introduction

Introduction

OverviewRole of Audit Firm

ASC 820ASC 805

Lease AccountingQuestions

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Role of Audit Firm

Statement on Auditing Standards No. 73 - Using the Work of a Specialist

• Provides guidance to the auditor who uses the work of a specialist in performing an audit in accordance with generally accepted auditing standards (GAAS)

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Role of Audit Firm

Specialist. A person (or firm) possessing special skill or knowledge in a particular field other than accounting or auditing. Specialists include, but are not limited to:

• Actuaries • Appraisers• Engineers • Environmental Consultants• Geologists

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Role of Audit Firm

• Real estate appraisers are valuation specialists in the area of real property.

• Often referred to as valuers • Must understand and use the language of

potential clients • Professional attributes: property valuation

(and valuation-related) skills, knowledge, education, experience and training

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Role of Audit Firm

Real property valuation specialists – essential team members.• Directed by auditor and company that the

auditor represents • Viewed as subject matter expert (SME)

by the audit and tax users of their services

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Audit IssuesRole of Audit Firm

• Land – quality of land sale data• Replacement Cost New – source and applicability of

data• Indirect Costs & Entrepreneurial Profit – market

support• External Obsolescence – market support• Downtime – market support• Above/Below Market Leases – support for market rents• Reimbursements – market support• Discounted Cash Flow – market support for key

underlying assumptions − 8 −

Role of Audit Firm

Real property valuation specialists may be required to: •Estimate fair value at highest and best use•Allocate a purchase price among land, building and site improvements and assist others with personal property and intangible assets•Evaluate asset impairment •Perform valuation assignments for other purposes (i.e., alternate use, etc.)

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Fair Value under ASC 820ASC 820

• The FASB issued ASC 820 (formally known as FAS 157), which defines fair value as, “the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

• Source: SFAS No. 157, Financial Accounting Standards Board, Sept. 2006

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Fair Value ObjectivesASC 820

• Make financial reports understandable, relevant, reliable, and comparable

• Provide greater transparency than historical cost-based measurements

• Define fair value• Establish a framework for measuring fair

value• Expand disclosures about fair value

measurements

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Fair Value ApplicationsASC 820

• ASC 820 applies to all other statements issued by the FASB where fair value is discussed and it amends previous statements that provided different definitions of fair value.

• It does not eliminate the practicability exceptions to fair value measurements in accounting pronouncements within the scope of the Statement

• Market participants include buyers and sellers in the principal or most advantageous market for the asset

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Fair Value – Standard Expressed in ASC 820ASC 820

• Intended to provide information to investors about the price an asset could be sold for at the measurement date

• Not intended to provide information on anticipated IRR or future results

• Retains exchange price notion in earlier FASB definitions of fair value

• Clarifies that the exchange price is the price in an orderly transaction between market participants and not a forced transaction

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Fair Value – Standard Expressed in ASC 820ASC 820

• The Board revised the definition of fair value in this Statement to refer to an orderly transaction, as do other definitions used in valuations for purposes other than financial reporting that are similar to fair value (for example, fair market value)

• Fair value is generally consistent with similar definitions of fair market value

• The FASB recognized that fair market value relates mostly to assets (property)

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Definitions - Some real estate assets affected before others:

ASC 820

• For all financial and nonfinancial assets recognized at fair value on a recurring basis ….

• For nonfinancial assets measured on a nonrecurring basis, such as impaired real estate

• For real estate investment companies investing in office buildings and the like, having a calendar year, and marking that investment to fair value on a recurring basis

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Definitions - Some real estate assets affected before others:

ASC 820

• Provides a new definition of fair value • Creates a framework for developing fair

value estimates (or opinions) • Requires additional disclosures for fair

value estimates (or opinions)

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Note the distinction between estimates and opinion:ASC 820

• Preparer of financial statements may estimate an asset’s fair value

• In other instances, a fair value opinion will be acquired from a valuation specialist

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Fair Value under IFRS 13, is effective after January 1, 2013

IFRS 13

• Fair value is the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties.

• A fair value measurement of a non-financial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.

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ASC 820 prioritizes valuation inputsASC 820

1) Identify exit market2) Identify market participants

a) Principal or most advantageous marketb) In-use or in-exchange

3) Identify valuation premise (highest and best use)

4) Determine market participant assumptions5) Apply inputs to valuation techniques6) Exit price/fair value

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Three Level HierarchyASC 820

Level 1• Quoted market prices in active markets for identical

assets• An active market for the asset or liability is a market in

which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available….

Example: Valuation of an investment in the stock of a publicly traded REIT.

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Level 2 - Directly or Indirectly Observable Inputs• Quoted market prices in active markets for similar

assets• Quoted market prices for identical or similar assets

in inactive markets• Inputs other than quoted prices that are

observable (credit risks, default rates, prepayment speeds, volatility index, interest rate and yield curves at quoted intervals)

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Level 2 - Directly or Indirectly Observable Inputs (continued) There are few transactions for the asset The prices are not current Price quotations vary substantially, either

over time or among market makers Little information is released publicly Inputs other than quoted prices that are

observable for the asset

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Level 3 - Unobservable Inputs• Allowed when observable inputs are not available• For situations when there is little, if any, market

activity at the measurement date• Reporting entity’s own assumptions about the

assumptions market participants would use• Most private companies and the equity and debt

securities in them fall into the Level Three category• Developed from the best information available in

the circumstances, which may include the reporting entity’s own data.

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Framework for Evaluating Fair ValueASC 820

Assumptions•Exposure to the market prior to the measurement date•Not a forced transaction (e.g., forced liquidation or distressed sale)•Sale of the asset occurs from the perspective of a market participant that holds the asset•The price is the one that would be received to sell the asset at the measurement date. The FASB determined that exit price is appropriate as it presumes current expectations of future cash flows pertaining to the asset.

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Framework for Evaluating Fair Value (continued)ASC 820

Reporting entity and valuation specialists need to determine:•The asset that is the subject of the measurement•For an asset, the valuation premise appropriate for the measurement (consistent with its highest & best use)•The principal (or most advantageous) market for the asset•The valuation technique(s) appropriate for the measurement

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Principal (or Most Advantageous) Market • Fair value assumes the sale of the asset occurs in the

principal market for the asset or, in the absence of a principal market, the most advantageous market. Principal market is the market … with (1) the

greatest volume and (2) the greatest level of activity.

Most advantageous market … maximizes the amount that would be received for the asset considering transaction costs ….

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Principal (or Most Advantageous) Market • Fair value is considered from the perspective of

the reporting entity, allowing for differences between, and among, companies having different activities.

• If there is a principal market for the asset, then the fair value measurement represents the price in that market, even if the price in a different market is potentially more advantageous.

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Transaction Costs• The price used to develop an asset’s fair value is

not to be adjusted for transaction costs. Represent the incremental direct costs to sell the

asset or transfer the liability in the principal (or most advantageous) market for the asset or liability … not an attribute of the asset or liability…[but] specific to the transaction ….

Do not include cost to transport the asset to or from its market (applies to personal property).

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Transaction CostsHowever, when disposition of the asset is typical for developing the fair value, then the disposition costs are included. ExampleIn developing fair value using a DCF model, where the market participant would anticipate disposition costs in the final year’s reversion amount, those costs are relevant in estimating what a buyer would be willing to pay for the asset.

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Identification of Market Participants• Buyers and sellers in the principal (or most

advantageous) market for the asset that are: Independent Knowledgeable Able to transact for the asset Willing to transact for the asset (not forced or

compelled)

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Identification of Market Participants• Determination of fair value uses the same

assumptions market participants would use to price the asset. The reporting entity identifies: Characteristics that distinguish market

participants The principal (or most advantageous) market for

the asset Market participants with whom the reporting

entity would transact in that market − 32 −


Highest and Best Use: Value In-ExchangeThe highest & best use of the asset is in-exchange if the asset would provide maximum value to market participants principally on a standalone basis. If the highest & best use of the asset is in-exchange, the fair value of the asset shall be measured using an in-exchange valuation premise. When using an in-exchange valuation premise, the fair value of the asset is determined based on the price that would be received in a current transaction to sell the asset standalone.

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The highest & best use of the asset establishes the valuation premise used to measure the fair value of the asset, specifically in-use or in-exchange. Fair value of an asset in-use is based on the use of the asset together with other assets as a group (at its highest & best use from the perspective of market participants), even if the asset … is aggregated (or disaggregated) at a different level for … other accounting pronouncements.

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Highest and Best Use• Management’s intention may not be relevant

unless by coincidence it indicates market participants’ assumptions.

• For real estate (and personal property), the highest & best use principle can have a significant influence on fair value.

• The highest & best use for the asset is based on its use by market participants, not the subject reporting entity.

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Initial Recognition• When an asset is acquired in an exchange

transaction for that asset, the transaction price represents the price paid to acquire the asset (an entry price). In contrast, the fair value of the asset represents the price that would be received to sell the asset (an exit price). Valuation specialists need to understand that

conceptually, entry prices and exit prices are different and entities do not necessarily sell assets at the prices paid to acquire them.

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Initial Recognition “In many cases, the transaction price will equal

the exit price and, therefore, represent the fair value of the asset or liability at initial recognition.”

In determining whether a transaction price represents the fair value of the asset at initial recognition, the valuation specialist needs to consider factors specific to the transaction and the subject asset.

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Initial Recognition• The transaction price may not represent the fair value…

at initial recognition if: Transaction is between related parties Transaction occurs under duress or seller is forced to

accept the price Unit of account represented by the transaction price is

different from the unit of account measured at fair value

Market in which the transaction occurs is different from the market in which the reporting entity would normally sell the asset

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Accepted Methods of ValuationASC 820

In selecting the appropriate valuation techniques, it is important to consider the availability of data to develop valuation inputs that represent the assumptions that market participants would use in pricing the asset … and the level in the fair value hierarchy within which the inputs fall.ASC 820 recognizes the three generally accepted valuation approaches: •Market (Sales Comparison) Approach•Income Approach•Cost Approach

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Accepted Methods of ValuationASC 820

• In some cases, a single valuation technique is appropriate

• If multiple valuation techniques are used, the results (respective indications of fair value) shall be evaluated and weighted (i.e., reconciled) as appropriate, considering the reasonableness of the range by those results

• A fair value measurement is the point within that range that is most representative of fair value in the circumstances

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Conclusion — Opportunities for AppraisalASC 820

• “Typical” valuation assignment• Client and Audit Firm will review• Results impact Client’s financial statements

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ASC 805Business Combinations

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OverviewASC 805

• ASC 805 requires that intangible assets, aside from goodwill, be recognized if: Contractual or other legal rights, such as patents

or trademarks, give rise to intangible assets, or The intangible asset can be separated or divided

from the acquired entity and sold, transferred, licensed, rented or exchanged individually, or in combination with a related contract, asset or liability.

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Tangible and Intangible AssetsASC 805

In accordance with ASC 805, the allocation of purchase price considers following tangible and intangible asset categories:Tangible Assets•Land•Building and site improvements•Equipment and/or FF&E•Tenant improvements

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Tangible and Intangible AssetsASC 805

Intangible Assets•Above/below market leases (leasehold value)•In-place lease value, inclusive of downtime costs, lease commissions and legal fees•Mark-to-market value of assumed debt•Mark-to-market value of assumed ground lease position•Customer (tenant) relationships

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Land ValueASC 805

Using the Sales Comparison Approach land is valued by comparing the subject site to similar, recently sold properties in the surrounding or competing area. This approach relies on the principle of substitution, which holds that when a property is replaceable in the market, its value tends to be set at the cost of acquiring an equally desirable substitute property.

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Building and Site ImprovementsASC 805

The Cost Approach is based upon the economic principle of substitution, which states that the price of an asset tends to be no higher than the cost of producing a substitute property having equal utility, available without delay. This approach considers all hard and soft costs and the three potential forms of depreciation:•Physical depreciation•Functional depreciation•External obsolescence

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Go-Dark Analysis (Land + Building and Site Improvements)

ASC 805

Alternatively, the combined value of the site and building improvements can be estimated via an estimate of the “as vacant” value of the property, with consideration given to the following:•Lease-up period (to stabilization)•Carrying costs, including all fixed and variable operating expenses•Lease-up costs, including tenant improvements, leasing commissions and legal feesTypically accomplished using a discounted cash flow analysis, considering market conditions

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Tenant ImprovementsASC 805

Tenant improvements for occupied space is a negotiable item and ranges from “as-is” to “turn-key.” The value of tenant improvements should be based on the cost of the original fit-out of the space, but current market data can be considered when actual costs are unavailable.

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Equipment and/or Furniture, Fixtures and EquipmentASC 805

Tangible personal property is defined as: “a right or interest in things of a temporary or moveable nature.” Typically valued using Cost or Market Approach methodology.

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Above/Below Market Leases (Leasehold Value)ASC 805

The value of above and below market leases is estimated by calculating the difference between present value of the rental income coupled with the expense reimbursement revenue of each tenant as set forth in the lease agreements and the rental revenue that would be generated for that same tenant space at a market oriented rate as of the acquisition date.

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In-place Lease ValueASC 805

Collectively, downtime costs, leasing commissions and legal fees are added together in order to calculate the in-place lease value. •Downtime costs represent the value of the revenue that would be lost during downtime, including all rents and reimbursements, if the property were purchased 100% vacant and were then leased to the existing tenants using market oriented lease-up assumptions. •Leasing commissions and legal fees reflect the estimated commissions/fees the landlord would have paid had they originated the leases in place on the acquisition date.

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Mark-to-Market Value of Assumed DebtASC 805

A mark-to-market adjustment (enterprise value component) for application to the free and clear estimate of property value is estimated by discounting the remaining loan payments at a market oriented interest rate and comparing the resulting value to the current principal balance. Factors that warrant consideration include loan-to-value (LTV) ratios, debt service coverage ratios (DSCR) and debt yield.

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Ground LeaseASC 805

The value of the leasehold position associated with a ground lease is estimated in the same manner in which the value of above and below market leases are estimated. An estimated market rent for the site is compared to the contractual rent obligation and the difference is discounted to a present value.

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Customer (Tenant) RelationshipASC 805

Reflects the value associated with establishing an ongoing relationship with tenants, which are anticipated to generate income to the landlord through new, future lease agreements. The value must be measured separately from the value of in-place leases and can be quantified as the value resulting from the income that the relationship will generate.

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Purchase Price Allocation StepsASC 805

1) Estimate the fair value of the real estate interest acquired

2) Fair value of land via sales comparison approach or mark ground lease to market using income approach

3) Value of building as if vacant using the cost and/or income approach

4) Estimate fair value of site improvements using the cost approach

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5) Estimate the fair value of tenant improvements (if paid for by the tenant) based on the cost

6) Estimate the fair value of in-place leases via an income approach

7) Estimate the above/below market lease fair value using income approach

8) Estimate customer (tenant) relationship fair value using income approach

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9) Estimate mark-to-market value of assumed debt using income approach

10)Allocate the fair value based upon the resulting purchase price allocation component values

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Conclusion — Opportunities for AppraisalsASC 805

• Niche Business • Client and Audit firm will review.• Results impact client’s future financial

statements.• Understand the accounting literature

before being engaged

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Lease Accounting

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Current Practices and New ConsiderationsLease Accounting

• The objective of the proposed standard is to ensure that all assets and liabilities arising from leases are reported in the financial statements in a consistent manner.

• As a result, the Boards concluded that certain fundamental changes are required and that the proposed changes address this issue.

• Any organization that is required to comply with International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (U.S. GAAP) will be affected by the proposed changes.

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The Underlying Asset ApproachLease Accounting

• The lessee would amortize the right-of-use asset based on the estimated consumption of the underlying leased asset over the lease term. Consequently, the higher the consumption rate, the more the income statement effects would resemble those that would arise from purchasing the underlying asset and financing it separately.

• The lower the rate of consumption, the more the income statement effects would resemble the rental expense pattern under current operating lease accounting.

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The Underlying Asset ApproachLease Accounting

• Where it stands ... Although the boards did not make any formal

decision, the IASB indicated an initial leaning toward this approach, if it is confirmed that it is operational and useful.

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The Interest-based Amortization ApproachLease Accounting

• The lessee would amortize the right-of-use asset on a systematic basis that reflects the pattern of consumption of expected future economic benefits (this is consistent with the 2010 Leases exposure draft) for those leases for which substantially all of the risks and rewards of the underlying leased asset have been transferred to the lessee.

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The Interest-based Amortization ApproachLease Accounting

• For leases that do not transfer substantially all of the risks and rewards of the underlying leased asset, the lessee would use an amortization approach that would result in recognizing total lease expense in a pattern that would typically resemble the rental expense pattern under current operating lease accounting.

• Where it stands ... Although the boards did not make any formal

decision, the FASB indicated an initial leaning toward this approach.

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Conclusion — Opportunities for AppraisalsLease Accounting

• Yet to be determined….• Large companies will use model-based

approach. Smaller companies may use outside help or complete analysis internally.

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Questions

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Contact Information

Michael P. Hedden, MAI, CRE, FRICSManaging Director

(646) [email protected]

Marc R. Shapiro, MAI, MRICSManaging Director

(973) [email protected] Johnson, MAI, CRE, FRICS

Partner(212) 872-5838

[email protected]

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About FTI Consulting, Inc.FTI Consulting, Inc.

FTI Consulting, Inc. is a global business advisory firm dedicated to helping organizations protect and enhance enterprise value in an increasingly complex legal, regulatory and economic environment. FTI Consulting professionals, who are located in all major business centers throughout the world, work closely with clients to anticipate, illuminate and overcome complex business challenges in areas such as investigations, litigation, mergers and acquisitions, regulatory issues, reputation management and restructuring.

www.fticonsulting.com

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introduction

Documents

fair value measurements

fair value applicationsasc

fair value objectivesasc

fair value standard

role of audit firmstatement

role of audit firmspecialist

fair valueexpand disclosures

advantageous market