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Income Volatility and the Valuation of Investment Property
Cecilia Lambert†
Christopher Lambert†
Abstract
Sustained debate on the appropriateness of adopting fair values for
financial assets has ensued in the wake of the current economic crisis.
Accounting regulators are addressing implementation issues in measuring
financial securities when markets are illiquid. Accounting regulators are now
sanctioning greater use of management assumptions as the basis for fair value,
with mark-to-model valuations replacing mark-to-market valuations. However,
greater the use of unobservable inputs lowers the reliability of the valuations.
This study contributes to an understanding of the application of fair values to
non-financial assets by examining financial statement volatility in the
measurement of investment property. Moreover, prior literature suggests that
weaknesses in corporate governance at the firm and national level (such as
management incentives to choose less reliable fair values, implementation and
enforcement of standards) do not reduce information asymmetry despite greater
transparency achieved through the market valuation of investment property.
This paper explores measurement error in the valuation of investment property
in the context of corporate governance mechanisms adopted by real estate
companies in the UAE.
†
Zayed University, Abu Dhabi, United Arab Emirates
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Introduction:
Much has been written lately on the valuation of financial assets in the
wake of the current economic crisis. Accounting has been accused of
exacerbating the “meltdown” in the US banking system, of being pro-cyclical as
financial institutions wrote-down investments, then attempted to raise capital to
meet prudential requirements, sold assets at “firesale” prices which drove prices
and valuations down even further (Johnson, 2008; Anon, 2008a).
An article published in the Financial Times in March 2008 commences
“Accounting rulemakers have defended the use of ‘fair value’ accounting against
attacks from bankers and insurers, who claim that applying it to financial
instruments in the current turmoil risks undermining its financial system.”
(Hughes, 2008c). Hughes (2008c) concludes that “(t)he row over fair value is
pitting executives against many investors and the accounting profession. Most
alternative suggestions involve heavier reliance on subjective management
estimates, which investors dislike.”
However, goal of accounting regulators is not to promote financial
stability. “Ultimately…responsibility for interposing a circuit-breaker between
market process and banks’ capital adequacy falls on bank regulators, not
accountants” (Anon, 2008a), a sentiment shared by Sir David Tweedie,
Chairman of the International Accounting Standards Board (IASB), who has
reportedly suggested that the nexus between accounting rules and the regulatory
capital of banks be relaxed (Hughes, 2008b) as a salve to pro-cyclical tendencies.
Accounting regulators have turned, instead, to issues in the measurement
of financial securities when markets are illiquid. An expert advisory panel of the
IASB has recently provided new guidance to preparers on measuring and
disclosing fair values in compliance with IFRS when markets are no longer
active (IASB, 2008). The IASB has also proposed changes to extant regulation to
effectively diminish the volatility in reported earnings while extending the
disclosures for valuation techniques that “mark to model” (rely more heavily on
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unobservable inputs to derive fair value) rather than “mark to market” (use
observable, market prices). Their solution substitutes transparency in the
estimates used by management for transparency of movement in prices. For
some, the modification to the relevant accounting standard to allow
reclassification of some financial assets (thereby smoothing losses) was achieved
at the expense of a loss of reputation for the IASB and its Chairman, accused of
“caving in to political pressure” from European financial institutions (Hughes,
2008a).
In the US, the Securities and Exchange Commission (SEC) has been
charged with responsibility for analyzing the impact of fair value accounting on
the balance sheets of financial institutions and examining alternative methods as
a response to the credit “bailout”. In the interim, in September 2008 they also
issued a statement to provide interpretative guidance on the use of management
assumptions in the absence of market evidence of prices, stating that “in some
cases using unobservable inputs…might be more appropriate than using
observable inputs”. It stopped short, however, of suspending use of the
accounting method.
The IASB and FASB are currently jointly pursuing a theoretical
discussion of fair value measurement which can only broaden the debate on the
acceptability of fair values especially for non-financial assets. This study
contributes to an understanding of the application of fair values to non-financial
assets by examining financial statement volatility in the measurement of
investment property.
In addition, prior literature has documented the value relevance and
reliability of fair values for investment property (Owusu-Ansah and Yeoh, 2006;
Dietrich, Harris and Muller, 2001; Muller and Riedl, 2002; Muller, Riedl and
Sellhorn, 2008), providing evidence of the utility of fair values to investors.
However, Muller, Riedl and Sellhorn (2008) show that information asymmetry is
not mitigated by the mandatory provision of market values. Weaknesses in
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corporate governance at the firm and national level (such as management
incentives to choose less reliable fair values, implementation and enforcement of
standards) persist despite greater transparency achieved through adoption of
IFRSs. This paper explores sources of measurement error in the valuation of
investment property in the context of corporate governance mechanisms adopted
by real estate companies in the UAE.
Institutional Environment:
International Financial Reporting Standards (IFRSs) governing property
are contained in International Accounting Standard (IAS) 16 and IAS 40. The
specific regulation governing accounting for investment property is contained in
IAS 40. IAS 40 defines investment property as property held to earn rentals or
for capital appreciation or both, rather than use in production and sale in the
ordinary course of business. The latter type of property is referred to as owneroccupied property and is accounted for under the rules contained in IAS 16.
Following general principles for initial recognition of assets, investment
property is recorded at cost. Thereafter the company may choose either to
remeasure to fair value periodically (the fair value model) or maintain initial
cost (the cost model) subject to depreciation and impairment write-downs. Fair
value is defined as the price at which the property could be exchanged between
knowledgeable, willing parties in an arm’s length transaction. Changes in fair
value are recognized in income for the period.
In contrast the cost model requires investment property to be measured at
depreciated cost (less accumulated impairment losses). Systematic charges are
made for depreciation (as provided in IAS 16) and additional charges (or
reversals) for impairment losses (gains) as appropriate. Although the cost model
is the basis of valuation in the balance sheet, fair value must be disclosed as a
note to the accounts.
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In terms of balance sheet values, where prices are rising the fair value
model will have higher asset and shareholders’ equity values relative to the cost
method. In contrast, the cost method defers gains until realized and hence the
amount of any gain (loss) on disposal is likely to be larger than the fair value
model (which regularly remeasures asset value).
IAS 16 prescribes the accounting treatment for property, plant and
equipment used for productive or administrative purpose. Like IAS 40 it permits
choice between two methods of accounting: cost or revaluation. The cost model is
as previously described for IAS 40 with the asset carried at its cost less
accumulated depreciation and accumulated impairment losses. The revaluation
model differs from IAS 40 in one important respect: the treatment of changes in
fair value.
A gain in fair value is recognized in a reserve, not directly in income. In
contrast, a fall in value is recognized in income except where a balance in the
reserve is sufficient to offset the loss. While the reserve forms part of
stockholders’ equity the gains do not pass through the income statement
(constituting a “dirty surplus” as the income statement does not articulate fully
with the balance sheet). Thus a company using fair value would report similar
asset and equity under either IAS 40 or IAS 16 but reported income will be
higher under IAS 40.
IAS 40 provides for a two-level hierarchy of evidence of fair value, with
“the best evidence…given by current prices in an active market for similar
property in the same location and condition and subject to similar lease and
other contracts” (IAS40.45). In the absence of such value, active markets in
dissimilar properties, similar properties in less active markets and discounted
cash flows may be used. To the extent that fair values are not readily observable
they are approximated by using more unobservable inputs. However as
unobservable inputs increase the perceived reliability of these approximations of
fair value diminishes.
4
Fair value is a market-based measure, not entity-specific. In contrast,
impairment testing requires an estimate of the individual asset’s recoverable
amount, or the recoverable amount of the cash-generating unit to which the asset
belongs if the former cannot be estimated, thereby introducing entity-specific
estimates into asset valuation. Recoverable amount is the higher of an asset’s net
selling price and value in use. Since value in use represents the stream of future
cash flows expected from continuing use and disposal of the asset, management
expectations and entity-specific considerations contribute to be greater variation
between the values determined under either method.1
Financial Statement Volatility and the Valuation of Property:
As fair value encapsulates expected future cash flows, any changes in
expectations will result in a change in fair value. Barth (2004) describes three
sources of volatility in financial statements: estimation error volatility, inherent
volatility and mixed-measurement volatility. Estimation error relates to the
degree of precision in measuring the variable of interest. For investment
property it may arise from, say, illiquidity in local property markets,
management incentives to distort estimates and differences in monitoring
(internal and external audit, regulatory enforcement) of the application of
standards (Muller, Riedl and Sellhorn, 2008). Estimation error, and hence its
volatility, is expected to be greater for fair values determined using estimates of
fair value (unobservable inputs) than for observable market prices, given that
the former are reliant on the precision of the estimates (and models) used to
derive fair value.
Following this line of reasoning, the estimation error in the valuation of
investment property is lower than owner-occupied property. IAS 40.07 explains
that investment property generates cash flows that are largely independent of
other assets of the firm while the cash flows generated by owner-occupied
1
See Barth (2006) for a discussion of measurement attribute and its implications for valuation.
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property are interdependent with other assets of the firm. This difference in
economic attribute suggests that there is more likely to be market evidence of
fair value for investment property than for owner-occupied property with
owner-occupied property more likely to require unobservable inputs in
estimating fair value. Moreover, the synergies between assets are not separately
recognized in financial statements which, as a general rule, recognizes individual
assets only (Barth, 2006)
Estimation error will also vary with market liquidity (Muller, Riedl and
Sellhorn, 2008), with
liquidity
inversely
related to estimation
error.
Furthermore, where a property satisfies a dual purpose the standard
recommends bifurcation if feasible, otherwise the property is classified wholly as
investment property if an “insignificant portion” is held for owner-occupation.
Hendriks (2005) describes the valuation issues in apportioning value between
land and buildings and, in the case of investment property, the attribution of
differences in rental income to either component. Thus as dual-purpose property
requires either apportionment of value between its uses or disregards it,
estimation error is increasing in property with dual-purposes.
The reliability of fair value measurements (and the perception of
reliability held by users of accounting information) in enhanced by introducing
and communicating information on governance mechanisms in place. Boyles
(2008) describes a range of governance arrangements that contribute to the
reliability of measurements. Typical governance mechanisms for fair value
measurements are the use of independent, qualified valuers together with highquality auditors.
Inherent volatility refers to the underlying (economic) volatility of the
variable. The greater the inherent volatility, that is the greater the uncertainty or
timing of future cash flows the more variation in the expected realization of the
asset, and hence the greater the volatility in net assets and income for firms using
fair values. Property markets vary in momentum and direction. As they do so,
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expectations of future realizations of cash flows will also vary, and these changes
will flow through the financial statements as material movements with, from
time to time, reversing direction. Inherent volatility is exposed in the actual
realizations of the asset. Realized gains and losses provide historical information
on the variance in asset valuation.
The mixed-measurement model, in which assets are measured using a
variety of measurement bases such as cost, lower of cost and current market
value, fair value2, will also produce volatility in financial statements, as will the
use of fair value for assets but not liabilities as market interest rates change.
Barth (2004, p. 327) explains “(a)n interest rate increase has a relatively larger
negative effect on the financial statements, that is, lower net assets and lower net
income, than it would if assets and liabilities were both measured either using
fair values or using historical cost. Similarly, a decrease in market interest rates
has a relatively larger positive effect.”
Thus it is expected that the greater the commonality in the measurement
bases for assets and liabilities, the less exposed the firm to mixed-measurement
volatility. Thus firms with greater use of variable-rate borrowings and adopting
fair values for measuring assets will have lower mixed-measurement volatility
than firms using fixed-rate debt with fair valuation of assets. Similarly firms
using cost to value assets and fixed-rate debt will experience lower mixedmeasurement volatility than firms using cost and variable-rate debt.
Table 1 summarizes the hypothesized relationship between mixedmeasurement volatility and matching of asset-liability measurement bases.
2
Current market value and fair value differ in the treatment of the costs of disposal, typically net in
realizable value but not deducted in measuring fair value.
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Table 1: Relationship between the Valuation of Assets and Liabilities and
Measurement Volatility
Asset/Liability
Fair value
Cost
Variable-rate
debt
Low
High
Fixed rate debt
High
Low
To summarize,, high market liquidity reduces the estimation error in fair
values of investment property. Estimation error is also lower for firms using
independent qualified valuers for investment property and high-quality auditors.
Finally, firms with single-purpose property should also experience lower
estimation volatility than firms with dual-purpose property. The adoption of fair
value
accounting.
however, produces potential
volatility
from mixed-
measurement attributes in the financial statements. Firms with closer matching
between asset and liability measurement bases minimize mixed-measurement
volatility.
Application to Real Estate Companies:
To explore these propositions we examine firms with a material
investment in investment property in the UAE. We choose firms in the real estate
sector to ensure that investment property is a major asset of the firm and hence
reporting choice has a first-order effect. The UAE provides an interesting case
study for two reasons. First, the property market is experiencing intense growth
providing sufficient inherent volatility for firms to experience high-powered
incentives to select a specific accounting policy for investment property.
Moreover, as land grants are common in the UAE, the “appreciation” of
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property has considerable upside potential contributing to demand for the fair
value model albeit with the volatility that implies.
Sample Selection
There are three stock exchanges in the UAE—the Dubai Financial Market
(DFM), the Abu Dhabi Securities Exchange (ADX) and the Dubai International
Financial Market (DIFM). The first two are domestic markets regulated by the
Emirates Securities and Commodities Authority (SCA)3 while the DIFM is
currently at a much earlier stage of development with its own regulatory
arrangements. We restrict our sample to local companies listed on the DFM and
ADX.
We confine our sample to firms expected to have a material exposure to
investment property. The DFM lists ten companies as Real Estate and
Construction. Of these we excluded four companies that were incorporated in
Kuwait and a further company for which financial information was unavailable.
This process produced a reduced sample of five companies. The Abu Dhabi
Securities Exchange does not provide classification criteria to directly identify
Real Estate companies; a further three companies were identified for inclusion
in the study.
From these eight companies three with no existing investment property or
property under construction for future use as investment property, were also
excluded reducing the final sample to five companies.
Data Collection:
Companies listed on the DFM and ADX are bound by certain regulations
governing disclosure and transparency. Article 36 of the regulations, as amended
2004, requires listed companies to disclose annual, half-yearly and quarterly
3
The SCA is a member of the International Organization for Securities Commissions (IOSCO).
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reports no more than one month after the end of that period with the reports to
be certified by the company’s auditors. Information on each firm was handcollected from the annual report for the 2007 year. Information was collected on
accounting policy, fair value of investment property at reporting date,4
unrealized gain(loss) included in income for the period and terms of external
borrowing. We also perused the financial statements for purposes of property
held by the firm and quality of valuers and auditors.
Descriptive Information and Analysis:
As discussed earlier, we assume that inherent volatility is common to all
UAE firms holding investment property. We expect estimation error to be
randomly distributed across firms where (1) the firm has no material investment
in property with a dual purpose and (2) the firm uses independent qualified
valuers for investment property and engages a large, international accounting
firms. Only one company (Union Properties) has a dual-purpose property
classified as investment property. It describes the ancillary services as a
“relatively insignificant component”. Another company (Emaar) has classified
dual-purpose property (hotels and serviced apartment buildings) as property,
plant and equipment. We therefore conclude that there is no material investment
property with a dual purpose. All firms use independent valuers5 for investment
property and engage a large, international accounting firm. Table 2 provides
descriptive information on the governance mechanisms of interest to this study.
Turning now to mixed-measurement volatility we examine the match
between asset and liability measurement for each firm. Emaar, the only
company adopting the cost method for investment property, is expected to utilize
relatively more fixed-rate debt than other firms with investment property. The
4
5
Recall that firms choosing the cost method are also required to provide the fair value of investment
property.
Although Sorouh Real Estate reports management estimates as the basis for fair value of investment
property private communications with the company indicate the use of a firm of independent valuers.
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disclosures on financial liabilities were unsatisfactory for consistently
partitioning debt into variable and fixed rate components for each firm. The
measurement bases for financial liabilities is therefore approximated by the
relative use of short-term and long-term. Given the difference between carrying
value and contractual (undiscounted) obligations, the contractual amounts are
used to determine the proportions of short versus long term obligations.
Table 2 shows that both Emaar (cost valuation) and Aldar (market
valuation) have relatively high use of long-term debt at 71% and 75%
respectively. Thus we would expect, all else equal, Emaar will report lower
volatility in income than Aldar. A review of reported income in 2007, and the
contribution of appreciation in market values to income, show that Emaar has
the second lowest level of “volatility” in current-year earnings (4.5% compared
with 1.3% for Sorouh) while Aldar has the highest. Looking now at firms using
fair values, we expect firms using fair values to have greater use of short-term
debt. One firm, RAK properties, uses short-term debt exclusively. Other than
Aldar, the two remaining firms have 40% of debt in short-term financial
obligations.
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Table 2: Descriptive information on governance, policies on asset valuation and term of financial obligations
Company
Valuer
Auditor
Policy on Valuation of
Completed Investment
Property
Fair value based on
open market value
Union Properties
Cluttons
(described as
independent,
registered valuer)
KPMG
Emaar Properties
Not identified
directly;
described as
“third party
valuers”
Ernst & Young
Cost less accumulated
depreciation and
impairment losses.
Valuers used for
impairment review.
Aldar Properties
CB Richard Ellis
Deloitte
Sorouh Real
Estate
CB Richard
Elllis‡
Deloitte
Fair value: valuation of
shopping mall
determined by reference
to discounted cash
flows; fair value of land
held as investment
property valued by
management based on
recent prices for similar
property.
Fair value: estimated by
management
Policy on Property under
Construction or Development as
Investment Property
Cost less impairment losses. The
impairment model has been
revisited in 2007. Future cash flow
projections have been prepared and
discounted at the weighted average
cost of capital of 9% and a
perpetuity growth of 5% has been
assumed (p.22).
Classified as capital work in
progress; valuation policy
subsumed within PPE ie cost less
impairment losses (depreciation
specifically excluded from
depreciation).
Cost less impairment losses.
Liability Measurement



Carrying value of financial
liabilities 7,703,753
 Contractual value of financial
liabilities 11,730,639
o Short-term 3,364,394
o Long-term 8,366,245
 Carrying value of financial
liabilities 15,025,697
 Contractual value of financial
liabilities 15,222,288
o Short-term 3,863,558
o Long-term 11,358,730

Cost less impairment losses.

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Carrying value of financial
liabilities 3,821, 406
Contractual value of financial
liabilities 3,991,532
o Short-term 1,591,921
o Long-term 2,399,611
Carrying value of financial
liabilities 1,450,052
Contractual value of financial
liabilities 1,450,052
o Short-term 576,889
o Long-term 873,163
RAK Properties
Both Cluttons
and Rakcon
Consultants
KPMG
Fair value based on
market values
Cost less impairment losses.


‡Private communication with company.
The contractual value of financial liabilities represents undiscounted payments.
13
Carrying value of liabilities
370,351
Contractual value of financial
liabilities 370,351
o Short-term 370,351
o Long-term 0
Concluding Remarks:
Our analysis illustrates the relationship between income volatility and
asset and liability matching for real estate companies with material investments
in investment property. It is subject, however, to a number of limitations. First,
we assume that inherent volatility is similar for all firms yet the portfolio of
property of each firm is unique, in terms of location and features. Second, we
make an assumption that estimation error is randomly distributed across firms.
We are unable, however, to provide an objective measure of the quality of
valuation provided in the financial reports other than confirming the use of
external valuers and high-quality auditors. Real estate companies in the UAE
have been the subject of recent criticism for the use of fair value (Anon, 2008b).
It is unclear whether the criticism reflects concerns about estimation error, and
if so, how that may have affected reported values in 2007. Third, we assume that
mixed-measurement error is sufficiently material that firms match asset and
liability valuation, and that the classification of financial obligations as short and
long term is a good proxy for the variability in pricing of debt. Fourth, the
sample size is very small, and involves a single year.
A maintained assumption is that there is no difference in estimation error
for firms recognizing and disclosing fair values. Such an assumption is consistent
with the findings of Muller, Riedl and Sellhorn (2008) who are unable to find
evidence that investors perceive differences in quality (as evidenced by the bidask spread). Nevertheless, it is an open issue as to whether managers choosing
the cost method do so because of perceived differences in the reliability of the
valuation of their particular asset portfolio.
Features of our research setting which may limit its generalizability are
government sponsorship of property developers in the UAE and a requirement
to list a minimum of 55% of the company’s share capital. In our sample, both
Emaar and Union Properties have substantial Dubai government investment,
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and all the companies in our sample have concentrated ownership. Muller, Riedl
and Sellhorn (2008) find that managers of firms with more concentrated
ownership are less likely to voluntarily provide fair values in publicly available
financial statements consistent with the capacity of major stockholders to access
information from alternative sources. An area for future research would
examine the impact of information symmetry implied in the concentration of
stock ownership on the frequency of measurement of fair values. As insider stock
ownership also influences the capital structure of real estate firms (Ooi, 2000),
the preference for debt or equity could be the subject of future investigation.
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Anon
(2008a)
All’s
fair,
The
Economist,
September
18:
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November 11: http://ft.com/cms/s/
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Ooi, J. T. L. (2000) Managerial opportunism and the capital structure decisions of
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