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Vol. 16, No. 10, October 2010
Valuation of Investment Properties: Be Careful What You Ask For By Alfred M. King
Generally accepted accounting principles (GAAP) historically have not permitted companies to “write-up” the value of assets that have appreciated, although the reverse, write-down of reduced values, is mandatory. This lack of symmetry has been brought to the attention of accounting rulesetters for years. The answer for maintaining the status quo always boiled down to “conservatism,” recognize losses but not gains. This philosophical approach in effect favored prospective buyers of a company stock at the expense of existing shareholders. The existing shareholders had all losses recognized, thus depressing earnings and stock prices, and precluded those same investors from obtaining the benefits of any increases in value, again keeping stock prices low. Right or wrong, a few years ago the International Accounting Standards Board (IASB) took a first step toward providing a more level playing field. It permitted, but did not mandate, companies, under certain circumstances, to write up the value of appreciated fixed assets which include investment property as well as buildings, machinery, and equipment. The one caveat was that once a company started writing up the value of assets it had to continue such revaluations periodically, even if values subsequently went down. In other words this was not to be a one-way street of only increases in value, since history suggests that values can diminish just as easily as they increase. As a broad generalization, both the IASB and our own FASB appear to be desirous of moving toward a full fair value accounting system. In the
United States, the only fair value (FV) requirements mandated so far have dealt with financial instruments and derivatives. Those assets, in certain circumstances, must be revalued up or down each reporting period and changes in value reflected in the financial statements. But, to reiterate, in the United States, the only FV requirements for periodic financial reporting so far have been focused solely on financial assets. As this is being written (fall 2010) FASB has announced it just added a new project to its agenda; the proposal is for GAAP now to require that owners of “investment property” must determine and then disclose the FV of that property. Investment property essentially is considered to be real estate, land, and/or buildings, owned for the purpose of generating income. Investment property is not property used by the owner in his business. As an example, assume two identical warehouses have been built in an industrial center. One warehouse is owned by an investor who plans to rent it out at $5.00 per square foot per year on what is referred to as a triple net basis, where the tenant pays for taxes, maintenance and so forth. In other words the owner gets $5.00 net of all expenses, has to pay any interest on borrowed money, and obtains the tax benefits of depreciation, if any. The second warehouse is owned by a garment manufacturing firms that uses it for storage and distribution of its product to its customers. This would be considered “owner-occupied” or “owner-used.”
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Valuation Of Investment Properties: Be Careful What You Ask For
Business Valuation Update Executive Editor: Jan Davis Legal Editor: Sherrye Henry Jr. CEO, Publisher: David Foster Managing Editor: Janice Prescott Contributing Editors: Adam Manson, Vanessa Pancic, Doug Twitchell Graphic & Technical Designer: Paul Erdman Customer Service: Stephanie Crader Sales and Site Licenses: Linda Mendenhall President: Lucretia Lyons
Editorial Advisory Board NEIL J. BEATON CPA/ABV, CFA, ASA GRANT THORNTON SEATTLE, WASH.
GILBERT E. MATTHEWS CFA SUTTER SECURITIES INCORPORATED SAN FRANCISCO, CALIF.
JOHN A. BOGDANSKI, ESQ. LEWIS & CLARK LAW SCHOOL PORTLAND, ORE.
Z. CHRISTOPHER MERCER ASA, CFA MERCER CAPITAL MEMPHIS, TENN.
NANCY J. FANNON ASA, CPA/ABV, MCBA FANNON VALUATION GROUP PORTLAND, ME.
JOHN W. PORTER BAKER & BOTTS HOUSTON, TX.
JAY E. FISHMAN FASA, CBA FINANCIAL RESEARCH ASSOCIATES BALA CYNWYD, PA. LYNNE Z. GOLD-BIKIN, ESQ. WOLF, BLOCK, SCHORR & SOLIS-COHEN NORRISTOWN, PA. LANCE S. HALL, ASA FMV OPINIONS IRVINE, CALIF. JAMES R. HITCHNER CPA/ABV, ASA THE FINANCIAL VALUATION GROUP ATLANTA, GA. JARED KAPLAN, ESQ. MCDERMOTT, WILL & EMERY CHICAGO, ILL.
RONALD L. SEIGNEUR MBA CPA/ABV CVA SEIGNEUR GUSTAFSON LAKEWOOD, COLO. BRUCE SILVERSTEIN, ESQ. YOUNG, CONAWAY, STARGATT & TAYLOR WILMINGTON, DEL. JEFFREY S. TARBELL ASA, CFA HOULIHAN LOKEY SAN FRANCISCO, CALIF. GARY R. TRUGMAN ASA, CPA/ABV, MCBA, MVS TRUGMAN VALUATION ASSOCIATES PLANTATION, FLA. KEVIN R. YEANOPLOS CPA/ABV/CFF, ASA BRUEGGEMAN & JOHNSON YEANOPLOS, P.C. TUCSON, ARIZ.
JAMES S. RIGBY, ASA, CPA/ABV IN MEMORIAM (1946 – 2009) Business Valuation Update™ (ISSN 1088-4882) is published monthly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 972053035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to Business Valuation Update™, Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. The annual subscription price for the Business Valuation Update™ is $359. Low cost site licenses are available for those wishing to distribute the BVU to their colleagues at the same address. Contact our sales department for details. Please feel free to contact us via email at customerservice@BVResources.com, via phone at 503-291-7963, via fax at 503-291-7955 or visit our web site at BVResources.com. Editorial and subscription requests may be made via email, mail, fax or phone. Please note that by submitting material to BVU, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2010, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR.
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The owner of the first building has to determine the FV every year and take increases or decreases in value into the financial statements. The owner of the second building would be precluded from revaluing the facility, no matter how high an increase in value were to be realized, whereas in case of a decrease in market value there may have to be an impairment charge. Now, what we have are two separate, yet identical, properties with totally different accounting treatment. Is there some hidden logic to this proposed accounting treatment? It is sometimes difficult to ascribe motives to the actions of others because you may be wrong. There may be something they are not telling you that would explain their actions. But, in the absence of such information, reasonable common-sense conclusions as to motives often are proven correct. In this case, why do we think the FASB is proposing FV accounting for investment property? The stated reason is to “conform” GAAP to IFRS. But as noted, IFRS does not mandate use of FV, whereas the U.S. proposal does. So the concept of “convergence” is pretty hard to support since, if adopted, the U.S. approach will differ from IFRS, unless of course IASB in turn changes its requirements. What is far more likely, at least to this conspiracy theorist, is that the proponents of full fair value accounting at the FASB see this “convergence” as an easy first step on the road to total FV accounting. By arguing that this is “just convergence” and not a radical new step, the FASB hopes that the bitter medicine of FV accounting will go down smoothly. Many observers must think that valuation specialists will be ecstatic that for the first time FASB will be calling for valuations of assets other than financial instruments and derivatives. Just as the 1933 and 1934 Securities Acts gave lifetime employment to auditors, so some valuation specialists may believe that mandatory FV disclosures by companies will be the key to unlock some sort of future golden treasure.
Reprinted with permissions from Business Valuation Resources, LLC
BusinessValuation Update
October 2010
Valuation Of Investment Properties: Be Careful What You Ask For
Wrong! While most valuation reports present a singlepoint answer, as though that were the value, appraisers know better than anyone about the real lack of precision inherent in valuation. Until now, there has been relatively little legal liability placed upon appraisers when in good faith they present an answer to their client(s). Valuation reports are always written to a specific client and the purpose of the valuation is stated in the report. The value indication is valid only for that date and that purpose for that client. Put a different way, valuation specialists are not rating agencies (Moody’s or Standard & Poor’s) and they are also not security analysts or investment advisors. As long as the appraiser has done the work in good faith and without what I call a “thumb on the scale,” it is hard for someone to sue and claim they were misled. The whole valuation report explains what was done, why it was done, why what was not considered was that way, and, finally, what assumptions or projections were used. It is possible to take exception to the final indication of value in a well-written appraisal report. You don’t have to blindly accept the answer. You can challenge any of the assumptions or even the methodology itself. But in any event, the valuation specialist will have a chance to rebut any questions. In litigation each side can present an “expert” report and the other side has a chance to rebut. The parties still may not agree, but the points of difference will have been clearly delineated. Now let’s look at what the situation will be if full fair value accounting comes to pass. Very few companies will do their own valuation work, because of the legal risks following an error in values. Rather they will hire outside valuation specialists for the FV accounting, just as they do now for allocation of purchase price or impairment testing. Good news! Appraisers will have an increase in valuation work, and hence fee income. That, however, is where the good news stops. The bad news will very shortly follow, and that is spelled L-I-T-I-G-A-T-I-O-N.
The valuation groups in the Big Four accounting firms simply will not allow their values to be incorporated into SEC filings, with their name as the “expert.” This “expertizing” of valuation specialists in accounting has been resisted strenuously by those most knowledgeable about litigation risk, the Big Four audit firms. We all know how much litigation surrounds accounting, and as appraisers we have so far avoided almost all actual or potential loss. Once FV accounting is adopted, and companies have to disclose the FV of all their assets (and liabilities, for that matter), it is hard not to believe that certification from the valuation firm will not also be mandated. After all, whoever came up with the values has to be expected to support them. Valuation specialists will argue, “Well, those values are the client’s responsibility, just as the overall financial statements are the client’s”—which is the argument the accounting firms use when they are sued. “It’s not our accounting report, it’s the client’s!” That assertion, no matter how many times repeated, has not served to eliminate claims against accounting firms for their audit work. Is there any likelihood that valuation firms will not be expected to stand behind their work in the same way? I don’t think you would get very good odds from Jimmy the Greek on that happening. Once values of hard assets and intangibles are disclosed in financial statements, and the names of those responsible for preparing those values have also been disclosed, you will have to defend your values in court. How much will it cost to defend those values in litigation? The problem is simple to state and difficult to resolve. The accountants at the FASB act as if— and probably believe that—there is one value for any asset at a point in time, a value that can be derived and disclosed. In the real world things are more complex. • A block of stock representing 15% of the total shares outstanding is going to be worth more, or perhaps less, per share than a block of 100 shares. It will be worth more to
Reprinted with permissions from Business Valuation Resources, LLC October 2010
BusinessValuation Update
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Valuation Of Investment Properties: Be Careful What You Ask For
a buyer seeking control, and less if the owner wants to sell currently. FASB forbids the use of control premiums and blockage discounts. Sale of a block at a premium will cause tort lawyers to claim the company was undervalued and their client sold stock it shouldn’t have, whereas if the block sells at a discount the same lawyer will find a client who bought and allegedly suffered a loss. • The fair value of equipment in a factory dedicated to a single product, or product line, is going to fluctuate based on the current demand for, and profitability of, the products produced in the facility. If demand is strong and there are high gross profits, the FV of the factory and its assemblage is high, just at the time the company reports high earnings. If next year sales drop off, profits will be reduced, and the value of the equipment similarly will decline. Going to a FV reporting system means that in good years the value of the assets increases, and in bad years it decreases; this simply accelerates normal economic conditions, both up and down. Appraisers, in effect, will constantly be “behind the curve.” • A brand that has been purchased will appear as an asset. A brand that has been developed in-house, such as Coca-Cola or Apple, will not appear in any financial statement. Showing zero value for a good brand will cause a loss to someone.
• A class-action lawsuit has a potential liability for the company. How will an appraiser determine the true fair value of that liability, and what if the final settlement is materially different—either more or less? The appraiser most likely will be held responsible for his “error” in valuation. Developing and disclosing the fair value of all assets and liabilities is going to put valuation specialists at risk. In terms of fair value accounting, we may appear far removed. The proposals for FV of investment property, however, are the proverbial camel’s nose under the tent. Carried out, once this class of assets is being valued periodically, it will seem a natural result to FASB, and they will be able to point out, “Well, we already are requiring FV of investment property and companies seem to be able to comply with that. So what’s the problem?” As the proverb says, “Be careful what you ask for. You may get it!” Valuation specialists may initially welcome adoption of fair value accounting by FASB through adoption of the investment property requirement; the longer-term risk/reward ratio may not be in our favor. Developing the value of investment real estate, called for in this initial proposal, may seem almost risk-free. Look ahead, however, and the road is marked by a lot of potholes. Alfred M. King is vice chairman and senior technical director for the National Financial Valuation and Consulting Practice of Marshall & Stevens Inc.
• If a company values its assets on an in-use premise but then has to sell the assets at a liquidation price, the prior fair values are going to be suspect, again drawing attention from class-action lawyers.
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BusinessValuation Update
October 2010