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Practical guide to IFRS

Fair value measurement: implications of IFRS 13 for the real estate industry
At a glance
The International Accounting Standards Board (IASB) issued IFRS 13, Fair value measurement, in May 2011 as a common framework on how to measure the fair value when its determination is required or permitted by another IFRS. The new framework denes fair value and provides a single source of guidance for measuring fair value. It also eliminates various and sometimes differing provisions in the existing frameworks and requires additional disclosures about fair value measurements. IFRS 13 denes the fair value of an asset as an exit price, hence the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The effect of IFRS 13 on different industries may vary. This publication focuses on the implications for the real estate industry. IFRS 13 predominantly brings into a single standard the fair value concepts that were in other standards, but it also claries various requirements with regard to the appropriate measurement and disclosure of the fair value and its underlying inputs for example: For non-financial assets, highest and best use is the use to be assumed by market participants that maximises the value of an asset. The fair value measurement assumes that the hypothetical sale of the asset or exit transaction takes place in the principal market with the greatest volume and highest level of activity for the asset or liability. Alternatively, in the absence of such a principal market, the transaction should take place in the most advantageous market; management will therefore need to identify the relevant market. Disclosure requirements have been signicantly expanded to provide users of nancial statements with detailed quantitative and qualitative information about assumptions made and processes used when measuring the fair value. The three-level fair value hierarchy prioritises the inputs to be used in determining the fair value using certain valuation techniques. For real estate entities, the new standard may result in the requirement to redene processes and procedures; it will especially impact the following areas: Investment property carried at fair value: how investment properties are measured and the requirement for additional disclosures; Investment properties carried at amortised cost: how to determine fair value less costs to sell for IAS 36, Impairment of assets, and IFRS 5, Non-current assets held for sale and discontinued operations, and fair value for disclosure under IAS 40, Investment property; Fair value for property, plant and equipment: how to measure fair value under the revaluation model according to IAS 16, Property, plant and equipment; Fair value in a business combination: how to estimate fair value in a business combination according to IFRS 3, Business combinations. IFRS 13 applies prospectively for annual periods beginning on or after 1 January 2013; earlier application is permitted.

September 2011 Contents At a glance

Background: 2 the need for new guidance How does 2 IFRS 13 affect the real estate industry? Denition of 2 fair value Fair value hierarchy Valuation techniques Valuation premise 3 4 5

Highest and 6 best use Disclosure 8 requirements Outlook 9

A practical guide to IFRS Fair value measurement

Background: the need for new guidance

The IASB issued IFRS 13, Fair value measurement, on 12 May 2011. This new IFRS has been developed as a joint project with the FASB, which at the same time published an update to Topic 820 in the FASBs Accounting Fair value measurement project milestones
Exposure draft, Measurement uncertainty analysis disclosure for fair value measurements, June 2010 Discussion paper November 2006 Exposure draft, Fair value measurement, May 2009 IASB added project to agenda September 2005 Effective date: January 2013 (earlier application permitted)

Standards Codication (formerly referred to as SFAS 157). The new standard has been developed since September 2005. The key milestones of the project are shown below..

Fair value measurement IFRS 13, published May 2011

Up until now, denitions and guidance on measuring fair value have been dispersed across many IFRSs and have not always been consistent. Existing guidance is not always able to provide a clear measurement objective or a robust measurement framework. The new standard is intended to establish a single source of guidance and codication for all fair value measurements. The Boards also intended to achieve international harmonisation of fair value measurements and corresponding disclosure requirements; a further important step towards convergence between IFRS and US GAAP.

The Boards have seen the need for enhanced disclosures on fair value measurements in response to the latest nancial crisis. So in order to improve and align fair value measurement and disclosure requirements, the Boards decided to establish a single source of guidance for all fair value measurements. IFRS 13 does not say when to use fair value as the measurement basis, nor does it extend the scope of fair value measurements. It only provides guidance on how the concept of fair value should be applied where its use is already required or permitted by other standards

How does IFRS 13 affect the real estate industry?

Denition of fair value
Fair value is dened as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. [IFRS 13 paragraph 9] The denition is similar to the former fair value denition (for example, importance of an orderly transaction that is, not values derived from distressed sales), but there is the notion of an exit price to be considered in the new denition. The IASB intends to clarify with the new denition that fair value is a market-based measurement, not an entity-specific measurement, and that fair value reects current market conditions. In the Boards view, both denitions articulate essentially the same concepts. From a real estate industry perspective, in most cases there wont be substantial change in the estimation of fair value due to the amended denition, as the exit price will often be equal or almost equal to the exchange value. In the current standard, the estimation of the relevant price should always be based on a market participants view.

A practical guide to IFRS Fair value measurement

Under IFRS 13, a fair value measurement takes into account the characteristics of the asset. Applying this to real estate, those characteristics could be as in the current IAS 40 the condition and location of the asset and restrictions on its use. The concept of fair value as a marketbased estimation remains unchanged; management should be aware of this when referring to appraisals that are based on other sources of guidance that use different denitions of fair value.1

identical to the asset being measured. Consistent with existing guidance, if there is a quoted price in an active market (that is, a Level 1 input), an entity uses that price without adjustment when measuring fair value; (2) Level 2 inputs are inputs other than quoted prices in active markets included within Level 1 that are directly or indirectly observable; and (3) Level 3 inputs are unobservable inputs that are usually determined based on managements assumptions. However, Level 3 inputs have to reect the assumptions that market participants would use when determining an appropriate price for the asset. The entity is not free to choose which level of inputs to use: An entity shall use valuation techniques that are appropriate in the circumstances and for which sufcient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. [IFRS 13.61]

Fair value hierarchy

One of the major changes in IFRS 13 compared to IAS 40 is the change in the fair value hierarchy. IAS 40 denes a fair value hierarchy based on valuation techniques; IFRS 13 uses a different approach. In IFRS 13, fair value measurements are categorised into a three-level hierarchy based on the type of inputs and no longer based on the valuation method. The new hierarchy is dened as follows: (1) Level 1 inputs are unadjusted quoted prices in active markets for items Fair value measurement project milestones

Level 1 inputs Quoted prices (unadjusted) for identical assets in an active market Level 2 inputs Quoted prices for similar assets or liabilities in active markets Quoted prices for identical or similar assets or liabilities in markets that are not active Inputs other than quoted prices that are observable for the asset or liability (for example, market observable interest rates) Inputs that are derived principally from or corroborated by observable market data by correlation or other means Level 3 inputs Unobservable inputs

Fair value hierarchy

IFRS 13 allows the application of the following valuation techniques: market approach, income approach or cost approach.

In some cases the inputs used to measure fair value may be categorised within different levels of the fair value hierarchy. In such instances, the fair value measurement

is categorised in its entirety based on the lowest level input that is signicant to the measurement.

The IVSC is currently reviewing the valuation standards to develop the new IVS. IFRS 13 might be taken into account in the due process of the new IVS guidance.

A practical guide to IFRS Fair value measurement

Due to the nature of real estate assets which are often unique and not traded on a regular basis and the subsequent lack of observable input data for identical assets, fair value measurements of real estate will be categorised as Level 2 or Level 3 valuations. All observable market data (that is, transaction prices) are given Fair value measurement valuation inputs
Input level Input (example) 2

a higher priority and should be preferred over unobservable inputs, even if the market is inactive and transactions of comparable assets are rare. The table below gives examples of inputs to real estate valuations and their typical categorisation in the fair value hierarchy.

Sale prices per sqm for similar properties in similar locations Observable market rent per sqm for similar flats Property yields derived from latest transactions Yields based on the management estimation Significant yield adjustments based on managements assumptions about uncertainty/risk Assumptions about future development of parameters (for example, vacancy, rent) that are not derived from the market Cash flow forecast using the entitys own data

Management should maximise the use of relevant observable inputs and minimise the use of unobservable inputs. The use of unobservable inputs is a complex and judgmental area where IFRS 13 provides certain guidance: An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entitys own data. In developing unobservable inputs, an entity may begin with its own data, but it shall adjust those data if reasonably available information indicates that other market participants would use different data or there is something particular to the entity that is not available to other market participants (eg an entity-specic synergy). An entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, an entity shall take into account all information about market participant assumptions that is reasonably available. Unobservable inputs developed in the manner described above are considered market participant assumptions and meet the objective of a fair value measurement. [IFRS 13.89] Unobservable inputs should therefore still be adjusted for market participant assumptions, but the information gathered to determine market participant assumptions should be limited to the extent that is reasonably available.

Valuation techniques
In contrast to the fair value hierarchy in IAS 40 and IAS 16, IFRS 13 does not prefer a specic valuation technique. The fair value hierarchy in existing IFRS guidance prioritised the application of a market approach (or a comparable sales method) over the income approach (that is, a valuation technique based on discounted cash ows) and for the valuation of property plant and equipment the cost approach. However, the fair value hierarchy in IFRS 13 is based on valuation inputs by maximising the use of relevant observable inputs and minimising the use of unobservable inputs rather than the valuation techniques themselves. According to IFRS 13, there are generally three approaches that can be used to derive fair value: the market approach, the income approach and the cost approach. To measure fair value, management should use valuation techniques consistent with one or more of these approaches. It should use valuation techniques that are appropriate in the circumstances and for which sufcient data is available, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. Valuation techniques should be applied consistently. However, a change in the valuation technique or its application can be

A practical guide to IFRS Fair value measurement

appropriate if the result is equally or more representative of fair value. IFRS 13 does not exclude the application of a cost approach in the fair value measurement of investment property under IAS 40. Nevertheless, the practical impact of this change will be limited, as IFRS 13 requires an entity to choose those valuation techniques that are appropriate to the specic circumstances and maximises the use of observable inputs. As market participants would usually estimate the price of an investment property based on their expectations about future income, an income approach or a market approach will often be more suitable to measure fair value in this case. A market or income approach will therefore usually be more appropriate in these circumstances, even if the application of a cost approach is permitted and possible due to the availability of sufcient data. The challenge in using the cost approach is to consider whether or not an adjustment to the actual building costs (for example, change in materials, change in oor usage, etc.) is necessary. The valuation has to be based on the specications that are considered necessary to reect the market participants highest and best use of the property. As a result, specications that include no added value to the market participants are not considered in the valuation. IFRS 13 encourages an entity to apply multiple valuation techniques (market approach, income approach and cost approach), if appropriate. In this case, the results (that is, the respective indications of fair value) should be evaluated considering the reasonableness of the range of values indicated by those results. Fair value measurement unit of account
Unit of account for investment properties is dened according to IAS 40

The fair value measurement is the point within that range that is most representative of fair value in the circumstances. This approach obviously requires signicant judgement, and the results of the multiple valuation techniques should be evaluated carefully.

Valuation premise: principal market and unit of account

IFRS 13 requires management to identify the relevant market in which a typical transaction of the asset would take place. A fair value measurement assumes that the transaction to sell an asset takes place in the principal market for the asset or, in the absence of a principal market, in the most advantageous market for the asset. The principal market is the market with the greatest volume and level of activity for the asset or liability that can be accessed by the entity. In the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market or, in the absence of a principal market, the most advantageous market. However, management does not need to continuously monitor different markets to identify the most advantageous market at the measurement date. The identication of the principal market requires rst the identication of the unit of account, which is subject to transactions in this market. IFRS 13 refers to the unit of account as it is dened by the respective IFRS that requires or permits fair value measurement:

Whether the asset or liability is a stand-alone asset or liability, a group of assets, a group of liabilities or a group of assets and liabilities for recognition or disclosure purpose depends on its unit of account. The Unit of account for the asset or liability shall be determined in accordance with the IFRS that requires or permits the fair value measurement, except as provided in this IFRS. [IFRS 13.14]

The principal market for the asset sold on its own at the unit-of-account level should in most cases be determinable by knowledgeable market participants. IFRS 13 states that the fair value of a nonnancial asset assumes that the asset is sold

consistently with the unit of account specied in other IFRSs (which may be an individual asset). According to IAS 40.5 investment property is property (land or building or part of a building or both) held (by the owner or by a lessee under a nance lease) to earn

A practical guide to IFRS Fair value measurement

rentals or for capital appreciation or both. The unit of account the single property (for example, land and building) is the relevant level to measure an investment property at fair value according to IAS 40 and IFRS 13. However, the valuation principles in IFRS 13 have implications that management should take in to account. The standard discusses some valuation principles to be applied when considering how to determine fair value of a non-financial asset used in combination with other assets as a group. The fair value might be the same whether the asset is used on a stand-alone basis or in combination with other assets. This conclusion is based on the assumption that the use of the assets as a group in an ongoing business would generate synergies that would be available to market participants. As a result, market participants would judge the synergies on a stand-alone basis as well as in an asset group on the same basis. However, for real estate assets, the valuation of the investment property is generally on a stand-alone basis. Only in rare circumstances the entity might measure the asset at an amount that approximates its fair value when allocating the fair value of the asset group to the individual assets of the group [IFRS 13.B3] Fair value measurement

lit. e]. There may be the following rule/ exception ratio for the real estate industry: valuation on a stand-alone basis, considering synergies only to the extent they are available to typical market participants; and only in limited situations (exception), allocating the fair value of the asset group to the individual asset (considering the unit of account).

Highest and best use

IFRS 13 denes the concept of highest and best use. The absence of a denition of this concept in existing guidance on fair value accounting has given rise to varying interpretations in the past. This is especially true for real estate valuations, as land values depend signicantly on the assumptions about the lands (potential) use. According to IFRS 13 paragraph 27, a fair value measurement of a non-financial asset takes into account a market participants ability to generate economic benets by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use. The highest and best use takes into account the use of the asset that is physically possible, legally permissible and nancially feasible.

A fair value measurement of a non-financial asset takes into account a market perticipants ability to generate economic benefits by using the assets in its highest and best use or by selling it to another market perticipant that would use the asset in its highest and best use. Physically possible Legally permissible Financialy feasible

Takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (for example, the location or size of a property).

Takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (for example, the zoning regulations applicable to a property).

Takes into account whether a use of the asset generates adequate income or cash flows (taking into consideration the costs of converting the asset to that use) to produce an investment return that market participants would require from an imvestment in that asset put to that use.

A practical guide to IFRS Fair value measurement

Highest and best use is determined from the perspective of market participants. IFRS 13 includes some guidance on how to understand the highest and best use concept on real estate, which is shown below. Example A piece of land being developed for industrial use as a site for a factory could be developed as a site for high-rise apartment buildings if there is a future change in legislation for example, a new zoning. How should management estimate the highest and best use? According to IFRS 13 BC 69: a fair value measurement can assume a different zoning if market participants would do so (incorporating the cost to convert the asset and obtain that different zoning permission, including the risk that such permission would not be granted). In this case, there would need to be appropriate supporting evidence that the potential re-zoning would be considered by market participants when determining the fair value. Furthermore, the use of the asset must be physically possible and nancially feasible. However, an entitys current use of a nonnancial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximise the value of the asset. In cases where the current use differs from the highest and best use, IFRS 13 requires management to estimate a fair value based on the hypothetical exit price assuming the assets highest and best use by market participants. This issue will arise from time to time in the real estate industry, as the way an entity uses land sometimes differs from the use of surrounding land. According to IFRS 13, when determining the highest and best use of a non-financial asset, management should take into account two possibilities: the highest and best use

of the asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise congured for use) or in combination with other assets and liabilities (for example, a business). If the highest and best use of the asset is to use the asset in combination with other assets or with other assets and liabilities, the fair value of the asset is the price that would be received in a current transaction to sell the asset, assuming that the asset would be used with other assets or with other assets and liabilities and that those assets and liabilities (that is, its complementary assets and the associated liabilities) would be available to market participants. However, the fair value measurement of a non-financial asset assumes that the asset is sold consistently with the unit of account specied in other IFRSs (which may be an individual asset). This is the case even when the fair value measurement assumes that the highest and best use of the asset is to use it in combination with other assets or with other assets and liabilities. The estimation of the exit price is not based on a transaction including the complementary asset and liabilities; it assumes that the market participant already holds the complementary assets and the associated liabilities. To illustrate this, take a look at the following example: An undeveloped plot of land without street access has to be valued. In front of the plot there are industrial sites with street access. There are three companies located next to the undeveloped plot, which are strongly in need of additional storage space. For those three market participants, the undeveloped plot although hinterland is very valuable, whereas for all others it is all but worthless. Following the denition in IFRS 13, the value of the plot would be the exit price that one of the industrial companies would be willing to pay.

A practical guide to IFRS Fair value measurement

Disclosure requirements
The Board has included signicantly enhanced disclosure requirements into the new standard, in order to provide users of nancial statements with better information about the measurement uncertainty inherent in fair value measurements and to strengthen market participants condence in fair value measurements after the latest nancial crisis. The required disclosures include: information about assets measured at fair value that are used in a way that differs from their highest and best use; information about the hierarchy level into which fair value measurements fall; transfers between Levels 1, 2 and 3; and
FV Measurement Disclosure requirement All All non-recurring All recurring

methods and inputs to the fair value measurements and changes in valuation techniques. Fair value measurements categorised within Level 3 of the fair value hierarchy are more subjective than those derived from observable market prices, so IFRS 13 requires additional disclosures for Level 3 measurements. These include a reconciliation of opening and closing balances, quantitative information about unobservable inputs and assumptions used, and a description of the valuation processes in place. The table below gives an overview of the most important disclosure requirements for non-financial assets under IFRS 13.

Fair value measurement at the end of the reporting period Level of the fair value hierarchy The reason for the measurement Amounts of transfers between Level 1, 2 and 3 The entitys policy for determining when transfers between levels are deemed to have occured Transfers from and into Level 1 Description of the valuation technique(s) and the inputs used in the fair value measurement Changes in valuation techniques and reasons for making those changes Description of the valuation technique(s) and the inputs used in the fair value measurement Changes in valuation techniques and reasons for making those changes Quantative information about the significant unobservable inputs used in the fair value measurement if reasonably available Description of valuation processes, policies and procedures If the highest and best use differs from its current use, an entity should disclose the fact and why the non-financial asset is being used in a manner that differs from its highest and best use Narrative description of sensitivity of the fair value measurement to significant changes in unobservable inputs (recurring only)

Level 1 Level 2

Level 3

If there is evidence that users of nancial statements need additional information to evaluate the quantitative information disclosed, the entity should disclose additional information necessary to meet this objective.

Due to the lack of active markets for identical assets, preparers of fair value measurements for real estate often will have to rely on Level 2 or Level 3 inputs; this could result in considerably more work for reporting entities in the real estate industry.

A practical guide to IFRS Fair value measurement

Outlook
Market value should not change due to a new fair value denition, and the concepts in IFRS 13 are in line with the current practice in general, so the measurement results should be quite similar in most circumstances under the new standard as under IAS 40. Nevertheless, the new valuation premises and the new principles may have an impact on the real estate industry. Real estate entities should consider what kind of (limited) situations will require a redenition of the rules and procedures to full the regulations of the new fair value measurement standard. At the same time, all real estate entities will face with a lot more disclosure requirements as a result of the new regulations. Management may need to reconsider some of the valuation procedures in place to minimise the impact as far as possible. Regarding the valuation principles and the valuations under IFRS 13, there may be a new challenge for management to make judgments and to explain their decisions and their resulting inuence on the valuation results. During the next few months, management, valuation experts and auditors will become familiar with the IFRS 13 and will face new questions, especially when presented with scenarios to be considered in future valuations.

A practical guide to IFRS Fair value measurement

Contacts
Australia IFRS specialist: James Dunning james.dunning@au.pwc.com Valuation specialist: Peter Power peter.power@au.pwc.com Austria Valuation specialist: Wolfgang Vejdovsky wolfgang.vejdovsky@at.pwc.com Belgium IFRS specialist: Ann Smolders ann.smolders@be.pwc.com Valuation specialist: Jean-Paul Ducarme jean-paul.ducarme.rbr@be.pwc.com Bulgaria Valuation specialist: Vanya Assenova vanya.assenova@bg.pwc.com Canada IFRS specialist: Frank Magliocco frank.magliocco@ca.pwc.com Valuation specialist: Michael Chung michael.chung@ca.pwc.com Channel Islands IFRS specialist: Karl Hairon karl.hairon@je.pwc.com China Valuation specialist: Nova Chan nova.chan@cn.pwc.com Cyprus & Global ACS Leader IFRS specialist: Tasos Nolas tasos.nolas@cy.pwc.com Czech Republic Valuation specialist: Jan Hadrava jan.hadrava@cz.pwc.com Denmark IFRS specialist: Henrik Steffensen henrik.steffensen@dk.pwc.com France IFRS specialist: Daniel Fesson daniel.fesson@fr.pwc.com Valuation specialist: Geoffroy Schmitt geoffroy.schmitt@fr.pwc.com Germany IFRS specialists: Anita Dietrich anita.dietrich@de.pwc.com Daniel Ranker daniel.ranker@de.pwc.com Valuation specialist: Dirk Hennig dirk.hennig@de.pwc.com Hong Kong IFRS specialist: Alan Ho alan.ho@hk.pwc.com Valuation specialist: Christopher Chan christopher.chan@hk.pwc.com Hungary Valuation specialist: Nora Sarlos nora.sarlos@hu.pwc.com Italy IFRS specialist: Elisabetta Caldirola elisabetta.c.caldirola@it.pwc.com Valuation specialist: Margherita Biancheri margherita.biancheri@it.pwc.com Japan IFRS specialist: Takeshi Shimizu takeshi.shimizu@jp.pwc.com Steve Sloman steve.p.sloman@jp.pwc.com Luxembourg IFRS specialist: Kees Hage kees.hage@lu.pwc.com Kenneth Iek kenneth.iek@lu.pwc.com Valuation specialist: Philipp Koch philipp.koch@lu.pwc.com Norway IFRS specialist: Ola Annsen ola.annsen@no.pwc.com Poland IFRS specialist: Malgorzata Szymanek-Wilk malgorzata.szymanek-wilk@pl.pwc.com Valuation specialist: Grazyna Wiejak-Roy grazyna.wiejak-roy@pl.pwc.com Portugal Valuation specialist: Teresa Santos teresa.oliveira.santos@pt.pwc.com Romania Valuation specialist: Razvan Penescu razvan.penescu@ro.pwc.com Russia Valuation specialist: Mark Hannye mark.hannye@ru.pwc.com Singapore IFRS specialist: Eng Beng Choo eng.beng.choo@sg.pwc.com Valuation specialist: Kok Keong Lie kok.keong.lie@sg.pwc.com Spain IFRS specialist: Gonzalo Sanjurjo Pose gonzalo.sanjurjo.pose@es.pwc.com Sweden IFRS specialist: Johan Ericsson johan.m.ericsson@se.pwc.com Valuation specialist: Per-Erik Waller per.erik.waller@se.pwc.com Switzerland IFRS specialist: Markus Schmid markus.schmid@ch.pwc.com Valuation specialist: Marie Seiler marie.seiler@ch.pwc.com

(continued)

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A practical guide to IFRS Fair value measurement

Contacts (continued)
The Netherlands IFRS specialist: Sidney Herwig sidney.herwig@nl.pwc.com Valuation specialist: Jens Osinga jens.osinga@nl.pwc.com Turkey Valuation specialist: Orhan Cem orhan.cem@tr.pwc.com United Kingdom IFRS specialist: Sandra Dowling sandra.dowling@uk.pwc.com Valuation specialist: Nick Croft nicholas.h.croft@uk.pwc.com United States IFRS specialist: Tom Wilkin tom.wilkin@us.pwc.com Valuation specialist: David Seaman david.p.seaman@us.pwc.com

A practical guide to IFRS Fair value measurement

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