An International Exploration of Financial Reporting Practices
in the Real Estate Industry
Robert Edelstein
Haas School of Business
University of California at Berkeley
Berkeley, CA 94720
edelstei@haas.berkeley.edu
Steve Fortin
Desautels Faculty of Management
McGill University
Montreal, QC H3A 1G5
steve.fortin@mcgill.ca
;Desmond Tsang
Desautels Faculty of Management
McGill University
Montreal, QC H3A 1G5
desmond.tsang@mcgill.ca
September, 2010
; Corresponding author. This paper is developed based on the unpublished report titled “Performance Measurement and Recognition of Real Estate Assets: An International Exploration of Reporting Practices
Adopted in the Real Estate Industry” and we thank the Real Property Association of Canada for its generous support on the project. We acknowledge the able research assistance of Francois-Pierre Dionne
and Jonathan Shen.
Abstract
The adoption of International Financial Reporting Standards (IFRS) has drastically changed the reporting environment of real estate firms around the world by allowing fair value accounting for their real estate investment properties. In this exploratory study, we examine the financial statements and disclosures of 33 international real estate firms to investigate how the implementation of IFRS has affected the reporting practices of real estate companies. We find that under IFRS, companies place more emphasis on net income and they are less likely to report alternative performance measure such as Funds from Operations (FFO). We also find that real estate firms seem to embrace the fair value reporting approach as most companies choose to report fair values of their investment properties in the financial statements. However, we find there is a wide variation across firms in terms of disclosure on how fair values are determined.
Keywords: International Real Estate; International Financial Reporting Standards; Investment Properties; Funds from Operations; Net Income; Fair Value Reporting
2
1. Introduction
International Financial Reporting Standards (IFRS), which was adopted by the European Union and many other countries in the world since 2005, has drastically changed the reporting environment of real estate firms by allowing fair value accounting for their real estate assets. Under IFRS, companies are now required to report their
1 While the U.S. real estate industry traditionally investment properties at fair values.
argues that depreciation expense is based on historical cost and assumes incorrectly that real estate asset values diminish predictably over time, IFRS allows companies to not
recognize depreciation expense for their investment properties.
The mandatory inclusion of depreciation in the calculation of net income in the U.S. has prompted some industry regulators (e.g., National Association of Real Estate Investment Trusts) to argue that net income is an insufficient profitability measure of real estate company performance. Consequently, the U.S. real estate industry is characterized by the widespread use of a voluntary performance measure known as Funds from
Operations (FFO) as an alternative to net income, where FFO is generally calculated by adding back to net income the amount of real estate depreciation and related gains and losses on real estate assets. However, under IFRS, the problem relating to depreciating real estate assets is addressed differently. As opposed to restatement of a performance measure like the approach adopted for the computation of the voluntary FFO measure,
real estate firms are now required under IFRS to recognize fair values for their
investment properties and no depreciation on these assets if the fair value method is
applied. Arguably, if the largest item omitted from FFO is accounting depreciation, the fact this expense is no longer recognized under IFRS net income may improve the
1 In addition, companies have the option to revalue their owner-occupied properties at fair values.
3
usefulness of the net income measure and may reduce the need for FFO. On the other hand, since fair value adjustments include unrealized gains and losses on real estate properties, investors may demand a more reliable measure excluding these gains and losses and the need of FFO may still remain. The first objective of this exploratory study is to examine whether international real estate firms under IFRS continue to report FFO or other similar alternative performance measures.
Under IFRS, companies have two options to report their investment properties: (1) at fair values on the balance sheet with unrealized gains and losses on the income statement (i.e., fair value method), and (2) at cost on the balance sheet, with fair values disclosed in the notes to the financial statements (i.e., cost method). Though fair values are required to be reported somewhere in the financial statements, managers have a
choice to not report fair values on the balance sheet and the associated unrealized fair value gains and losses on the income statement. Given the real estate market has been burgeoning since the adoption of IFRS in 2005 till before the recent financial crisis, it might have been beneficial for real estate companies to adopt the fair value method such that the unrealized gains related to fair value increases on their investment properties are reflected and emphasized on the income statement. Alternatively, unrealized gains and losses on investment properties, if they are substantial relative to the real estate companies’ rental and other income, can introduce enormous volatility to the net income measure when real estate values fluctuate with market conditions. Hence, managers may feel that it is not beneficial for their firms to include unrealized gains and losses in net income and may continue to adopt the cost method in accounting for investment properties, with fair value information de-emphasized and resorted to the notes to the
4
financial statements. The second objective of our study is to document what methodologies these real estate firms adopt in implementing IFRS fair value reporting.
Finally, we examine the disclosure practices of firms with regards to their real estate assets. IFRS requires firms to provide additional details on the assumptions and measurements of investment properties. In this study, we intend to evaluate the quality of the companies’ disclosures with regards to details on how real estate asset fair values are determined, particularly for the following aspects: (1) whether companies disclose the use of external appraisers in the determination of fair values for properties and whether companies explicitly state the standards and methodologies used in the calculation of fair values, and (2) whether companies provide additional details in the reporting of investment properties, and more particularly what seems to represent “best practices.”
By providing detailed documentation on the reporting practices of a sample of international real estate companies under IFRS, our study provides significant insights on the future of financial reporting for real estate companies in the world. The convergence to IFRS in Europe first started with the European Union (EU) when the European Parliament passed a resolution in March 2002 requiring all EU publicly traded companies to prepare their financial statements under IFRS. Since its adoption in 2005, around 7,000 EU publicly traded companies are now required to adopt IFRS. The adoption of IFRS by the EU has prompted many other countries around the world to also harmonize their
2 As of the end of 2009, more than 120 countries or national standards with IFRS.
2 For instance, the Australian Accounting Standards Board (AASB) had been working towards converging to IFRS and since January 1, 2005, Australian companies are required to follow the Australian equivalent of IFRS. In New Zealand, the Accounting Standards Review Board (ASRB) and the Financial Reporting Standards Board (FRSB) had devised their New Zealand equivalents to IFRS and had recommended early adoption of the new standards with mandatory adoption by January 1, 2007. In Hong Kong, the Hong Kong Institute of Certified Public Accountants had fully converted the Hong Kong Financial Reporting Standards to IFRS by the end of 2004, with the new standards effective for the financial periods starting January 1,
5
3 For the U.S. that constitutes the largest jurisdictions require or permit the use of IFRS.
market in the world, the Financial Accounting Standards Board (FASB) has also devised a “roadmap” for the total convergence to IFRS. In particular, a recent FASB meeting has
decided to issue an accounting standard update to be implemented in 2011 to first achieve convergence with IFRS on the accounting of investment properties. The proposed new rule attempts to adopt IFRS with regard to investment properties in a more restrictive setting requiring all companies to report their investment properties at fair values on the income statement instead of disclosures in the notes to the financial statements (Price Waterhouse Coopers, 2010).
The remainder of the paper is organized as follows: In section 2, we discuss existing reporting practices of real estate companies and provide details on the development of the new IFRS with regards to real estate properties. Section 3 outlines the sample selection process and describes our sample firms. Section 4 presents our findings and the last section concludes.
2. Existing Reporting Practices of Real Estate Companies and the New IFRS
In financial reporting, net income, computed according to Generally Accepted Accounting Principles (GAAP), is traditionally recognized as the key summary measure for company performance. For U.S. real estate companies, they are required to record their properties at historical costs and to include depreciation expense in the calculation of net income. However, the real estate industry argues that net income does not
2005. For Singapore, the Council on Corporate Disclosure and Governance (CCDG) had devised a plan of changes to the financial reporting framework since 2004 to converge its local accounting standards with IFRS. By May 2006, the Singaporean accounting standards and IFRS were almost identical despite minor differences in certain standards. 3 Source: www.iasplus.com
6
accurately reflect the profitability of real estate assets due to its inclusion of depreciation expense. As a consequence, the concept of FFO was developed. Yet, there has been continued debate among industry participants and standard setters on the reliability of the voluntary FFO measure as compared to the GAAP-governed net income measure, and academic researchers have provided mixed evidence on the usefulness of FFO versus net income (e.g., Fields, Rangan, and Thiagarajan, 1998; Gore and Stott, 1998; Vincent, 1999; Graham and Knight, 2000; Stunda and Typpo, 2004; Hayunga and Stephens, 2009; Ben-Shahar, Sulganik and Tsang 2010). At present, to our knowledge, there is no study documenting the use of FFO for international real estate companies.
Prior to the adoption of IFRS, international real estate companies had different accounting treatments for their real estate investment properties. For example, the U.K. government dictated that investment properties were to be revalued every year. The revalued amount was reported on the balance sheet, with the changes in market value of investment properties recorded as a reserve in shareholders’ equity. The New Zealand
standard was based on the standard in the U.K. but it gave managers the option to recognize changes in market value of investment properties as a revaluation reserve or as unrealized gains or losses on investment properties in the income statement. In Hong Kong, investment properties were carried at fair market values with changes in the fair market values of investment properties recorded in revaluation reserve. When the revaluation reserve is calculated as an accumulated deficit, a loss must be recognized on the income statement. In Australia, there were no specific accounting standards to govern the reporting of investment properties prior to the adoption of IFRS. Academic research on this pre-IFRS era, predominantly on examining investment properties for U.K. and
7
Australian companies, generally show that fair value estimates are less biased and more accurate measures of selling prices than historical costs (e.g., Aboody, Barth and Kasznik, 1999; Dietrich, Harris and Muller, 2001; Danbolt and Rees, 2004; and Barth and Clinch, 1998).
As an effort to harmonize accounting practices across its member countries, the International Accounting Standards Board (IASB) developed rules for investment properties, IAS 40 Investment Properties, under the IFRS. IAS 40 requires investment
properties to be recorded initially at cost but allows managers to choose between measuring investment properties at fair value or at cost subsequent to the initial recognition. If investment properties are measured at fair value, the associated gains and losses arising from changes in fair value should be included in the income statement. If investment properties are accounted for at cost, IAS 40 nonetheless requires the assessment of the fair value to be disclosed in the notes to the financial statements. In addition, the standard requires more detailed disclosures of the methods and assumptions
4 applied in determining fair value and of whether an independent appraiser is employed.
3. Sample Selection and Description of Sample Firms
In selecting our sample, we begin by examining firms that are included in the
5FTSE EPRA/ NAREIT Global Real Estate Index. As of January 2005 (i.e., the adoption
4 IASB also developed similar rules for property, plant and equipment under IAS 16. Under IAS 16, companies can choose to report their owner-occupied properties using the cost model or the revaluation model. Given that international real estate companies hold properties for investment purpose and they classify the majority of their real estate assets as investment properties, we focus on their reporting practices under IAS 40. 5 Though there are other major indices (e.g., MSCI Global Real Estate Index) that track real estate firm performances around the world, we elect to include firms that are listed in the FTSE EPRA/ NAREIT Global Real Estate Index because the constituent companies in this index are subject to stricter requirements. For example, they must be traded on an official stock exchange, have a minimum market
8
of IFRS), there were 247 real estate firms in the index representing 20 countries. We examine whether each of the 20 countries follow IFRS or have IFRS-equivalent standards and exclude countries/ jurisdictions that do not follow IFRS. As a result, our sample includes firms from 16 countries: Austria, Australia, Belgium, Denmark, Finland, France, Germany, Great Britain, Greece, Hong Kong, Italy, Netherlands, New Zealand, Singapore, Spain, and Sweden.
Our research requires detailed analysis of financial statement information and hand-collection of data. Hence, we choose firms with the largest market capitalization in each country (with sufficient data for analysis) for inclusion in our analysis. Our final sample consists of 33 firms. Table 1 lists the sample firms with their countries of
6 operation and market capitalizations as of the beginning of 2005.
[Insert Table 1]
We collect financial statements and other related financial information of the sample firms from the companies’ websites. Since all sample firms are public, their
financial statements are audited by independent accounting firms. Previous research (e.g., Pittman and Fortin, 2004) shows that financial statement information audited by the Big Four accounting firms (i.e., Deloitte & Touche, Ernst & Young, KPMG, and Price Waterhouse Coopers) usually implies more reliable financial information. Hence, we first examine whether our sample firms are audited by the Big Four accounting firms to ensure the overall reliability and quality of their financial information. In some countries, firms hire a single auditor to perform their audits whereas in others, two auditors must be
capitalization of $200 millions USD for Asian and North American stocks or ?50 millions for European stocks, and are required to provide audited annual reports in English. 6 We collect financial statements over the period of 2005-2009. However, we find that while firms’
financial reporting practices are different across firms, the practices are mostly stale across time. Hence, we choose 2005, the first year that IFRS was adopted, as the base year to conduct our qualitative analysis.
9
appointed. We find that sample firms that are required to hire a single auditor for their audit used Big Four auditors. For firms appointing more than one auditor, five sample accounting firms hire a smaller auditing firm in addition to one of the Big Four auditors and one company retained two Big Four firms. Figure 1 shows the distribution of the Big Four auditors for our sample firms.
[Insert Figure 1]
Examining the financial statements of each of these 33 firms, we find that our sample firms concentrate on various types of property investments. Though most of our sample firms are diversified REITs that invest in various types of property investments, they tend to concentrate on one or two types of properties. From the companies’ websites
and their annual reports, we are able to obtain information on their property investments. We summarize the sample firms by their major property investment types in Figure 2. Our sample firms are investing heavily in office and retail properties. It is interesting to note the low representation of residential REITs in our sample. One explanation is that REITs that concentrate on residential properties tend to require less capital investment and are more likely to be smaller or private entities.
[Insert Figure 2]
4. Key Findings
4.1 Extensive Use of FFO and Alternative Performance Measures
4.1.1 FFO Reporting
We first examine whether real estate companies that are subject to IFRS report FFO or other similar alternative performance measures. Interestingly, almost none of the
10