While the near-term use of International Financial Regulatory Standards (IFRS) in the US by domestic public companies will not be required, IFRS is highly relevant to many US businesses in 2013.
Companies are and will be affected by IFRS at varying times and degrees of magnitude, driven by factors such as size, industry, geography, M&A activity, and global expansion. Despite an unclear SEC adoption timeline, the impact of accounting changes will be significant and will have broad based implications.
As it relates to the fundamental carrying basis of nonfinancial assets, such as commercial real estate/investment property, US Generally Accepted Accounting Principals (GAAP) generally utilizes historical cost and prohibits revaluations except for certain categories of financial instruments, which are carried at fair value. IFRS however, permits the revaluation to “fair value” of some intangible assets, including property, plant, equipment and investment property. When fair value is applied, the gain or loss arising from a change in the fair value is recognized in the income statement. The carrying amount is not depreciated. The election to account for investment property at fair value may also be applied to leased property.
This means Commercial Real Estate balance sheet values can go up or down and thus both income and asset reporting under IFRS may be more variable. This can affect companies in several significant ways:
- Mergers and Acquisitions may be significantly impacted by comparing the book value of commercial real estate assets vs. a “Fair Value Measurement” of the commercial real estate. Additionally, in some market cycles, appreciating assets for some businesses may be more interesting/attractive than their cash flow.
- The effective tax rate of a corporation may be significantly impacted. For example, in adopting IFRS “Fair Value Measurement” of commercial real estate, a company or a subsidiary might find that its debt-equity levels are affected, thereby limiting, or increasing, the amount of interest that may be deductible in a jurisdiction, with a related impact on the company’s effective tax rate.
- Reporting will be affected since depending upon whether a subsidiary follows IFRS or GAAP, there will be new balance sheet and effective tax rate strategies to be evaluated at the subsidiary and parent level.
Since the biggest impact related to Commercial Real Estate is the “Fair Value Measurement” issue, the rest of this document describes how IFRS 13, Fair Value Measurement applies to IFRS reports that require or permit fair value measurements or disclosures.
IFRS 13 was originally issued in May 2011 and applies to annual periods beginning on or after 1 January 2013.
Fair Value Measurement Overview
IFRS defines fair value on the basis of an ‘exit price’ notion and uses a ‘fair value hierarchy’, which results in a market-based, rather than entity-specific, measurement. The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. IFRS 13 provides the guidance on the measurement of fair value, including the following:
- An entity takes into account the characteristics of the asset or liability being measured that a market participant would take into account when pricing the asset or liability at measurement date (e.g. the condition and location of the asset and any restrictions on the sale and use of the asset) [IFRS 13:11]
- Fair value measurement assumes an orderly transaction between market participants at the measurement date under current market conditions [IFRS 13:15]
- Fair value measurement assumes a transaction taking place in the principal market for the asset or liability, or in the absence of a principal market, the most advantageous market for the asset or liability [IFRS 13:24]
- A fair value measurement of a non-financial asset takes into account its highest and best use [IFRS 13:27]
- A fair value measurement of a financial or non-financial liability or an entity’s own equity instruments assumes it is transferred to a market participant at the measurement date, without settlement, extinguishment, or cancellation at the measurement date [IFRS 13:34]
- The fair value of a liability reflects non-performance risk (the risk the entity will not fulfill an obligation), including an entity’s own credit risk and assuming the same non-performance risk before and after the transfer of the liability [IFRS 13:42]
The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants and the measurement date under current market conditions. Three widely used, and acceptable valuation techniques for commercial real estate are:
- market approach – uses prices and other relevant information generated by market transactions involving identical or comparable (similar) assets, liabilities, or a group of assets and liabilities (e.g. a business)
- income approach – converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts.
- cost approach – reflects the amount that would be required currently to replace the service capacity of an asset (current replacement cost)
IFRS 13 requires an entity to disclose the valuation techniques and inputs used to develop those measurements along with the fair value measurement at the end of the reporting period. Quantitative disclosures are required to be presented in a tabular format unless another format is more appropriate. [IFRS 13:99]
Implementation of IFRS makes regular “Fair Value Measurement” of commercial real estate asset far more important than was the case under GAAP reporting. Companies with significant real estate portfolios should be sourcing professional valuation vendors as soon as possible for the 2013 reporting period.