In 2008, the Accounting Standards Board of Canada (AcSB) announced that effective January 1, 2011, all profit-oriented Publicly Accountable Enterprises (PAEs) will be required to adopt a new framework for financial reporting known as International Financial Reporting Standards (IFRS). IFRS will replace Canadian Generally Accepted Accounting Principles (GAAP), a system of financial reporting that has been used in Canada since the 1960s. Depending on the level of preparation, the adoption of this new “common language” for financial reporting will be either challenging or rewarding for PAEs. While most companies have developed implementation strategies to manage the shift to IFRS, inevitably some issues will be “lost in translation”. From a hotel appraiser’s perspective, the main issues that have arisen in the transition period have been the difference between the Property, Plant, & Equipment and Investment Property asset classes, and how these classifications impact the choice between the cost or fair value method of measurement.
Who will be impacted?
First, it is important to clarify who will be impacted. Although private hotel owners will have the option of voluntarily adopting IFRS, the AcSB will only require PAEs to submit IFRS-compliant balance sheets starting in 2011 (with comparatives for 2010). So for a company with a December 31 year-end, it will convert to IFRS on January 1, 2010 and report its first full IFRS financial statements in 2011 with comparatives for 2010. The AcSB defines a PAE as a for profit entity that “has issued…debt or equity instruments that are, or will be, outstanding and traded in a public market” or “holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses.” This definition includes Real Estate Investment Trusts (REITs), publicly traded companies, and pension funds, who in recent years have become the largest holders of hotel real estate in the country.
Which Asset Class for Hotels?
Under GAAP, hotel real estate assets are listed on the balance sheet under a broad tangible asset class called Property, Plant, and Equipment (PP&E). This asset class will carry forward under the new IFRS framework (IAS 16); however, there will also be a new asset class known as Investment Property (IAS 40). The main differences between PP&E and the new Investment Property are as follows:
Examples of investment property: [IAS 40.8]
- land held for long-term capital appreciation
- land held for undetermined future use
- building leased out under an operating lease
- vacant building held to be leased out under an operating lease
- property that is being constructed or developed for future use as investment property
The following are not investment property and, therefore, are outside the scope of IAS 40: [IAS 40.5 and 40.9]
- property held for use in the production or supply of goods or services or for administrative purposes
- property held for sale in the ordinary course of business or in the process of construction of development for such sale (IAS 2 Inventories)
- property being constructed or developed on behalf of third parties (IAS 11 Construction Contracts)
- owner-occupied property (IAS 16 Property, Plant and Equipment), including property held for future use as owner-occupied property, property held for future development and subsequent use as owner-occupied property, property occupied by employees and owner-occupied property awaiting disposal
- property leased to another entity under a finance lease
It is estimated the majority of commercial real estate held by PAEs will fall under the Investment Property asset class, as typical office, retail, and industrial owners lease out their property to generate rental income. However, hotels are unique insofar as the vast majority are owned and occupied by the same entity, and thus, may be classified as PP&E or Investment property depending upon the ownership and usage. While this may seem like a trivial accounting exercise, as you will find out, it plays a central role in informing the choice between cost and fair value asset measurement.
Cost vs. Fair Value Measurement
One of the most confusing aspects of the transition period to date has been the one time choice to stick with the historic cost method of asset measurement used in GAAP, or to choose the new fair value method (IFRS 1 – First Time Adoption of IFRS). There are pros and cons of both approaches, and accountants and CFOs should be keenly aware of the impact their choice may have upon issues such as debt/equity ratio and share price. However, from a valuation perspective, there are a number of important things to bear in mind:
Under the Investment Property asset class, regardless of your choice, the fair value of the asset must be listed, either as your “deemed cost” value or in the notes section. Thus, the Investment Class is said to show a bias towards the fair value approach. Accountants that do not adopt the fair value approach simply double their workload. In the PP&E class, the choice is much more difficult, as IAS16 does not require the disclosure of fair value, should the cost method be chosen. After weighing the pros and cons, and choosing the initial method of recognition for establishing the one time “deemed cost”, there will also be a choice of adopting either the cost method or the revaluation method (fair value) for updating the amount carried on the books. The cost method is simple in this respect, as there will be very little change in measurement after recognition. However, as discussed above, the revaluation model (fair value) will provide a more accurate estimate of value. Given that the IAS16 regulations state that revaluations must be conducted with “sufficient regularity”, a large amount of discretion is placed in the hands of accountants who will decide when revaluations are necessary (i.e. If asset values are thought to have changed).
The choice between cost and fair value for initial asset recognition and then cost and the revaluation model for updates, is a difficult one. In looking at the European adoption of IFRS in 2005, a survey conducted by the Institute of Chartered Accountants in England and Wales showed that almost all companies with properties in the Investment asset class adopted the fair value model, while only 20% of companies with PP&E classified assets chose to do the same. However, recently with everything that has happened with the global financial crisis, regulatory bodies and investors alike have become increasingly critical of the level of disclosure and its accuracy. Thus, while the easiest choice may be to stick with the old-standby cost approach, the fair value model provides a more accurate measurement of asset value.