PLUGGING THE EXPECTATION GAPS
Real estate assets such as land and buildings (or in valuation terms, real property interests) are, more often than not, significant assets of companies. These assets are commonly required by accounting standards to be reported at their fair values on the companies’ financial statements. It is therefore pertinent for the valuation process of such assets to be efficient and effective for the financial reporting ecosystem to function well.
Accounting standards, International Valuation Standards (IVS) and professional valuation bodies each stipulates its respective requirements for the valuation of real properties. Inevitably, the misalignment of expectations among the Reporting Entities, Valuers and Auditors do exist, resulting in inefficiencies for the financial reporting ecosystem.
ISCA, through its Financial Reporting Committee (FRC), FRC Valuation Sub-Committee and Property Valuation Working Group, has discussed, deliberated and studied the practical issues and pain points encountered by stakeholders in the valuation process. Under the leadership of our FRC immediate-past Chairman Prof Chua Kim Chiu and Chairman Reinhard Klemmer; FRC Valuation Sub-Committee immediate-past Chairman Keoy Soo Earn and Chairman Lie Kok Keong; Property Valuation Working Group Chairman Andre Toh Sern, and the contributions of various individuals, ISCA has developed a guidance (currently in draft form) for reporting entities when engaging valuers to undertake real property valuation for financial reporting purposes (the “Guidance”). The upcoming Guidance seeks to bridge the expectation gaps and facilitate the valuation process among the Reporting Entity, Valuer and Auditor. Feedback from targeted stakeholders is currently being sought on the Guidance.
At the inaugural IVSC-WAVO Global Valuation Conference 2018, ISCA’s FRC Valuation Sub-Committee Chairman Mr Lie presented a segment on “Real Property Valuation for Financial Reporting”. His presentation included an overview of the expectation gaps among stakeholders in the preparation of the valuation report for the purpose of financial reporting, why Auditors need to understand how valuation is performed, responsibilities of the Reporting Entity, how the Reporting Entity and Auditor should work with the Valuer and key requirements of SFRS(I) 13 Fair Value Measurement. He also shared some snippets of the upcoming Guidance and addressed questions from the floor.
This article captures some key highlights and insights from Mr Lie’s presentation.
EXPECTATION GAPS AMONG STAKEHOLDERS
Without timely planning and communications, expectation gaps can exist among stakeholders, namely, the Reporting Entity, Valuer and Auditor, when preparing the valuation report for financial reporting (Figure 1). Common issues/pain points include the following:
1) Valuation reports used are not fit for purpose: the valuation reports may have been prepared for different purposes (example, for financing), and the extent of the investigation could be just desktop;
2) Involvement of experts at short notice/last minute;
3) Auditors may not have sufficient valuation knowledge to understand the experts’ reports;
4) Reporting Entities may not want to get involved in the valuation process as they feel it is not their job and they already paid the professionals.
The above typically stems from a lack of understanding of each party involved in the valuation process and misalignment of expectations. The upcoming Guidance seeks to mitigate those gaps.
WHY DO AUDITORS NEED TO UNDERSTAND HOW VALUATION IS PERFORMED?
Auditor is responsible for conducting the audit in accordance with SSAs
Singapore Standards on Auditing (SSAs) are to be applied to the audit of historical financial statements, and require Auditors to exercise professional judgement and maintain professional skepticism throughout the planning and performance of the audit.
SSA 200 states that in conducting an audit of financial statements, an Auditor is to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement. Reasonable assurance is a high level of assurance and is obtained when the Auditor has obtained sufficient appropriate audit evidence.
What is sufficient appropriate audit evidence is a matter of professional judgement. The Auditor obtains an understanding of the auditee’s business context and exercises his professional judgement when designing audit procedures to determine what needs to be performed. The Auditor is also required to maintain professional skepticism whereby he looks out for consistency of valuation conclusion with other audit evidence, ensures that valuation conclusion is supported by appropriate evidence and performs alternative audit procedures if needed.
In the event that a Valuer is being engaged to perform a valuation and the valuation information is being used in the preparation of the financial statements, the Valuer is known as the management’s expert in this relationship (Figure 2). The Auditor is required by SSA 500 to assess if the Valuer’s work constitutes sufficient appropriate audit evidence (Figure 3), and he does this by:
a. Evaluating the competence, capabilities and objectivities of the Valuer
This is typically done through the review of the Valuer’s curriculum vitae and confirmation by the Valuer of its independence;
b. Obtaining an understanding of the Valuer’s work
The Auditor will typically review the terms of reference, purpose and objective of the Valuer’s work, roles and responsibilities of the Valuer and Reporting Entity, sources of data used and assumptions made in the valuation;
c. Evaluating the appropriateness of the Valuer’s work as audit evidence
The Auditor will typically review for the following:
(a) relevance and reasonableness of Valuer’s conclusion in the context of the business;
(b) relevance and reasonableness of methods, assumptions and data used;
(c) extent of investigation by the Valuer;
(d) limitations (if any) faced by the Valuer in carrying out the engagement.
Fair value estimates to be determined in accordance with the measurement framework in SFRS(I) 13
SFRS(I) 13 Fair Value Measurement defines fair value and sets out in a single SFRS(I) a framework for measuring fair value.
IVS 2017 states that “bases of value describe the fundamental premises on which the reported values will be based”. The bases of value include IVS-defined bases such as market value and non-IVS defined bases such as fair value under IFRS.
Under SFRS(I) 13, fair value is defined 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” (that is, the exit price from the perspective of a market participant that holds the asset or owes the liability).
Under IVS 2017, market value is defined as “the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowingly, prudently and without compulsion”.
For bank financing purposes, property valuers often use market value as the basis of value. However, for financial reporting purposes, SFRS(I) requires the basis of value to be fair value. While the definitions of fair value and market value are similar, there exists subtle differences. ISCA had previously commissioned a study, working together with the property valuers, to develop a guidance to assist property valuers in performing the valuation for financial reporting purposes. The findings of the study have been incorporated into the upcoming Guidance.
WHAT ARE THE KEY REQUIREMENTS OF SFRS(I) 13?
A fair value measurement requires the determination of:
- The characteristics of the asset being valued
Such characteristics include, for example, the condition and location of the asset, and restrictions, if any, on the sale or use of the asset;
- The valuation premise that is appropriate and consistent with the asset’s highest and best use
The highest and best use takes into account the use of the asset that is physically possible, legally permissible and financially feasible, as follows:
- Physically possible: takes into account physical characteristics of the asset as considered reasonable by market participants
- Legally permissible: takes into account any legal restrictions on use of asset
- Financially feasible: generates adequate returns to market participants;
- The principal (or most advantageous) market for the asset;
- The appropriate valuation technique
Three widely used valuation techniques are:
- the market approach: this approach uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities or a group of assets and liabilities, such as a business;
- the cost approach: this approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost);
- the income approach: this approach converts future amounts (example, cash flows or income and expenses) to a single current (that is, discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts.
In terms of the disclosure requirements relating to fair value measurements, SFRS(I) 13 requires the disclosure of the valuation techniques and inputs used to develop the fair value measurements; for fair value measurements using significant unobservable inputs (Level 3), the disclosure of sensitivity of the fair value measurements to changes in those unobservable inputs.
WHAT ARE THE RESPONSIBILITIES OF THE REPORTING ENTITY?
The Reporting Entity is responsible for the preparation of financial statements that give a true and fair view in accordance with the provisions of the Companies Act, Chapter 50, and Financial Reporting Standards in Singapore. The directors’ responsibilities include overseeing the company’s financial reporting process. For listed entities in Singapore, the Code of Corporate Governance requires Audit Committees to review significant financial reporting issues and judgements to ensure integrity of the financial statements. The responsibility of ensuring that the financial statements are true and fair lies with the Reporting Entity. Therefore, the Reporting Entity should remain intimately involved in the valuation process and work with both the Auditor and the Valuer.
HOW SHOULD THE REPORTING ENTITY AND THE AUDITOR WORK WITH THE VALUER?
The key is timely planning and communication.
It is important for the Reporting Entity to provide clear instructions to the Valuer through the establishment of terms of reference for the engagement. The terms of engagement should also be discussed and agreed on with the Auditor. Once the terms of reference are established, the Valuer is generally autonomous in his work.
The terms of reference would include the scope of work, purpose and date of the valuation, basis of valuation (which is fair value for financial reporting purposes), extent of investigation by the Valuer, and any known limitations and any disclosure requirements. As stated earlier, the Auditor is required to understand how the valuation work is performed. Hence, there should be discussions and sharing of key information among the Valuer, Reporting Entity and Auditor.
Further guidance relating to the engagement process among the Reporting Entity, Auditor and Valuer could be found in our upcoming Guidance. Snippets of the Guidance are shared below.
SNIPPETS OF THE GUIDANCE
The key objective of the Guidance is to facilitate engagement among the Reporting Entity, Auditor and Valuer, and to reduce diversity in practice. Key topics covered in the Guidance include:
- Key information required in the Valuation Report;
- Terms of reference which includes the scope of work, purpose of valuation, and basis of value;
- Disclosure of significant assumptions and limitations faced;
- A recommended workflow of the engagement process of valuation among the Reporting Entity, Valuer and Auditor (Table 1).
Table 1 Recommended workflow of the engagement process of valuation among the Reporting Entity, Valuer and Auditor
Mr Lie concluded the presentation with the key message that the Reporting Entity, Auditor and Valuer are to work together for an effective and efficient financial reporting ecosystem.
Lim Ju May is Deputy Director, and Felicia Tay is Manager, Corporate Reporting & Ethics, ISCA.