Fair value reporting for investment properties under US GAAP

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equivalent US standard that allows for investment properties to be measured at fair value and there would be no basis for excluding investment properties from the new proposed lessor accounting requirements. To remedy this lack of consistency between IASB and FASB guidance, and at the request of some participants in the real estate industry, the FASB announced at its March 10, 2010 meeting that it was adding a project to its agenda to consider whether entities should be given the option (or potentially be required) to measure an investment property at fair value through profit and loss (FVTPL). A similar project previously had been on the FASB’s agenda under phase two of the fair value option project, but was removed from the agenda in October 2008, partially because of resistance to optional fair value accounting by the SEC Advisory Committee on Improvements to Financial Reporting and concerns about the use of fair value models in general for "non-traded" assets. Staff resource constraints are also believed to have played a role in the original removal of the project from the agenda, with the expectation that the United States would ultimately adopt IFRS, including IAS 40. At its July 14, 2010 meeting, the FASB discussed the investment property project and certain proposed models put forth by the staff. Rather than starting with a new model, the FASB tentatively decided to issue a proposed Accounting Standard Update using IAS 40 as a basis, however the ASU would require an investment property to be measured at fair value. The FASB recognized that its tentative decision would not achieve complete convergence with IAS 40, which permits, but does not require, investment properties to be measured at fair value. Nonetheless, the FASB instructed the staff to begin drafting the ASU and to continue to reach out to constituents and hear their concerns and thoughts. It is also possible that the IASB will amend IAS 40 to be consistent with this new ASU and require the use of fair value for investment properties. The exposure draft for Accounting for Investment Properties could be issued as early as September 2010, with a comment period to end contemporaneously with that of the lease standard (i.e., December 15, 2010). In the United States there are certain entities that currently report investment property at fair value, including pension funds and entities that are considered to be investment companies under ASC 946 (formerly the AICPA Audit and Accounting Guide - Investment Companies). As part of the convergence project on consolidation, the IASB is nearing the issuance of an exposure draft on the definition of an investment company, a designation that did not previously exist in IFRS. The discussion to date bears striking similarities to SOP 07-1, Clarification of the Scope of the Audit and Accounting Guide "Investment Companies" and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies, issued by the AICPA in 2007 and subsequently indefinitely deferred. If the FASB adopts a similar definition or ultimately converts to IFRS, entities will need to re-evaluate whether they are or are not investment companies under the new guidance; and if not, if they would no longer be able to report as investment companies. In some cases, certain real estate entities (generally vertically integrated property operating companies) may no longer qualify as investment companies, but many investors in those entities may still need fair value information for their own reporting (e.g. pension funds). If adopted by the FASB, this new guidance on investment properties may provide some relief for those funds that would no longer be within the scope of an investment company, by requiring investment properties to be reflected at fair value under non-investment company US GAAP. On the other hand, because of the definition of “investment property” within IAS 40, some investments, such as hotels and assistedliving facilities, which had historically been reported by these investment company entities at fair value, may no longer have a basis to be reported at fair value because the entities owning such property may not be investment companies and the property may not meet the definition of an investment property. For entities that historically have not been deemed to be investment companies, but which have owned or operated rental properties, the current reporting model is based on the historical cost of the property as adjusted for depreciation and impairment. Depending on the type of underlying properties, this includes many of the real estate investment trusts (REITs) and real estate operating companies (REOCs). In addition, many financial institutions, such as banks and insurance companies, which hold such investments for their own account (i.e., “general account” investments), will also be affected if these investments meet the definition of investment property. Absent the ability to reconsider fair value elections on related debt financing these investments (both recourse and non-recourse), many of these financial Fair value reporting for investment properties 2 PricewaterhouseCoopers
institutions could have mismatches, creating unusual net results with liabilities carried at amortized cost. IAS 39.9 allows the classification of such liabilities at FVTPL in order to eliminate a mismatch (where applicable). This new FASB guidance could also affect owners of “non-traditional” real estate, such as production facilities, power plants, wind/solar farms, or pipelines, which otherwise may meet the definition of an investment property, and which are subject to “leases,” either directly or through take-or-pay contracts or power purchase contracts under ASU 840-10- 15 (formerly EITF 01-8). While international standards (International Financial Reporting Interpretations Committee ["IFRIC"] 4) have equivalent lease definitions, whether or not they were considered investment property under IAS 40 has not been a focus for owners of these assets because fair value reporting has been optional. In addition, due to the complexities of valuation, historical cost has generally been elected. Since the FASB’s new investment property standard would not allow for such an option, the evaluation of whether these are considered “investment properties” will be critical. Banks and other financial institutions also receive property in foreclosure (i.e., other real estate owned or “OREO” assets) that they may hold for sale/rent for a period of time to maximize their returns/recovery. These OREO assets may meet the definition of an investment property and may be required to change from the current historical cost model to a fair value model once obtained in foreclosure until their ultimate disposal. Many historical cost-reporting entities, such as REITs/REOCs, have long disagreed with the concept of depreciating “appreciating assets,” which has lead them to provide the market with alternative measures of performance, such as Funds from Operations (“FFO”). FFO excludes the impact of depreciation of these real estate assets from earnings. Others have argued that the asset on the balance sheets of REIT and REOCs were not comparable among companies because property acquisitions are recorded at historical cost at the time of acquisition (which is at different times for different acquisitions and different companies) and subsequently were depreciated using a method that doesn’t necessarily reflect the real economic decline in value of a property. These industry participants believe that fair value reporting would improve the relevance of financial reporting. Critics of the fair value model note that real estate valuations are generally level 3 under the current fair value framework and point to the inherent uncertainty of valuations and potential differences of assumptions such as market rents or discount and cap rates by different parties for similar properties. These critics believe that fair value reporting would not improve the comparability of financial statements among different real estate companies. Ultimately, it remains to be seen whether the public markets will embrace this change or not. History of investment property standard under IFRS Prior to the adoption of IFRS, the accounting for investment properties was governed by local GAAP. Although the accounting in each jurisdiction varied, it generally followed either the historical cost model or the revaluation model, or an option to choose between the two. The cost model was based on the historical cost of the property as adjusted for depreciation and impairment. Under the revaluation model, properties were carried at fair value, with changes in fair value recorded in equity. The fair value model, in which properties are carried at fair value with changes in fair value through profit or loss, was generally not applied internationally prior to the adoption of IAS 40. Under IFRS (specifically IAS 40), the initial measurement of an investment property is its purchase price plus any directly attributable transaction costs. Subsequent to initial measurement, Fair value reporting for investment properties 3 PricewaterhouseCoopers Global Survey of listed Investment Property owners* 8% 92% Applied the fair value model for subsequent measurement of investment property Applied the cost model * In a 2008 global survey of listed investment property owners conducted by PricewaterhouseCoopers - 50 entities surveyed.
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