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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 1 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 1 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 2 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. 3 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. 5 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, 6 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. 7 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 8 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). 9 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. 10 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. 11 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. 12 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, 14 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. 15 References: Anon (2008a) All’s fair, The Economist, September 18: http://www.economist.com/finance/ Anon (2008b) UAE real estate companies exploit fair value loophole, Khaleej Times, September 6, p.32. Barth, M. (2006) Including estimates of the future in today’s financial statements, Accounting Horizons, 20(3): 271-285. ―― (2004) Fair values and financial statement volatility in The Market Discipline across Countries and Industries, edited by C. Borio, W.C. Hunter, G.G. Kaufman and K. Tsatsaronis, Cambridge, M.A.:MIT Press. Boyles, J. (2008) Fair value accounting: Are you ready? Strategic Finance, August: 29-32. Dietrich, D., Harris, M. and Muller, K. (2001) The reliability of investment property fair value estimates, Journal of Accounting and Economics, 30(2): 125-158. Hendriks, D. (2005) Apportionment in property valuation: Should we separate the inseparable? Journal of Property Investment and Finance, 23(5): 455-470. Hughes, J. (2008a) IASB chairman warns on risk to rules, Financial Times, November 11: http://ft.com/cms/s/ ――(2008b) IASB questions relaxing of fair vale accounting, Financial Times, November 7: http://ft.com/cms/s/ ――(2008c) Accounting chiefs defend ‘fair value’ system, Financial Times, March 18: http://ft.com/cms/s/ International Accounting Standards Board (IASB) (2008) Measuring and Disclosing the fair value of financial instruments in markets that are no longer active, London: IASB Johnson, C. (2008) Wall St. points to disclosure as issue: Accounting rule cited in turmoil, Washington Post, September 23: http://washingtonpost.com/wpdyn/content/article/2008/09/22/ Muller, K.A., Riedl, E.J. and Sellhorn, T. (2008) Consequences of voluntary and mandatory fair value accounting: Evidence surrounding IFRS adoption in the EU real estate industry, Working paper 09-033, Harvard Business School. ―― Muller, K.A., Riedl, E.J. (2002) External monitoring of property appraisal estimates and information asymmetry, Journal of Accounting Research, 40(3): 865-881. Ooi, J. T. L. (2000) Managerial opportunism and the capital structure decisions of property companies, Journal of Property Investment and Finance, 18(3): 316328. Owusu-Ansah, S. and Yeoh, J. (2006) Relative value relevance of alternative accounting treatments for unrealized gains: Implications for the IASB, Journal of International Financial Management and Accounting, 17(3), 228-255. Securities and Exchange Commission (2008) SEC Office of the Chief Accountant and FASB Staff clarification on fair value accounting, September: http://www.sec.gov/news/press/2008/2008-234.htm 16 17