their current accounting practice is not providing their shareholders with suitable transparency and as such whilst they hold their real estate on their balance sheet at cost, they also include the fair value of the assets within their financial statements. While this is a step in the right direction, the number of businesses who report in this way are few and far between.

Rules and regulation around accounting practices are set by the IFRS, with transparency being one of their key objectives. This can be seen from IFRS 16 which will require companies to account for their lease liabilities, which will include leased real estate. Nevertheless, there is limited regulation to ensure transparency on the real value of trillions of dollars of real estate.

The practice of cost accounting for real estate hides the true value of a company’s balance sheet, misleads investors and over or undervalues companies. We believe that occupier clients should adopt a regular valuation programme that assesses the value of their freehold estate, to provide stakeholders with the necessary transparency around the true value of their real estate.