04 May 2020
The knock-on effect of having a lockdown is the significant impact on the real estate sector. Investor spend on London office buildings was down nearly 75 per cent in March 2020. This is likely to have an impact on the valuation of all business property under FRS 102.
What does FRS 102 say?
Under FRS 102 property is classified as Investment property (Section 16) or Property, Plant and Equipment (Section 17). Investment property is measured at fair value at each reporting date with changes in fair value recognised in profit or loss (paragraph 16.7). Property classified as Property, Plant and Equipment (PPE) may be measured using:
- the cost model – at cost less any accumulated depreciation and impairment losses (paragraph 17.15A); or
- the revaluation model – fair value at the date of revaluation less any subsequent depreciation and impairment losses with revaluations made with sufficient regularity to ensure that the carrying amount does not differ materially from fair value at the reporting date (paragraph 17.15B).
For Investment Property, and PPE measured using the revaluation model, the carrying value of a property at the year-end should be fair value (or an amount not materially different from fair value).
For PPE measured using the cost model, preparers of the accounts should reflect any impairment of the carrying amount of the property. Where indicators of impairment exist, preparers of accounts are required to assess the recoverable amount of the property which includes a determination of the higher of fair value less cost to sell and value in use of the property and recognise an impairment when the recoverable amount is lower than the carrying value.
Changes in the carrying value of a property should be considered for deferred tax implications.
Practical impact and interpretation for preparers
For investment property and PPE measured at revaluation, preparers will need to reflect the fair value of a property at the reporting date. In practice this will require a valuation exercise to be performed by the directors, which may involve the engagement of a property valuation expert.
The valuation expert’s report may include a material uncertainty clause in line with the requirements of valuation standards issued by the International Valuation Standards Council (IVSC). This reflects the significant uncertainty that arises where inputs available for a valuation are likely to reflect conditions that existed before the event and that these inputs may not reflect the underlying conditions at the reporting date. Where inputs have been adjusted to incorporate the impact of coronavirus, these may also lead to estimation uncertainty.
In the case of PPE measured at cost, preparers may need to determine the fair value of a property in assessing whether the carrying value exceeds the recoverable amount.
For entities with a December 2019 reporting date, there is likely to be little impact on the valuation of property at the reporting date because inputs used in the valuation calculation should be based on conditions that existed at 31 December 2019 when the impact of coronavirus on the property market would have been minimal. However, the accounts should include disclosure about the nature and estimated financial effect of the impact of coronavirus on post reporting date fair values.
For entities with a reporting during or after March 2020, there is likely to be some impact on the value of property at the reporting date as inputs to the valuation calculation will need to take into account the effects on the property market of coronavirus. When determining the inputs to use in the valuation done for March and later reporting dates, the impact of market changes which come to light subsequently may provide evidence of conditions that existed at the end of the reporting period. The valuation should take into account these conditions if they are adjusting events after the end of the reporting period. Due to the rapidly changing situation it may be difficult to determine what factors are indicative of conditions at the year end and what are indicative of factors arising after the reporting date and judgement will therefore be required.
For entities with reporting dates between December 2019 and March 2020, judgement will need to be applied to determine whether there is likely to be a significant impact of coronavirus on the inputs to the valuation.
- If a valuation expert has been engaged to assist the directors in determining the fair value of a property, they should contact the experts early to ascertain potential practical issues eg the valuation expert may normally require access to the property as part of their procedures. Some valuations may be able to be performed via a desktop review, but this may not be possible in other cases, for example for new or substantially redeveloped properties.
- Where the basis of valuation is the recent selling price of properties with similar characteristics (use, age, location etc) there may be no recent transactions and entities should consider whether such comparisons with properties sold pre-coronavirus remain appropriate.
- Entities with external funding should review their lending agreements and consider pro-active discussion with lenders as the following may affect covenant compliance:
- any reduction of the carrying value of a property will be reflected in the accounts (either as the result of a fall in fair value or an impairment), affecting both interest cover and asset carrying value; and
- the effect of new government measures around commercial and residential tenant protection on cash flows, and impairment of debtors.