Fair value: the new black

Citation

French, N. (2006), "Fair value: the new black", Journal of Property Investment & Finance, Vol. 24 No. 4. https://doi.org/10.1108/jpif.2006.11224daa.001

Fair value: the new black

In classic science fiction film The Invasion of the Body Snatchers there is an iconic scene where the hero is accosted by an individual in the street who just repeats and repeats “they are coming, they are coming” in a manic voice. The irony was that “they” had already arrived and had taken over without anyone noticing.

That is what is happening in the property world, just as we thought that we had decided upon a universal definition of “market value” for use in all property valuations, the accountancy profession, for very laudable and valid reasons, has usurped the initiative with the introduction of the definition of “Fair Value”.

Market value (the internationally accepted definition – IVSC):

The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion.

This definition is now the only basis adopted by the RICS for property valuation and after a period when there a plethora of different definitions (in 1994, the RICS Red Book had 14 different bases of value), the adoption of market value as the only basis for capital valuation was a significant step in the evolution of global standards for valuation. The RICS now fully subscribes, quite rightly, to the International standards set by the International Valuation Standards Committee.

However, in the last few years there have been similar moves towards international integration by the accounting profession. The accounting profession now has its own international standards in the form of International Financial Reporting Standards (IFRS). Theses are Standards set by the International Accounting Standards Board (IASB) with the objective of achieving uniformity in accounting principles. The Standards are developed within a conceptual framework so that elements of Financial Statements are identified and treated in a manner that is universally applicable. These Standards were previously known as International Accounting Standards (IAS).

The most important single innovation of International Financial Reporting Standards is a move away from the historical cost principle under which accounts have traditionally been prepared. Companies are now given an option1. They may carry their long-term property and other assets at figures based on original cost or they may carry them at “fair values”. In the second case the figures for properties in the accounts will be based on a valuation.

The adoption of fair value as the primary basis of measurement for accountancy is being driven by the need to ensure information in financial statements is useful to users. In this respect, it needs to be understandable, relevant, reliable and comparable. Thus the balance sheet at “fair value” includes all assets and not just property. The IASB has adopted what is essentially a market value definition of “fair value” and expresses it in most of its standards as:

The amount by which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

A definition similar to, but not the same as, market value. In simple terms, it has been argued that market value would not include an alternative use value whereas fair value could. Thus fair value for investment property is would normally be market value but fair value for owner-occupied property will need more clarification on the assumptions underpinning the valuation.

However, there is a lack of clarity in the International Financial Reporting Standards (IFRS) as to the assumptions that have to be made when valuing assets for different purposes. Accounts generally are produced on the assumption that the entity is a going concern, unless management either intends to liquidate the entity. Therefore fair value might be expected to reflect the value of the particular asset as part of the continuing business. This needs to be clarified and the IASB has acknowledged some of the difficulties surrounding the application of fair value concepts in IFRS and is currently undertaking a project to review the principles of measurement in Financial Statements. The outcome of which are due to be reported in late 2006.

In the commentary contained in the RICS’ Appraisal and Valuation Standards (the Red Book) the RICS states:

Pending clarification of the assumptions underpinning the concepts of Fair Value for different purposes in IFRS, RICS considers that where there is a significant difference between the value of an owner-occupied property on the alterative assumptions that either: it is sold as part of the continuing enterprise in occupation; or it is sold in isolation after removal of the business in occupation, it is best practice to report the Market Value on each of these assumptions.

The RICS has produced an excellent document to help valuers through the mire and confusion surrounding fair value (see Property under IFRS: A guide to the effects of the new International Financial Reporting Standards2)

And so we have a new definition and one that may become the dominant definition, at least for financial reporting. It is not coming, it is already here.

This is more of a problem internationally than in the UK as companies have been given the option to use current cost accounting

PDF available from: www.rics.org

Nick French