ARE LISTED PROPERTY COMPANIES IN SWEDEN READY FOR …475952/FULLTEXT01.pdf · statements in accordance with a single set of accounting standards, International Accounting Standards

Department of Infrastructure Division of Building and Real Estate Economics Royal Institute of Technology, Stockholm, Sweden

Master of Science Thesis no. 178

ARE LISTED PROPERTY COMPANIES IN SWEDEN READY FOR FAIR VALUE ACCOUNTING?

Stockholm 2003

By: Henry Muyingo Supervisors: Hans Lind Christina Gustafsson

Are listed property companies in Sweden ready for fair value accounting?

Acknowledgements

This thesis was written in partial fulfilment of the requirements for the award of the MSc degree in Real Estate and Construction Management at the Royal Institute of Technology in Stockholm. I would like to thank my supervisors Hans Lind and Christina Gustafsson who have been of tremendous help during the course of this work as well as Professor Stellan Lundström and all the staff in the Section of Real Estate and Construction Management. I gratefully acknowledge the assistance received from the board of directors of Sveriges Fastighetsägares näringslivsfond, that granted me a scholarship to carry out the study, as well as Ernst & Young Real Estate Group –Stockholm for sponsoring this study. As this study was to a great extent based on interviews I am indebted to all of you in Sweden, the UK and in the Netherlands that agreed to help me in my work by sharing your experiences and knowledge of the subject matter. A special thanks goes to my daughters Marion and Matilda for their patience, as well as to Helena Fennö, Sylvia Namagga, Mathius Sendawula, Julia Finkielsztajn, and Joris Bongenaar. Without you, things would have been tougher than they were. Stockholm 2003-01-24 Henry Muyingo

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Abstract

Title: ARE LISTED SWEDISH PROPERTY COMPANIES IN SWEDEN READY FOR FAIR VALUE ACCOUNTING?

Author: Henry Muyingo Department: Building and Real Estate Economics The Royal Institute of Technology, Stockholm Master thesis number: 178 Supervisors: Hans Lind Assoc. Professor, Royal Institute of Technology Christina Gustafsson, Managing Director, Swedish Property Index Keywords: Accounting standards, IAS 40, Swedish Real Estate Companies,

Fair value model, Property Valuation. The aim of this Masters thesis has been to find out if, and how, listed Swedish property companies have prepared themselves for the regulation passed by the European Parliament that requires all EU companies listed in a regulated market as well as companies preparing admission to trading, at the latest from 2005 onwards, to prepare their consolidated financial statements in accordance with a single set of accounting standards, International Accounting Standards (IAS). The thesis work has been concentrated on the analysis of the fair value model in IAS 40, investment property and how companies will measure the fair value of their property. The data and results for this study were collected through interviewing various actors in the real estate market in Sweden, the UK and the Netherlands on the use of fair value accounting for investment properties. Results from the study show that: • 57% of the listed Swedish property companies have started preparations to apply IAS by the year 2005 but it is not likely that any of the companies will change before 2005. • Currently there is significant divergence between some of the IAS and the RRs, which is causing some problems in the conversion process. However there is a general misconception that Swedish laws will need to be revised before the EU regulation can come into effect. • Changes in accounting principles will not affect the underlying cash flows and financial analysts will probably not take much notice of the new “ IAS profits”. • Unlike in the UK and the Netherlands, use of the fair value model will not affect the dividend payouts or remuneration policies in Sweden. But it will affect the accounting for long leasehold property investments in all of the three countries. • The fair value model was considered to have a lot of advantages over the cost model. • Listed Swedish property companies, unlike the English and Dutch companies, are not ready to adopt the use of the fair value model mainly due to the uncertainty surrounding the measurement of the fair values. • Measurement of the fair values will be based mainly on the discounted cash flow method. • In contrast to the companies studied in the UK and the Netherlands, Swedish property managers were distrustful of the exclusive use of external valuers.

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Sammanfattning

Titel: Är börsnoterade Svenska fastighetsbolagen redo att redovisa enligt verkligt värde?

Författare: Henry Muyingo Institution: Bygg- och fastighetsekonomi

Kungliga Tekniska Högskolan, Stockholm

Examensarbete nr: 178 Handledare: Hans Lind, KTH Christina Gustafsson, VD Svenskfastighetsindex Sökord: Redovisningsnormer, IAS 40, Fastighetsbolag, Verkligt värde,

Fastighetsvärdering, Enligt ett beslut i EU-parlamentet ska bolag vars aktier eller skuldebrev är noterade på en börs, upprätta sin externa redovisning enligt International Accounting Standards (IAS)/International Financial Reporting Standards (IFRS)1 senast år 2005. Syftet med detta examensarbete har varit att undersöka om och hur svenska börsnoterade fastighetsbolagen har förebrett sig för kravet om IAS som i praktiken kommer att medför redovisning enligt verkligt värde. Arbetet har koncentrerats till att analysera verkligt värde modellen i IAS 40 och hur fastighetsbolagen kommer att verkligt värdera sina fastigheter. För att får en uppfattning av hur redovisning av fastigheter enligt verkligt värde fungerar i praktiken gjordes ett antal intervjuer hos noterade fastighetsbolag och andra aktörer på fastighetsmarknaden i Storbritannien och Nederländerna innan intervjuerna i Sverige. Undersökningen visar att: • 57 % av de börsnoterade fastighetsbolagen i Sverige har kommit i gång med förberedelserna att redovisa enligt IAS/IFRS senaste år 2005 men det är osannolikt att noterade fastighetsbolagen övergår till IAS/IFRS tidigare än år 2005. • Det finns ett antal väsentliga skillnader mellan några IAS och RR vilket komplicerar konverteringsarbetet. Emellertid finns det en missuppfattning att det behövs några lagändringar innan beslutet om IAS/IFRS kan vara tillämplig i Sverige. • Ändringar i redovisningsnormer kommer inte att påverka företagets kassaflöde och finansanalytikerna troligen kommer inte att bry sig så mycket om de nya ”IAS vinsterna”. • I motsats till policyn i de engelska och nederländska fastighetsbolagen kommer tillämpning av den verkligt värde modellen inte att påverka utdelningspolicy eller ersättningar i de studerade svenska fastighetsbolagen. Men det kommer att ha en stor betydelse i frågan om leasingavtal. • Den verkligt värde modellen i IAS 40 ansågs att ha många fördelar över den kostnadsmodellen.

1 IAS har bytt namn till International Financial Reporting Standards (IFRS)

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• De undersökta svenska börsnoterade fastighetsbolagen, i motsats till de i UK och Nederländerna, är inte redo att välja verkligt värde modellen i IAS 40 mest på grund av osäkerheten kring värderingsprocessen och metoderna. • Undersökningen visar också på att bedömning av det verkliga värdet kommer, för det mesta, att baseras på kassaflödesmetoden. • I motsats till fastighetsbolagschefer i Storbritannien och Nederländerna är de svenska fastighetsbolagscheferna mycket negativa till att ha enbart externa värderare. • Den gemensamma tillämpningen av IAS/IFRS i Europa kommer att underlätta jämförelsen av noterade bolags finansiella rapporter och leda till mer fokus på bolagsledning och dess effektivitet. Men än så länge tillämpas inte gemensamma värderingsnormer i alla länder, eller ens i samma land, och därför rekommenderas fortsatt försiktighet gällande rapporterna.

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TABLE OF CONTENTS Acknowledgements .................................................................................................................... 2 Abstract ...................................................................................................................................... 3 Sammanfattning ......................................................................................................................... 4 PART I. INTRODUCTION ...................................................................................................... 8 1.0 INTRODUCTION................................................................................................ 8

1.1 Background ................................................................................................................................... 8 1.2 Literature review ......................................................................................................................... 10 1.3 Objectives of the study................................................................................................................ 11 1.4 Limitations of the study .............................................................................................................. 11 1.5 Disposition .................................................................................................................................. 11 1.6 Definitions................................................................................................................................... 12

2.0 METHODOLOGY OF THE STUDY................................................................ 13 2.1 Study’s character......................................................................................................................... 13 2.2 Conceptual framework ................................................................................................................ 13 2.3 Research approach ...................................................................................................................... 13 2.4 Research perspective................................................................................................................... 14 2.5 Data collection ............................................................................................................................ 14 2.6 Analysis of the methodology used .............................................................................................. 15

PART II. THEORY.................................................................................................................. 16 3.0 ACCOUNTING THEORY ................................................................................ 16

3.1 Concepts of accounting theory.................................................................................................... 16 3.2 Principles of accounting theory................................................................................................... 17 3.3 Financial reporting ...................................................................................................................... 18 3.3.1 Financial ratios............................................................................................................................ 19 3.4 Fair value accounting in IAS/IFRS ............................................................................................. 19 3.5 Harmonization of accounting standards ...................................................................................... 20 3.5.1 Advantages of harmonization ..................................................................................................... 20 3.5.2 Disadvantages of harmonization ................................................................................................. 20 3.5.3 Interested parties ......................................................................................................................... 20 3.6 Harmonization of accounting standards in the EU...................................................................... 21

4.0 ACCOUNTING FOR INVESTMENT PROPERTY:IAS 40 ............................ 22 4.1 Recognition ................................................................................................................................. 22 4.2 Measurement............................................................................................................................... 22 4.3 Transfers to / from investment property...................................................................................... 23 4.4 Frequency and basis of revaluations ........................................................................................... 23 4.5 The fair value model ................................................................................................................... 23 4.6 The cost model ............................................................................................................................ 23 4.7 Consequences of the fair value model......................................................................................... 24 4.8 Effect of the uncertainty in the measurement of the fair value.................................................... 25

5.0 VALUE THEORY AND THE PRINCIPLES OF VALUATION..................... 26 5.1 Value theory................................................................................................................................ 26 5.2 Principles of property valuation: approaches and methods ......................................................... 27 5.2.1 The market (sales) comparison approach.................................................................................... 27 5.2.2 The income approach .................................................................................................................. 28

PART III. RESULTS AND CONCLUSIONS....................................................................... 30 6.0 FAIR VALUE ACCOUNTING IN PRACTICE ............................................... 30

6.1 Principles and practise of financial reporting in the UK ............................................................. 30 6.1.1 Effects of applying IAS 40 in the UK ......................................................................................... 31 6.1.2 Analysis....................................................................................................................................... 31 6.2 Principles and practise of financial reporting in the Netherlands................................................ 31 6.2.1 Effects of applying IAS 40 in the Netherlands............................................................................ 32 6.2.2 Analysis....................................................................................................................................... 33

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6.3 European Public Real Estate Association (EPRA)...................................................................... 33 7.0 IMPLEMENTATION OF IAS/IFRS BY SWEDISH PROPERTY COMPANIES........................................................................................................................... 35

7.1 Principles and practise of financial reporting in the Sweden ...................................................... 35 7.2 Differences between IAS and RRs.............................................................................................. 35 7.3 Effect of the harmonized accounting standards on the property companies. .............................. 36 7.4 Interview results .......................................................................................................................... 38 7.4.1 Preparedness for IAS/IFRS by listed Swedish property companies............................................ 39 7.4.2 Effects of fair value accounting .................................................................................................. 41 7.4.3 Measurement of the fair value of investment property ............................................................... 43

8.0 CONCLUSION .................................................................................................. 47 8.1 Preparedness for IAS/IFRS by listed Swedish property companies............................................ 47 8.2 Use of fair value accounting........................................................................................................ 48 8.3 Measurement of the fair values ................................................................................................... 48 8.4 Discussion ................................................................................................................................... 49 8.5 Closing remarks .......................................................................................................................... 50 8.6 Suggestions for further studies.................................................................................................... 50

REFERENCES......................................................................................................................... 51 APPENDICES.......................................................................................................................... 54

Appendix 1: Listed property companies ..................................................................................................... 54 Appendix 2: Interview questions.................................................................................................................. 55 Appendix 3: IAS/IFRS and their corresponding RRs ................................................................................ 57 Appendix 4: Decision tree for investment property ................................................................................... 58 Appendix 5: Property Companies and Financial analysts contacted: ...................................................... 59

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PART I. INTRODUCTION

1.0 INTRODUCTION

This chapter presents the background and a discussion of the problem. This is followed by the purpose and contribution of this study. Limitations to the study are also presented here. The chapter concludes with a disposition and a few basic definitions that are crucial to this study.

1.1 Background According to a regulation passed by the European Parliament and the Council of the European Union on the 27th of May 2002, all EU companies listed in a regulated market (about 7,000) as well as companies preparing admission to trading, will be required, at the latest from 2005 onwards, to prepare their consolidated financial statements in accordance with a single set of accounting standards, International Accounting Standards (IAS)2. Member States also have the option of extending the requirements of this regulation to unlisted companies and to the production of individual accounts. The regulation is aimed at helping to eliminate barriers to cross-border trading in securities by ensuring that company accounts throughout the EU are more transparent and can be more easily compared. This would in turn increase market efficiency and reduce the cost of raising capital for companies. The purposes and obstacles to standardization and harmonization have been frequently discussed in international accounting literature. Nobes, C. & Parker, R (2000) provides one of the more comprehensive descriptions of the questions connected with the issue. The International Accounting Standards Board (IASB)3- is an independent private sector standards-setting body founded in 1973 by professional accounting organizations in nine countries and restructured in 2001, to harmonize international accounting standards. Before the restructuring, the IASC issued 41 International Accounting Standards (IAS)4. The IASB represents over 120 accounting organizations from 91 countries. Of the approximately 7,000 registered companies in the EU, only 275 prepare their consolidated financial statements under IAS (Deloitte Touche Tohmatsu, 2001), therefore this requirement, if fully implemented is going to have far reaching effects. In order to meet requirements of financial reporting using IAS/IFRS, by the latest 2005, the companies concerned will have to start either preparing consolidated financial statements or retreating them according to IAS already in 2003 and 2004 so as to comply with IAS norms on first time application.

2 IASB publishes its Standards in a series of pronouncements called International Financial Reporting Standards (IFRS). It has also adopted the body of Standards issued by the Board of the International Accounting Standards Committee. Those pronouncements continue to be designated "International Accounting Standards" (IAS) issued by IASB 3 The International Accounting Standards Council (IASC) is the predecessor to IASB, which succeeded the IASC and assumed its responsibilities on April 1, 2001. 4 www.iasb.org.uk presents a detailed summary of the 34 current IASB standards. (Some earlier ones have been replaced).

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Swedish accounting practice for listed companies is to a great extent based on IAS through standards (recommendations) given by Redovisningsrådet5 (RR), and divergence occurs only when IAS is in conflict with Swedish laws, mainly the Swedish Annual Accounts Act. RR 24, Investment property is based on IAS 40, Investment Property, which prescribes the accounting treatment for investment property and related disclosure requirements. A major point of divergence between RR 24 and IAS 40 is that IAS 40 allows for a choice between a fair value model and a cost model whereas only the later is permitted in RR 24. Use of the cost model entails a requirement to disclose the fair value of the investment property in the notes to the financial statement. Swedish property companies are to start applying RR 24 to account for investment property in their financial statements covering periods beginning on or after 1 January 2003. For the first time all property companies will be required to disclose the fair value of their investment properties. At present most companies disclose the market value of their properties on a voluntary basis. At the latest 2005, property companies in Sweden will have to use IAS/IFRS in their financial reports and they will also be free to choose the use of the fair value model in IAS 40. The EU regulation will override the Swedish accounting laws. Careful thought is needed before a change from the depreciated cost model, as in RR 24, to the fair value model. “An enterprise should apply the model chosen to all its investment property. A change from one model to the other model should be made only if the change will result in a more appropriate presentation”. The Board states that this is highly unlikely to be the case for a change from the fair value model to the cost model.”6 In the exposure draft form of IAS 40, opponents to the fair value model felt that certain property markets are not yet sufficiently mature for this model, and that a rigorous definition of investment property is not possible. Value is created by the anticipation of benefits to be derived in the future.7 The whole purpose of accounting is to give an accurate view of a company’ s inner workings and true earnings by those holding this information. To reassure investors, shareholders and lenders, managers need to recognize information asymmetries and strive to minimize them. “Today, international trend is towards the use of fair value accounting. However the question of whether assets (and liabilities) on a balance sheet should be at historic cost or at their current or fair value has been debated in many contexts over many years”. (Damant, 2001) Recognizing fair values in the income statement leads to volatility in the reported earnings, volatility that is highly correlated to how the fair values have been measured. On the other hand, the use of depreciated cost creates a smoothing of the reported figures, which can have major consequences for an investor.

5 The Swedish Financial Accounting Standards Council 6 (IAS 40 §25) 7 The appraisal of Real Estate, 11th ed, Appraisals Institute

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1.2 Literature review Though the degree of maturity and other aspects of the Swedish real estate market has been documented in a number of studies and academic papers not much has been written in relation to Swedish property companies and accounting standards. Most of the work on financial reporting by Swedish property companies is either of an advisory nature from the property owner’s organization8 or has been concentrated on analysing the information contents in the reports. (Forsberg, M & Karlsson, A., 1995; Delwar N., 2001; Gunnarsson, E. & Hansson R., 1997) The Swedish real estate market is quite transparent and with highly educated practitioners as noted by McParland et al (2002, pp134) “ Use of the comparative method is popular in Sweden due to the high level of property market transparency as a result of the Land Data Bank System”. On page 130 they go on to write, “ 81% of the Swedish (property) appraisers had a Real estate postgraduate degree, only 16% in Germany.” Apart from a few articles on the need to undertake the conversion to IAS/IFRS as soon as possible, (Rippe, J. 2001; Lundmark, B. J., 2002; Arnell, G., 2001), there is an apparent lack of literature on the effects of fair value accounting covering the Swedish real estate market or investment property in general. Eccles and Holt (2001) and Ernst & Young (2001) provide a good insight on what the use of fair values will entail generally. The standards, accuracy and methods used in Swedish property valuation as well as the Swedish real estate market in general has been extensively studied by among others Ekelid, M. et al (1998); Mokrane, M. (2002); Jaffe, D. M. (1994); and Lind H (1998). The general conclusion is that the Swedish commercial real estate market is quite transparent and liquid and with an ever increasing degree of maturity.

8 www.fastighetsagarna.se

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http://www.fastighetsagarna.se/


1.3 Objectives of the study Given the apparent lack of literature on fair value accounting for investment property in Sweden I have chosen to take a closer look at four problems involved in the conversion to IAS/IFRS and the practicalities of IAS 40, Investment Property:

To list the main differences between IAS and RRs that will affect Swedish listed property companies, To find out if, and how, listed Swedish property companies have prepared for the required use of IAS/IFRS in their consolidated reports, To analyse how the measurement of fair value will be done, when using the fair value model, To identify, through a study of fair value accounting for investment properties in the U.K and Netherlands, the advantages and problems that might arise for Swedish Real Estate companies that choose to use the fair value model. The Swedish real estate market can be considered as mature but will Swedish property companies adopt the fair value model when allowed or are they going to retain the cost model that they are familiar with? It is of interest to find out what the use of IAS/IFRS will entail for listed Swedish property companies and in particular, how the companies will be affected through the choice of the fair value model in IAS 40.

1.4 Limitations of the study

This study is directed towards an audience that is well conversant with theories involved in investment property management. The comparison between IAS/IFRS and RRs covers only those standards and recommendations that were in use or effective by at the latest 1st January 2003. Though a range of investors other than property companies own investment property, this study is concentrated to Swedish real estate companies listed on the Stockholm Stock Exchange. Annual reports referenced to in this study are those of the property companies as of 31 December 2001. In analysing how the measurement of fair value will be done in Sweden, emphasis has been on commercial properties. In this study, fair value is defined as stated below and is used synonymously with market value. The question of recognition, transfer and disposal of investment property in IAS 40 is noted, but not analysed in any detail.

1.5 Disposition

This thesis work is divided into three main parts. PART I: Introduction – which comprises of chapters 1 and 2 presents the background, objectives of the study, limitations to the study, basic definitions that are crucial to this study and the methodology used in the study. PART II: Theory – consists of three chapters: Chapter 3 describes accounting theory, its uses and users as well as the advantages and disadvantages of different accounting methods. Issues involved in the efforts to harmonize accounting standards are also presented.

Chapter 4 describes IAS 40, investment property and some of the consequences of using the fair value model.

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Chapter 5 describes valuation theory and discusses the three main approaches to the valuation of commercial property in Sweden.

PART III: Results and Conclusions - consists of three chapters.

Chapter 6 describes the study on the use of fair values in the U.K and Holland and the effect that applying IAS 40 will have on listed property companies in those countries.

Chapter 7 presents the main differences between IAS and RRs that will affect listed Swedish property companies as well as the results of the study on if and how listed real estate companies have prepared for the required use of IAS/IFRS in their consolidated reports.

Chapter 8 presents conclusions from the study as to whether listed Swedish property companies are ready to apply IAS/IFRS and the fair value model in IAS 40. The chapter ends with as some suggestions to further research.

The thesis work also includes acknowledgements, references and appendices.

1.6 Definitions Investment property: is property (land or a building - or part of a building - or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both.9

Fair value: is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction”. (IASB)

Solidity: (Equity/assets ratio) is the shareholders’ equity plus minority interest as a percentage of total assets.

Return on equity: Profit for the period as a percentage of average shareholders’ equity.

P/L account: Profit and loss account.

IAS/IFRS: The IASB publishes its Standards in a series of pronouncements called International Financial Reporting Standards (IFRS). It has also adopted the body of Standards issued by the Board of the International Accounting Standards Committee. Those pronouncements continue to be designated "International Accounting Standards" (IAS) issued by the IASC.

RR: Redovisningsrådet, the Swedish Financial Accounting Standards Council. RR also denotes the Swedish accounting standards like RR24.

9 Definition in IAS 40 as of 2002-11-15. Currently IASB is reviewing this definition.

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2.0 METHODOLOGY OF THE STUDY

This chapter aims at giving the reader an understanding and a glimpse into the methodology that has been used in this thesis. The chapter starts with a description of the study’s character, followed by an account of the procedure of how the study was prepared and carried out.

2.1 Study’s character Research methodology refers to the method and procedural framework within which the research is conducted. It describes an approach to a problem that can be put into practice in a research process, which could be formally defined as an operational framework within which facts are placed so that their meaning may be seen more clearly. It also gives methods for the researcher to answer the research problems systematically. The choice of subject for this study came about because of the interest awakened by the course in real estate valuation and in particular, how valuations can be made more reliable. The ongoing debate about the merits of fair value accounting for investment property as well as the required use of IAS/IFRS in EU made the subject even more important and interesting as a research topic.

2.2 Conceptual framework There are two different conceptual frameworks from which to approach scientific studies, the positivistic and the hermeneutic frameworks. The positivistic approach is the basis for quantitative, statistical methods and the roll of the researcher is to be objective. The hermeneutical approach provides the basis for the qualitative studies whose main aim is to interpret and understand and in which the researcher has to be subjective. Though the study was to a great extent based on interviews, a combination of both the qualitative and quantitative research methods was best suited to achieving the objectives.

2.3 Research approach Five different approaches can be used to study a problem: explorative, descriptive, explanatory, predictive and prescriptive. (Lind, H. 2001)

• The explorative approach is used when the information on the subject is insufficient or there is limited knowledge of the subject area.

• The descriptive approach is used if a problem area already contains so much information that developed theory about the problem exists and is primarily used when the researcher is interested in showing the characteristics of a specific problem area.

• When a researcher aims to do a prognosis for the future development of a phenomenon, the predictive approach is used.

• The prescriptive approach is based on the researcher identifying what should happen or be done.

• The explanatory approach is based on the researcher observing a phenomenon and trying to explain why it occurs.

To study the research issue in this thesis a combination of the prescriptive, descriptive and explorative approaches has been used.

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2.4 Research perspective Induction and deduction are two of the different perspectives used in explaining the research problem. An inductive perspective is characterized by going from empirical reality to theory whereas a deductive perspective uses the opposite approach. An alternative is the abduction perspective which brings together the two aforementioned perspectives and in which the analysis of the empirical findings can be combined with or based on previous theories. In this thesis the abduction perspective was used in reaching a conclusion about the findings on preparedness and the theoretical frames of reference on property valuation.

2.5 Data collection There are two fundamental sources of data, primary and secondary data. Primary data is material collected by the researcher himself from original sources by means of interviews, questionnaires, surveys and observations. Secondary data is material that has already been collected such as books, articles, statistical reports and information on the Internet. For this study, the primary data collection consisted of interviews with property company Chief Financial Officers (CFO) or controllers. Discussions with financial analysts, property valuers and authorised public accountants were also used. The choice to use the interview technique instead of a questionnaire was due to the relatively small number of listed property companies in Sweden and the possibility to a deeper discussion. The companies were initially contacted by e-mail to present the study. Thereafter the persons concerned were contacted by telephone so as to book the interviews. The study has been concentrated on Swedish companies listed on the Stockholm stock exchange under the sub industry “real estate”. 15 companies were listed as on the 1st of November 2002.10 13 of these were contacted for interviews.11 Realia, which is listed on the Nordic Growth Market, was also included in the study in addition to three non-listed property companies12that are major actors on the Swedish property market. The interviews in London and Amsterdam were with accountants, financial analysts and property company managerial staff that had been referred to the author through real estate educational staff at different universities in UK or through contacts at conferences attended. In the UK contact was made with the two largest property companies, Land Securities and British Land. In addition to these companies very useful information was acquired through the accounting firm of Ernst & Young (Real Estate, Hospitality & Construction), as well as Mr. Anthony Holt,13 Kingston University London and Mr. Nick French.14, University of Reading.

10 See appendix 1. 11 Klövern, and Lundbergs företagen were not included in this study due to communication problems. 12 Vasakronan, APFastigheter and Skandia Fastigheter 13 Senior Lecturer in Accounting and Finance, Kingston University 14 Acacia Senior Lecturer in Land Management, University of Reading

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In the Netherlands four property companies15 were contacted but only two16 responded to the request for interviews. In addition to these companies useful information was acquired through Mr. Gert-Jan Kapiteyn17, Professor Gerjan Vos of the School of Real Estate Studies in Amsterdam, Mr Dirk Brounen and Dr Dick van Offeren at the University of Amsterdam, as well as Mr. Aart C. Hordijk MD of ROZ/IPD, the Netherlands Property Index. To find out how well the Swedish property companies were prepared for IAS/IFRS the study started by identifying some of the major divergences between RRs and their counterparts in IAS through the help of Mr Dan Phillips of Ernst & Young (Stockholm). The secondary data used was in form of literature on the subject of valuation of commercial real estate in Sweden and that of fair value accounting for non-financial assets and academic articles and papers found for the most part through journals on the Internet. The search engines used were: Google, EbscoHost, Helecon, KTH library and Emerald. Search terms used were: accounting standards, property valuation, fair value accounting and real estate. Most of the literature on valuation of commercial properties in Sweden referenced to in this study is in Swedish.

2.6 Analysis of the methodology used

Only two persons out of 17 did not respond to the request for interviews. Of the respondents, 10 answered the interview questions. The use of interviews gave the interviewees a chance to diverge into general questions in regards to applying IAS/IFRS that would have been missed in a questionnaire on IAS 40 only18. The answers received are quite representative for all of the listed Swedish property companies and can be relied upon for the conclusions as to whether listed Swedish property companies are prepared to apply IAS/IFRS by the year 2005 and the use of the fair value model in IAS 40.

15 Wereldhave N.V, Rodamco N.V, VastNed, Redevco 16 Wereldhave N.V and Redevco 17 A financial analyst at the investment bank of Amsterdam Effectenkantoor, 18 Though 15 minutes were requested most of the respondents added another 25-30 minutes!

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PART II. THEORY

3.0 ACCOUNTING THEORY

This chapter presents the accounting theories behind this study. It starts with a general presentation of financial reporting and ends with the effort to harmonize accounting standards in the EU. “Accounting is a system of measuring economic activity and communicating the result (of these measurements) to users”. (Kinserdal, 1995) To account, economic data must be recorded, measured and communicated. Recording has to be done in a systematic way as the economic events take place. It must be possible to record the event and the event must have a financial character. Thus many important events of value for the company fall outside the accounting system. Measurement must be made according to specific rules. Some of these are quite clear and indisputable; others are open to alternatives. In many cases there are various possibilities for measurement. These must be specified and written down as accounting policies. The final goal for accounting is to communicate the measured economic events to users usually in the form of a financial report. Accounting by the firm that is addressed to external users is what is normally known as financial accounting as opposed to management accounting (for internal use). Laws normally regulate the former and the strength of this regulation varies between countries. Though companies are required by law to account for the company’s financial standing, financial reporting is mainly aimed towards the investors. Among the other users of the reports are creditors, corporate staff, public authorities, suppliers and customers. The information contained in financial reports is used in a variety of ways: dividend policy decisions, staff incentives or salary negotiations, taxation purposes, portfolio management, benchmarking, credit control etc.

3.1 Concepts of accounting theory The four fundamental concepts underlying measurement in financial accounting are: • The firm as a separate unit with a life of its own. • The going concern: i.e. accounts are prepared and presented under the condition that the firm will continue. • The accounting period concept is a necessity of having economic information at certain intervals in order to know the result of decisions made and / or to make adjustments, for example in incentives/dividends. • The monetary concept, which means that accounting information, is expressed in monetary terms.

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3.2 Principles of accounting theory The six basic principles of financial accounting are: • The transaction principle: Records are built upon the transactions that take place. This puts a restriction on the types of economic events that are taken into the accounts and the timing for recording economic events. • The historical cost principle: Records show values based on purchase prices reduced by annual depreciations (book values). • The accrual principle: revenues and expenses measure the profit for a period, where expenses represent the cost in the period for a relevant item. • The matching principle: When measuring profit for a period, the revenues of that period have to be matched against those expenses necessary to generate the revenues. • The prudence principle: Assets and revenues should not be overvalued and liabilities and expenses should not be undervalued. • The principle of consistency: The same accounting principles and measurement rules have to be followed in adjacent accounting periods. Users of the financial reports have to be informed of changes in accounting principle and the report from the period before has to be adjusted according to the new principle so as to provide comparable reports. Proponents of value-based accounting models challenge the informational value of the historical cost model and mean that after acquisition, accounting measurement should continue to express market values. Market value can be expressed either as “ replacement cost” or “ fair value” i.e. what the sales price for the asset would be (as if sold). Figure 3-1: Three accounting models and their sub models:

Future total cash flows

Historical c

Price-level adjhistorical co

Source: Kinserdal, (1995)

Valuation of the specific assets

Historical total cash flows

ost Market values

usted st

Fair values Replacement values

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3.3 Financial reporting “Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence”(FASB, 1978) Typically, a company will have a number of assets and liabilities. An asset can either be something currently held by the company which can be sold to release capital, or something that is owed to the company by somebody else. A liability is an obligation of an entity to transfer economic benefits as a result of a past transaction or event, something that is owed. A balance sheet is simply the tabular representation of these assets and liabilities at a particular point in time. TOTAL ASSETS - TOTAL LIABILITIES = NET ASSETS (Net Worth) Net worth (Shareholder equity) consists of the capital invested and the retained profit. The profit and loss (P/L) account is one indication of the changes to the balance sheet over the year of trading. It aggregates the expenditure and income. If the company has been successful, a profit will accrue and this will be transferred to the balance sheet in the form of increased assets. If a loss has occurred the assets on the balance sheet will be reduced by an equivalent amount. The other key statement to explain changes in the balance sheet is the cash flow statement, which breaks the expenditures and income down into their component parts and reflects the actual cash movements rather than profits/losses achieved by applying the relevant accounting regulations. Property can be a substantial asset on the balance sheet of the company. It will also appear as a cost (rent for leaseholds, depreciation for investment property) and as an income (changes in fair value of investment property) on the profit and loss account. “Though the position of the company as declared in the company accounts might change, the underlying performance (cash flow) of the company will remain unchanged and if analysts concentrate upon the cash position and not the accounting profit then accounting changes will not impact on the market”. (Evans, M et al, 2001) The financial report also contains disclosure of any other relevant information and events that though not financial in nature have an important bearing to understanding the financial condition of the firm. For property companies this includes the full list of the properties and their locations.

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3.3.1 Financial ratios To condense the huge amount of data in financial statements into a manageable form financial analysts calculate a few key financial ratios to measure the company’s performance. These can be divided into 5 different types: 1. Leverage ratios: show how heavily the company is in debt e.g.

o Debt ratio and Times interest earned 2. Liquidity ratios: measure how easily the company can lay its hands on cash e.g.

o Current ratio 3. Efficiency ratios: measure how productively the company is using its assets e.g.

o Sales to assets ratio 4. Profitability ratios: show the return that the firm earns on its investments e.g.

o Net profit margin => (EBIT – Tax)/ Sales o Return on Assets ROA => (EBIT – Tax) / (Average total sales) o Payout ratio => Dividends/ Earnings

5. Market value ratios: show how highly the firm is valued by investors e.g. o Price-earnings ratio (P/e) => Stock price/ Earnings per share o Dividend yield => Dividend per share/ Stock price o Market to book ratio => Stock price / Book value per share

o Tobin’ s Q => costs.t replacemen Estimated

assets of ueMarket val

For property companies some of the other important information is: o Total rental space: The sum of leased and vacant space, including indoor garage o Annual rent: The sum of contractual rents and estimated rent for vacant housing plus market rent for vacant commercial space after reasonable refurbishment measures. o Surplus ratio: Operating surplus as a percentage of rental revenues. o Total return on like-for-like portfolio: Change in the market value of like-for-like properties during the year as a percentage of the opening market value of the properties.

3.4 Fair value accounting in IAS/IFRS “By embracing global accounting standards, Europe is embracing a vision for financial reporting that is not necessarily that widely known or understood. It is a vision that considers fair value measurement to be paramount, and rejects historical costs, accruals, and the realization principle as irrelevant. It regards the determination of taxable income or realized profits as having no place in financial reporting”. (Ernst & Young, 2001) Fair value is normally defined as the current market value of an asset19 but as evidenced by among others Lind, H (1998b), McParland, C. et al (2000), Dunckley, J (2000) and Mokrane, M (2002), even “market value” can be defined in a number of ways. Under a system of fair value measurement in IAS/IFRS, the measurement of income relies heavily on changes in the fair value of net assets. Income will be reported in a single statement of financial performance that aggregates all accrual-based income with all value changes whether realised or unrealised. This “ statement of comprehensive income” will include such items as the change in the fair value of assets and liabilities, the change in the fair value of real estate, profits or losses on the sale of fixed assets, or the profits and losses on the sale of subsidiaries. This statement will therefore produce financial ratios like solidity, shareholders equity and profit after tax that will differ substantially from those derived from the traditional cost based values. 19 IAS 40: §29

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3.5 Harmonization of accounting standards Increasingly the products of accounting in one country are used in various other countries. Consequently, the reasons that make national accounting standards desirable also apply internationally. The pressure for international harmonization comes from those who regulate, prepare and use financial statements. National accounting standards reflect the culture, history, and the characteristics of accounting problems facing that country. As a result, much of the 20th century has witnessed a high degree of variation in the international accounting practices. In 1973, the International Accounting Standards Committee (IASC) was formed. One of the main objectives of this committee was the harmonization of accounting standards around the world. Harmonization can be defined as the process of reducing the degree of variation in international accounting practices. However, though cost advantages may be a major attraction to harmonization, it is impossible to ignore the numerous obstacles against harmonization/standardization.

3.5.1 Advantages of harmonization 20 Some of the benefits associated with harmonization are: Cost and money saving accruing to multinational companies. Comprehensiveness and comparability of cross-national financial reports and international financial information. Removing barriers to international capital flows by reducing differences in financial reporting requirements for participants in international capital markets. Improving the quality of financial reporting.

3.5.2 Disadvantages of harmonization

⇒

⇒

⇒

⇒

The main users of accounting information differ between countries. The different user groups require different information. Investors need information that is relevant to investment decisions. The tax authorities require information produced with national standardized planning in mind. It is difficult to accomplish all these different financial reporting requirements within a certain standard without many alternatives and flexibility in the application of the standard.

The duty of standard setting is surrendered to a foreign institution instead of the elected representatives.

The process of accounting harmonization is very time consuming and as globalisation speeds up it will clearly be difficult as well as costly to keep the standards and the due process up to date.

Standardization tends to assume that all countries are at the same level in terms of economic development.

3.5.3 Interested parties Among the different parties that are interested in international accounting harmonization are governments, investors, bankers and lenders, accountants and auditors and multinational corporations as well as private individuals that would wish to provide for their pensions through cross-border investments.

20The argumentation here is based on Nobes C. Chapter 5 “ Harmonisation and international accounting standards” in Comparative International Accounting, 6th edition, Pearson Education, Harlow, England. Pp 66-92

20


3.6 Harmonization of accounting standards in the EU “For the EU there are a number of macroeconomic benefits accruing to harmonisation: Increased investment implies stronger job creation and GDP growth. Harmonization is also in line with the encouragement of pension provision through individual investment on a cross-border market due to shifting demographic structures and thereby implications upon traditional pension funding arrangements”. (Eccles and Holt, 2001) The adoption of IAS/IFRS by the EU is linked to the introduction of the Euro and moves towards a single European economy within the broadly recognised concept of the globalisation of capital markets and stock exchanges. It is also a bold attempt by the EU to create a power block that can turn the focus away from the use of the US GAAP by European companies active on an international level towards a uniform standard within the EU. The EU has previously attempted to harmonise accounting practice through directives. The most relevant ones to accounting are the 4th (Requirements for individual company accounts), the 7th (Requirements for group accounts) and the 8th (Audit requirements). However the degree of harmonization has not been uniform in the member states. Blake et al (1998) found that there are significant obstacles to accounting harmonisation in Europe and that there is potential for continuing diversity of national accounting practises. By utilising an established and non-European accounting standards framework, namely that of the IASB, the EU Commission avoids being accused of promoting the accounting framework of one member state over that of another.

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4.0 ACCOUNTING FOR INVESTMENT PROPERTY:IAS 4021

This chapter presents a summarised form of IAS 40 as well as a look at some of the consequences of using the fair value model in IAS 40.

4.1 Recognition IAS 40 specifies that an investment property (land or a building or even part of a building or both) is one which is held to earn rentals or for capital appreciation, or both by the owner or by a lessee under a finance lease. Investment property excludes property occupied by the parent or a subsidiary or fellow subsidiaries. However, investment property includes property that is leased to an associate or joint venture, which occupies the property, since associates and joint ventures are outside the consolidated group. Assets (e.g. land) held by a lessee under an operating lease should be recorded according to the requirement of IAS 17: Leases. Properties held for use in the production or supply of goods or service, or for administrative purposes are accounted for under IAS 16: Property, Plant and Equipment (PPE). Properties held for sale in the ordinary course of business are accounted for under IAS 2: Inventory. If the owner uses part of the property for its own use, and part to earn rentals or for capital appreciation, and the portions can be sold separately, they are accounted for separately. If the enterprise provides ancillary services to the occupants of a property held by the enterprise, the appropriateness of classification as investment property is determined by the significance of the services provided. Investment property must be recognised as an asset when it is probable that the future economic benefit associated with the asset will flow to the enterprise and the cost of the asset to the enterprise can be measured reliably. The cost of a purchased investment property is its purchase price and any directly attributable costs such as professional fees for legal services, property transfer taxes and other transaction costs. The cost of a self-constructed investment property is its cost at the date when construction or development is complete. Until that date cost is measured in accordance with IAS 16.

4.2 Measurement When an investment property is acquired or constructed, the enterprise should be able to determine its fair value reliably on a continuing basis. If in exceptional cases, there is clear evidence when an enterprise first acquires an investment property that the fair value of the property will not be able o be reliably measured on a continuing basis (because comparable market transactions are infrequent and alternative estimates of fair value are not available), then that investment property is measured using the depreciated cost model under IAS 16 until it is disposed of. However, if a property that qualified as an investment property when acquired or constructed has previously been measured at fair value, the property should continue to be accounted for under the fair value model until disposal under IAS 40 even if comparable market transactions become less frequent or market prices become less readily available.

21 Summarised from PricewaterhouseCoopers, (2001a) and Deloitte Touche Tohmatsu (2001b)

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The entire class of investment properties is measured using either the fair value model or the depreciated cost model, depending on the policy chosen by the enterprise. The fair value model requires investment properties to be carried at fair value at the balance sheet date. A gain or loss arising from a change in the fair value of investment property is recognised in the income statement. Under the depreciated cost model, investment properties are carried at cost less accumulated depreciation and any accumulated impairment losses.22

4.3 Transfers to / from investment property When there is a change in use of the investment property, the standard provides detailed guidance for subsequent classification. Investment property to be sold is re-classified as inventories, and investment property to be owner occupied is reclassified as PPE.

4.4 Frequency and basis of revaluations The fair value of investment property must reflect the actual market conditions and circumstances as of the balance sheet date. An independent and qualified valuer is not required by the standard but is encouraged. A highest and best use basis is used to determine fair value. Revaluations must be made with sufficient regularity that the carrying amount does not differ materially from fair value.

4.5 The fair value model Investment property is measured at fair value, which is the amount for which the property could be exchanged between knowledgeable, willing parties in an arm’s length transaction. Gains or losses arising from changes in the fair value of investment property should be included in net profit or loss for the period in which it arises. Fair value should reflect the actual market state and circumstances as of the balance sheet date. The best evidence of fair value is normally given by current prices on an active market for similar property in the same location and condition and subject to similar lease and other contracts. In the absence of such information, the enterprise may consider current prices for properties of a different nature or subject to different conditions, recent prices on less active markets with adjustments to reflect changes in economic conditions, and discounted cash flow projections based on reliable estimates of future cash flows. There is a reputable presumption that the enterprise will be able to determine the fair value of an investment property reliably on a continuing basis. However, if, in exceptional circumstances, an enterprise follows the fair value model but at acquisition concludes that a property’s fair value is not expected to be reliably measurable on a continuing basis, the property is accounted for in accordance with the benchmark treatment under IAS 16, Property, Plant and Equipment (cost less accumulated depreciation less accumulated impairment losses). Where a property has previously been measured at fair value, it should continue to be measured at fair value until disposal, even if comparable market transactions become less frequent or market prices become less readily available.

4.6 The cost model After initial recognition, investment property is accounted for in accordance with the benchmark treatment under IAS 16, Property, Plant and Equipment (cost less accumulated depreciation less accumulated impairment losses). 22 PricewaterhouseCoopers, International Accounting Standards Pocket Guide - July 2001, pp 22

23


4.7 Consequences of the fair value model According to Nordlund, B (2002), the inclusion of capital gains or losses arising from changes in the fair values in the net profit or loss of the period will have wide effects on the net income or loss of the company: 1. Solidity, which is the equity/assets ratio, will increase as the fair value of the investment

properties increases, if the fair value model is applied. 2. Total equity, (shareholder’s equity) which is the sum of restricted equity and the retained

earnings will increase tremendously as value changes will be included in the profit. 3. Volatility in the net income will increase if the fair value model is applied. Nordlund (2002) illustrates the above in the diagrams below:

Fig.1: Effect of fair value model on solidity

0,0 5,0

10,0 15,0 20,0 25,0 30,0

1995

1996

19

97

1998

19

99

2000

20

01

Perc

enta

ge

Solidity according to IAS40 fair value model

Solidity according to current standard

Fig.2: Effect of fair value model on equity.

0

500

1 000

1 500

2 000

2 500

3 000

1995

1996

1997

1998

19

99

2000

2001

Mill

ion

SEK

Total equity according to IAS 40 fair value model Total equity according to current standard

Restricted equity

Fig. 3: Effect of fair value model on net incomeas % of turnover.

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

1995

1996

1997

1998

1999

2000

2001

Perc

enta

ge

Res. Efter tax as %of turnover accordingto fair value model.

Res. after tax as % of turnover according to current standard.

The underlying idea behind the use of fair value as a measurement attribute is that fair value represents a market price. Market prices capture the consensus view of all market participants about an asset or liability’s economic characteristics, including assumptions about cash flows, profit margins and risk. However, there are ongoing discussions and wide disagreements on an international level as to whether unrealised gains or losses should be taken to yearly income or to equity. At stake is the question of what the profit and loss account should show, and the basis on which profit should be calculated.

24


The use of the fair value model will increase the focus on the accuracy of the reported values and the valuation procedure. Some of the arguments presented by opponents to the use of the fair model during preparatory work on the standard included the fact that “there is often no active market for investment property and that real estate transactions are not frequent. Furthermore certain property markets are considered not to be sufficiently mature for a fair value model to work satisfactorily”. (IAS 40 §B46 and §B47)

4.8 Effect of the uncertainty in the measurement of the fair value As stated by Wilson, A. (2001), “well established valuation models can produce significant variability in the range of reasonable fair value estimates for an investment property and even minor changes in the assumptions in the valuation models can significantly alter the results. The question of whether fair values are reliable is a primary concern to most financial statement users, regulatory authorities, preparers and auditors. In an ideal world with liquid and transparent markets this would not be a problem. However the real estate market is characterised by inefficiency and heterogeneity. Fair values are thus based on valuations and not observed prices. For assets traded in illiquid markets the volatility in reasonable estimates of fair value can provide a vehicle for discretionary upward or downward adjustments of balance sheet and income amounts. Even in the absence of an enterprise’s intent to distort reported fair values, the variability of reasonable fair value estimates from enterprise to enterprise may significantly reduce the comparability of financial statements among enterprises”. Valuation accuracy is dependant on among others the assumptions used by the valuer as well as the choice of valuation method used. According to Hoesli M. and MacGregor B.D, (2000, pp 80) “valuation accuracy has been the subject of several studies in which the general approach is to compare valuations with subsequent selling prices and results tend to show a high degree of correspondence between the two.” In a study of appraisers’ assumptions, Gustafsson (2002(a) pp7) notes that “ appraisers made correct judgements of the first year’s rent, underestimated investments, operating costs and maintenance and overestimated net operating income by approx. 9% which corresponds to a shift of 0,5 % on the required return as compared to the data reported by the property owners to the SFI/IPD property index and in the company reports”. A range of ± 10% on the appraised value is generally accepted in real estate valuations! This over or underestimating of the value will affect the profit and loss of a company when using fair values in the income statement.

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5.0 VALUE THEORY AND THE PRINCIPLES OF VALUATION

This chapter presents the valuation theories behind this study. It starts with a general presentation of value theory. Thereafter the principles and methods used in the measurement of fair value of investment property are presented. “Investment in Real estate, either directly or indirectly, by means of share ownership in listed property companies or Real Estate Unit Trusts, is one of a number of options available to an investor. However, unlike the other investment vehicles, like conventional bonds and ordinary shares, movements in the property market are tracked by valuation and not actual prices. Thus risk and return are positively correlated to the accuracy and appropriateness of the valuation method employed” (Hoesli, M. & MacGregor, B. D, 2000)

5.1 Value theory

Value represents the monetary worth of property, goods or services to buyers and sellers. Modern value theory can be divided into classical theory (attributes value to cost of production), Marxist theory (all value is a direct result of labour), Austrian theory (regards value as a function of demand) and the neoclassical value theory in which market forces tend towards equilibrium where prices and production costs meet. Economic theory suggests various concepts of value, which will apply to property as a factor of production. Real estate value is created, changed and destroyed in part by the interaction of four forces 1) physical 2) political 3) economic and 4) social. In order to facilitate the analysis of these value components, many definitions of value have developed. These include among others; investment value, use value, mortgage lending value and market value. “Despite the number of alternative definitions relating to value, the central axis on which most valuations are found is market value”. (Hoesley, 1992) A definition of value is an attempt to clarify the assumptions made in estimating the exchange price of a property if it were to be sold in the open market. Competitive conditions, more than one buyer and seller, rational behaviour, normal sale conditions and all other terms and conditions of the sale should be assumed to be normal. Baum and Mackmin, (1990) and Frykblom M. et al, (1998, p14-20), list some of the many definitions of market value that have been in use. Lind H (1998a) presents some interesting conclusions of what the definition of market value should not include! For financial reporting purposes IASB has endorsed the definition of market value as laid down by IVSC23 and TEGoVA24 in the Approved European Property Valuation Standards. “Market value is the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion”. The definition of fair value as stated in IAS 40 although worded differently may be regarded as synonymous with the above definition of market value according to IVSC. IAS 40 defines fair value as “ the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction”.

23 International Valuation Standards Committee 24 TEGoVA = The European Group of Valuation Associations

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In their discourse on the definition of fair value Sayce, S & Connellan O (2002) conclude “fair value is an imprecise term designed to give flexibility to accountants and their corporate clients. This may conflict with the needs of valuers who require specificity in the order to give consistent advice”.

5.2 Principles of property valuation: approaches and methods Valuation theory is the process of estimating, measuring or predicting a defined value. The aim of a valuation is to determine the price at which it is expected that a property asset might change hands in the free market. The three traditional approaches to valuation are: market (sales) comparison, replacement cost and capitalisation of income. Sales comparison approach Income approach Cost approach Area method Net capitalisation Depreciated replacement cost Net capitalisation Discounted cash-flow (DCF) Others Assessment value method Profits method Multiple regression analysis Others Production cost Others Table 5.2-1: Approaches to valuation and related methods

5.2.1 The market (sales) comparison approach This approach determines market values with reference to prices paid for similar properties in a free and open market in the region. For the purpose of analysis the prices paid are put in relation to factors, which influence the value of the property, such as the property’s net income receivable, rents, or let-able floor area. The supply of relevant market data is decisive for the quality of the result. In the area method and the like, the market value (MV) is estimated using the following formula:

MV = Price of comparable sales

Unit of comparison for comparablesunit of comparison for the property×

The net capitalisation method uses the relationship between observed transaction prices for comparables and the comparables’ annual net operating incomes (NOIc) at the time of transaction. Market value is calculated from

MVNOI p

=yield

where yield = NOIc

Pr ice

The assessment value method focuses on finding a market value through the relationship between observed transaction prices and the assessed values for tax purposes.

MV = property theof valueAssesedscomparable of Value Assesed

sales comparable of Price×

27


5.2.2 The income approach In general terms, the income approach is a form of investment analysis. It is based on a property’s capacity to generate benefits and the conversion of these benefits into a present value. Crucial in the use of this approach is the proper analysis of the pattern and duration of the property’s income stream as well as all the assumptions that will affect the expenses due to owning or managing the property. For commercial properties prices paid are most commonly put in relation to the net income receivable. This method is referred to as the income capitalisation method or residual earnings approach. The market value estimate is derived by capitalising one year’s normalised NOI using a market yield from commonly accepted rates of return (discount rates) on similar properties (not sales) in the market. The discount rate can be derived as the risk free rate rf + expected inflation + a market risk premium (that can be derived using the CAPM theory25) or as the sum of the yield demand on the property (y) and the property’s expected future change in value (g).

(1) r = rf + I +rrisk or (2) r = y + g The future change in value, g, is usually measured in terms of the expected annual growth in NOI. Market value estimates can be expressed as

MVNOI

y= or MV

NOIr g

=−

(also known as Gordon’s formula)

It is clear that this estimate is constituted on a comparative method. The Discounted Cash Flow method is appropriate for income producing properties as they are by nature heterogeneous and there is often lack of sufficient data from comparable sales. In the same manner as in an investment analysis the present value of expected future cash flows is estimated together with of the exit value at the end of the analysis period. The market value will be given by the sum of the present values of the annual NOIs during the calculation period (n years) and the present value of the calculated residual value (Rn) at the end of the calculation period. In its simplest form the DCF method delivers MV as:

MV = ( ) ( )n

nn

tt

t

rR

rNOI

++

+= 111∑

or:

MV = ( ) ( )n

nn

tt

t

rR

rITFUDH

++

+−−−−−∑

= 11)(

1

V = Present value H = Rental income I = Capital expenditures (investments) D = Operational costs R = Exit value U = Maintenance costs n = Analysis period F = Property tax t = Time variable T = Ground rent r = Discount rate

25 Brealey, R. and Myers, S.C (2000). Chapters 7 and 8

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According to McParland et el (2002 pp 134) “the majority of Swedish (65.6%) and Dutch (57.1%) valuers prefer to use the discounted cash flow method of valuation”. Simon, R and Rickardsson, L. (2002) report a “91% use of the DCF method in 2001.”

Though companies or valuers claim to use the DCF method it is would be more truthful to say that most valuations are done using a hybrid between the DCF method and the sales comparable method. In their study Ekelid M et al (1998, pp 390) investigated the use of various valuation methods by valuers in estimating a market value. They noted that despite using different methods, the estimated market values did not differ very much. “As we see it, the most probable explanation is that appraisers started from observed prices and capitalization rates and saw that the only way to reach this price level with a cash flow analysis was to assume that the actors had a low required rate of return. Sometimes appraisers suggested that a certain rate of return is “derived” from the market”. Treatment of the uncertainty and variations in the valuation of commercial properties has been studied by among others Ekelid, M et al (1998), McParland, C et al (2000), Mallison, M & French, N (2000). In his study on property valuation accuracy and consistency in five European countries26, Mokrane, M (2002) notes that the gap between actual sales prices and the valuations has diminished. Though a lot has improved, Hordijk A.C and Condit J.C (1997 pp 481) list some real estate market problems that are still evident today: • Full valuation reports are rare. No justification or explanation of the appraisal process or market analysis is included. • Definitions and concepts of market value differ. • In some countries the cash flow analysis is rarely used. • A lack of trained appraisers. • Owing to privacy restrictions, sales and property data in most countries cannot be obtained directly from public records; or, because of attempts to avoid high transfer taxes, the records contain incorrect and unreliable data. This real estate information barrier frequently causes reliance on client generated data. • Lack of standard terminology and definitions, both within and between languages. Often abstract concepts, such as market value and property rights, change meaning when translated. The Swedish property index recommends all its contributors to follow the guidelines laid down by SFI/IPD so as to ensure uniformity and transparency in the reported data. (SFI/IPD, October 1999).

26 The UK, France, Germany, the Netherlands and Sweden

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PART III. RESULTS AND CONCLUSIONS

6.0 FAIR VALUE ACCOUNTING IN PRACTICE

This chapter presents the results from the part of the study on fair value accounting carried out in the UK and the Netherlands. An analysis of the effects of applying IAS 40, based on the interviews done, is given for each of the countries.

6.1 Principles and practise of financial reporting in the UK In the UK, accounting standards are currently created by the Accounting Standards Board (ASB) and released as Financial Reporting Standards (FRS). Prior to 1990 and the creation of ASB, accounting standards known as Statements on Standard Accounting Practise (SSAP) were issued and enforced by six accounting bodies any of which could veto the standard.27 The ASB adopted some of the SSAPs (like SSAP 19: investment property) in addition to its FRSs. Although FRSs are actually not part of company law, they receive the backing of the law through an overriding requirement that financial statements show a ”true and fair view”. This is best achieved by applying the SSAPs and FRSs. Assets may be valued at historical cost, current cost or using a mixture of the two! Most companies prepare financial statements under the historical cost convention modified by the revaluation of certain fixed assets. All tangible fixed assets other than investment properties must be depreciated on a systematic basis and reviewed periodically for impairment. The true and fair view is given as the reason for requiring investment properties not to be depreciated but to be included in the balance sheet at their open market value. (McParland et al, 1999, pp 90) This value is for all practical purposes synonymous to the concept of ‘fair value’. Changes in the value of investment properties are taken to an investment revaluation reserve. Revaluations must be kept up to date and done at least once every 5 years by external valuers. In his survey, Mokraine (2002) notes that income capitalisation is the most popular valuation method used in the UK. Revaluation gains are normally recognised in the Statement of Total Recognised Gains and Losses (STRGL) not in the profit and loss account. English law requires that only realised profits at the balance sheet date may be included in the profit and loss account. In practise it is the accountants who determine what “ realised” means.

27 Choi F. D. S. et al (2002 pp 87)

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6.1.1 Effects of applying IAS 40 in the UK Though the application of IAS 40 will affect gearing levels, property companies are not planning any financial structural changes. However according to one of the interviewees, a notable effect will be the accelerated recognition of lease expenses. An effect of IAS 40 will be a change in the dividend policy so that it is not directly related to reported profit. Presently companies have started a downward adjustment of the payout ratio, which in effect will reflect a dividend payable on the realizable profit. Split accounting28 (of land and building) will be problematic as the constituents are to be considered as separable and their residual values may be of very different proportions. Valuations in the two studied companies were on a semi-annual basis and entirely by external valuers. Unaudited reports (quarterly reports) do not have the same requirement on full-scale valuation as in the annual report. Therefore desktop valuations are commonly used for the interim reports. As a precaution against uncertainty in the valuations, at times (often in cases of acquisition) up to 3 different valuers may be commissioned concurrently to undertake the valuation of a particular property or portfolio. Studied property companies will use the fair value model when required. ASB is currently reviewing SSAP 19 at the same time as IASB is reviewing IAS 40! Companies are still waiting for these changes before they start using the fair value model. They hope to save time and conversion costs.

6.1.2 Analysis The use of the STRGL has meant that property companies have had access to the use of a non-distributable / not realisable reserve, which has shielded earnings from the volatility, imbedded in fair values. Debts and credits are recorded at recoverable amounts and benchmarking against property indices has been an important factor in the determination of incentives and other remunerations. Financial report preparers in the UK feel that current accounting is straightforward and meets the needs of the users and that IAS 40 will introduce an unnecessary complexity in the accounts. The property companies in the UK look upon conversion to IAS 40 in its current form with fair values in the P/L account as an extra cost since they have been satisfied with SSAP 19. They are therefore waiting for the coming changes before they adopt IAS 40.

6.2 Principles and practise of financial reporting in the Netherlands Financial reporting in the Netherlands is quite similar to that in the UK in its emphasis on the use of a “true and fair view”. Guidelines on generally acceptable accounting principles are issued by a private organisation, The Council for Annual Reporting. However a unique Dutch system, The Enterprise Chamber (a specialist court connected with the High court of Amsterdam) enforces a legal compliance with accounting requirements. Interested parties may lodge complaints with this court if they feel that the financial statements submitted by a company do not comply with the accounting principles. The choice between historical cost and current value is in principle a free one. If the balance sheet has been drawn up on the basis of current value, the income statement should be based

28According to IAS 40 §8, if land and building can be sold separately, then they comprise of two different entities.

31


on current value as well. Nearly all companies apply historical cost but with a revaluation of tangible fixed assets. Changes in the current value are then recognised in a revaluation reserve. The current value can be based on replacement value, net realisable amount or recoverable amount. According to Nobes, C. & Parker, R (2000, pp 169), “by recoverable amount is meant not the higher of net realizable value and net present value, as in the UK, but “ the value, at the time of valuation, of net turnover imputable to goods or collection of goods, which may be generated by operating the business in which they are employed or for which they are intended”. Net realisable amount is the valuation base mostly used and the closest to “fair value”. Currently the “P/L account” is divided between the Direct Investment Result (DIR) and the Indirect Investment Result (IIR). The DIR is restricted to operational items, such as rental income, operating expenses, overhead expenses and interest expenses. According to IAS/IFRS, more volatile and one-off items such as realised and unrealised capital gains should be included here. These items are currently recorded under the IIR.

6.2.1 Effects of applying IAS 40 in the Netherlands

• Changes in fair values will no longer go into a reserve but straight into the P/L account. • Of particular significance to Dutch property companies will be the inclusion of realised and unrealised capital gains in the P&L. This will have a notable effect on Earnings Per Share (EPS) and Net Asset Value (NAV). • Another effect will be the provision for deferred taxes in the balance sheet on a nominal value. • Dutch investment institutions (a category in which most of the listed property companies fall) are required to pay out 100% of their fiscal profit. Companies however base their dividend on the commercial profit as stated in the annual report. • “Changes in the fair value of the real estate is not considered to be a basis for fiscal pay out and thus the inclusion of revaluations in the P/L account will not lead to any volatility in the pay-out! (Comment by interviewee). • Financial analysts will “ correct” or “restate” IAS/IFRS profits (including revaluations) to operational profit or Funds From Operations. • Valuation is annual and is expected to continue so. • The DCF method is mainly applied when valuing investment property. • Applying IAS/IFRS will force Dutch property companies to include that part of general management expenses (30-40%) that companies currently have charged directly to equity in the P/L account. This will affect EPS and subsequently dividends paid. • Calculations done by the Amsterdam Effectenkantoor show that on average EPS will be lowered by 4.3%. • “Property companies are already taking on lower payout policies from 100% to 75%-85%”. (Gert-Jan Kapiteyn, 2002)

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Table 6.2:1Effect of applying IAS/IFRS29

Company EPS 2001

Capital costs Per share

Adj. EPS 2001

+/- DPS 2001

Adj. DPS 2001

+/- Pay-out 2001

AdjustedPay-out 2001

In EUR In EUR In EUR % In EUR In EUR % % % Corio 2,28 0,08 2,20 -3,3 2,28 2,20 -3,3 100 100 DIM (in USD) 1,17 0,07 1,10 -5,9 1,04 0,97 -6,7 89 88 ECP (00/01) 1,32 0,08 1,24 -6,0 1,33 1,25 -6,0 101 101 NSI 1,34 0,00 1,34 0,0 1,34 1,34 0,0 100 100 Rod. Asia (00/01)

1,17 0,06 1,11 -4,9 1,17 1,11 -4,9 100 100

Rodamco Europe 3,39 0,13 3,26 -3,8 2,72 2,59 -4,7 80 79 Uni-Invest 1,26 0,00 1,26 0,0 1,40 1,40 0,0 111 111 VastNed O/I 3,16 0,23 2,93 -7,3 3,16 2,93 -7,3 100 100 VastNed Retail 4,01 0,48 3,53 -12,0 4,01 3,53 -12,0 100 100 Wereldhave 5,45 0,00 5,45 0,0 4,10 4,10 0,0 75 75 AVERAGE -4,3 -4,5 Source: Gert-Jan Kapiteyn, Amsterdam Effectenkantoor (2002)

6.2.2 Analysis Though Dutch property companies have reported property at market value Dutch accounting rules have allowed for a number of accepted procedures that will disappear with the application of IAS 40. The inclusion of all operating costs in the P/L account will lead to changes in the EPS and allow for a more transparent comparison of the companies. However, due to an insufficient number of interviews with the property managers themselves, it was impossible to make a proper conclusion on the managers understanding of the effects of applying IAS 40. Three of the four companies contacted answered that they did not have an opinion yet and some of the answers received were quite contrary to results from other sources30. Due to the above reasons this study has relied mainly on information collected from financial analysts and academicians.

6.3 European Public Real Estate Association (EPRA) Transparency and comparability is one of the major reasons for a harmonizing of accounting standards. The European Public Real Estate Association (EPRA) is a non-profit association primarily focused on promoting the European quoted real estate sector. Members (132 in 19 countries)31 are real estate companies, investment banks, pension funds, lawyers, accountants and business schools. "One of EPRA’s goals is to assist in pushing the industry forward by making the financial statements of public real estate companies in Europe clearer, more transparent and comparable across Europe so that we, collectively and individually, improve our reception amongst the investment community”. (EPRA, 2001)

29 Some of the companies listed here have since publication (2002-04-25) disappeared through mergers. 30 There appears to be wide disagreement in regards to the effect on dividends of including management expenses in the P/L account. 31 5 companies in Sweden, 31 in the Netherlands and 33 in the UK.

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EPRA is neither an accounting body nor a valuation body. Consequently, EPRA is not in a position to dictate specific accounting treatment or valuation approaches. “However, as accounting standards are in a state of transition from national standards to International Accounting Standards (IAS), EPRA can encourage consistent, supplemental reporting of income. Equally, EPRA can encourage consistent supplemental reporting of net asset values and fair value reporting of other assets and liabilities. Consequently, our recommendations in this area are intended to be carried out through a supplemental EPRA page which we would hope would be included in the financial statements of each public real estate company throughout Europe.”(EPRA, 2001 p3) According to EPRA 2001, p5: “The most important part of indirect income is the revaluation of the investment portfolio. The new IAS 40 on Investment Property permits the choice of two valuation methods for the investment portfolio: • Fair value • Cost IAS 40 does not state a preference for one of the two methods. However, the fair value model is new, and it is considered to be a step in the direction of fair value reporting of all investment and financial assets. Recommendation and Rationale We recommend that public real estate companies include a separate EPRA profit and loss account page that separately identifies operating activities, gains/losses on the sale of assets and revaluation gains/losses. Our recommended profit and loss account is presented in recommendation 1 (D)32. If each public company includes a standard EPRA profit and loss page, on a consistent basis, each company can select its own approach to the unrealised increases/decreases in asset value, consistent with IAS/IFRS and local GAAP requirements, while reporting results that are consistent with all other property companies”. Though IAS/IFRS has not yet been implemented in the UK or the Netherlands, there is an ongoing effort to provide comparable financial reports through the “EPRA page”. This in part reflects the reason why companies in the UK and the Netherlands are not rushing to apply IAS 40 as they feel that investors already have access to much of the information they need.

32 See www.epra.com

34

http://www.epra.com/


7.0 IMPLEMENTATION OF IAS/IFRS BY SWEDISH PROPERTY COMPANIES

This chapter presents the results from the part of the study on the preparation for applying IAS/IFRS as well as fair value accounting for investment property, carried out in Sweden.

7.1 Principles and practise of financial reporting in the Sweden In Sweden, listed companies apply recommendations issued by a private body, Redovisningsrådet (RR), the Swedish Financial Accounting Standards Council, whereas unlisted companies have to follow standards drawn by a public authority Bokföringsnämden, the Swedish Accounting Standards Board. RR’s recommendations are often as close as possible a direct translation of the corresponding IAS. Assets are recognised at historical cost though it is permissible to revalue if there is a rise in market value that is expected to persist. However this is rarely done. From 1st January 2003, RR 24, the cost model in IAS 40, requires annual valuations of the investment properties and that the fair values must be disclosed in the notes to the financial statements. It is recommended though not required that an external valuer do the annual valuation of the investment properties. In addition to applying the RRs, Swedish property companies also voluntarily follow recommendations on further disclosure published by FAR, the Swedish Institute of Authorised Public Accountants. As companies are required by law to practise caution in their dividend policies in relation to the company’s liquidity and long-term survival and dividend policies in all of the studied companies are based on “realisable” profits from ongoing property management.

7.2 Differences between IAS and RRs At present none of the listed Swedish property companies apply IAS in their financial reports, as not all IAS are compatible with the Swedish Annual Accounts Act. However the EU regulation that comes into effect on the 1st of January 2005 will have overriding powers over the Swedish laws. This has in part prompted the Swedish government to commission an investigation into the consequences of applying IAS/IFRS in Sweden. (DIR 2002:106).33 The report is expected to provide recommendations on among others whether IAS/IFRS should be allowed for unlisted companies and for other than consolidated company reports. The investigation is also to look into the question of whether some of the Swedish laws need to be changed so that even companies that are not required to follow the EU regulation can easily provide comparable financial reports that are compatible with Swedish law.

33 http://62.95.69.15 (go to Kommittédirektiv. Search on IAS)

35

http://62.95.69.15/


Table 7.2:1: Some IAS and the corresponding RR of interest to property companies34

IAS RR Title of IAS Major differences 2 2 Inventories None 11 10 Construction

Contracts None on the consolidated level.

12 9 Income Taxes In the context of acquisitions, a deferred tax liability may be discounted. 16 12 Property, Plant and

Equipment RR 12, allows write-ups in some specific cases, IAS 16 allows systematic revaluations of classes of assets, whereas RR 12 only allows revaluations under very strict conditions. RR 12 also applies to assets relating to agriculture (IAS 41, Agriculture). Finally, any revaluation of tangible fixed assets does not need to be kept up-to-date.

17 6:99 Leases None 18 11 Revenue None 23 21 Borrowing Costs The Annual Accounts act requires that a company that capitalises interest expenses

disclose the size of the capitalised interest in relation to the assets’ purchase price. 36 17 Impairment of Assets None 39 - Financial

Instruments: Recognition and Measurement

40 24 Investment Property Would require changes in the Annual Accounts act if applied before 2005. Source: Ernst & Young Real Estate- Stockholm and www.iasplus.com

7.3 Effect of the harmonized accounting standards on the property companies. Foreign investment in the Swedish property market in form of direct investment or equity ownership is on the increase. Foreign investor acquisitions rose from SEK 8 billion (EUR 0.9 billion) in 1999 to SEK 18 billion (EUR 2 billion) in 200235. According to figures from research consultancies DTZ and Byggstatistik, foreign investors owned SEK 67 billion (EUR 7.4 billion) worth of real estate assets at the end of 2002. An average of 13% of the share capital in listed Swedish property companies (ranging from 52,5 % in Tornet to 2,2% in Heba) is in foreign hands. A harmonization of accounting standards leading to more transparent and comparable financial reports will affect the ownership structure in the listed Swedish property companies as investors will have a better tool on which to base their cross-border investment decisions. Currently there are five Swedish companies36 that are members in EPRA and nine Swedish property companies included in the EPRA index.37 Table 7.3-1: Foreign equity ownership in some listed Swedish property companies. (31/12/2001)

COMPANY % OF EQUITY CAPITAL IN FOREIGN HANDS38

Castellum 34,5 Drott 19,5 Heba Fastighets AB 2,2 JM 8,9 Kungsleden 8,5 Mandamus Fastigheter 43,8 Realia 8,0 Tornet Fastighets AB 52,5 Wallenstam Byggnads 12,0 Wihlborgs Fastigheter 18,8 34 See appendix 3 for the full list. 35 According to Newsec , consultancy firm 36 Castellum, Catella Property Consultants, Drott, Pandox and Skandia Life Insurance Co. 37 Castellum, Drott, Hufvudstaden, JM, Kungsleden, Mandamus, Pandox, Tornet and Wihlborgs 38 According to the companies’ financial reports.

36

http://www.iasplus.com/


Listed Swedish property companies have geographically focused their direct investment on the home market. (Lind H, 2000; Fennhagen B. and Green T. 2002). When Worzala and Bernasek (1996) examined the impact of European economic integration on real estate markets within a number of member states they concluded that though economic integration will result in a single market for individual goods, services and factors of production, the special characteristics of commercial real estate make it unlikely that a fully-fledged single direct investment market will result. The harmonization of accounting standards, though affecting the ownership structure, will therefore have little impact on the geographical ownership of property on a cross-border level. Conversion to IAS/IFRS will affect the way the companies present themselves to investors and other users of its financial statements. There will be substantially increased levels of transparency for many companies- for example through-expanded segmental disclosures and the increasing use of fair values in reporting financial performance. This will further highlight the effectiveness of property management strategies. Compliance with all of the IAS/IFRS will entail using fair value accounting in a number of IAS/IFRS. Reported performance is dependant on among others such elements as the ownership structure, financial structure, extent of leasehold properties, amount of investment property as well as amount of properties under construction. But under IAS/IFRS, investment properties could be reported at fair value in IAS 40, whereas properties under construction will be reported at historical cost under IAS 16! Conversion to IAS/IFRS is much more than just an accounting procedure and will require good preparation by the companies.

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7.4 Interview results All of the interviews have been based on the same questions and are related to the theories presented above. The initial part of the interview questions was aimed at finding out how well the companies have prepared themselves for the requirement to apply IAS/IFRS by the year 2005. This was followed by questions on whether fair value accounting will have any effects on company policies like dividend payout. Finally the valuation of, and accounting for investment property under IAS 40 by the property companies was studied. Though all of the interviewees were asked the same questions, not all of the questions were answered at all times. This accounts for the varying number of responses in the results tables. The response was in part due to how well the respondent was conversant with the conversion process or IAS 40 or the individual’s interest of the particular question asked39. Though there were 15 respondents, the presented study results are based on the 10 respondents that answered the interview questions. As a reason for not granting interviews, three of the five that did not want to be interviewed responded that they had not started preparation at all40.

Table 7.4:1 Property Companies contacted:

SECURITY NAME PERSON CONTACTED

POSITION ANSWERED INTERVIEW

Ap Fastigheter Christer Nerlich CFO No No Castellum Håkan Hellström CFO Y Questionnaire Celtica Fastighet Ulf Holmlund Managing Director Y No 41 Drott Roger Johansson Controller Y Y Fast Partner Anders Larsson Controller Y No Heba Fastighets AB Frank Sadleir Controller Y No Hufvudstaden Magnus Jacobson CFO Y Y JM Hans Ekbom No No Kungsleden Johan Risberg CFO Y Y LjungbergGruppen IngaLill Berglund Controller Y No Mandamus Fastigheter Bengt Evaldsson +

Thomas Broberger CFO + Controller Y Y

Realia Erik Turai CFO Y Y Skandia Fastigheter42 Per Davidsson CFO Y Y Tornet Fastighets AB Soren Andersson Accounting manager Y Y Wallenstam Byggnads Marie Ideström Controller Y Questionnaire Vasakronan AB Thomas Kristoffersson CFO Y Y Wihlborgs Fastigheter Olle Knaust CFO Y No

39 The response frequency became somewhat biased towards questions regarding the fair value model which the respondents were most curious about than the cost model. 40 One of the remaining two was well under way in their conversion process but did not have time for an interview. 41 Celtica only owns an option to purchase a property, an option they presently do not intend to exercise. (2002-11-15) 42 Though not listed, the parent company is an insurance company and investment property will be accounted for under IAS!

38


7.4.1 Preparedness for IAS/IFRS by listed Swedish property companies43 Table 7.4:2 Question 1

Question answered Result based on respondents Comments from interviewees Position of person responsible for the conversion process:

CFO ..........................................7 Controller...................................7 Other ..........................................3

Table 7.4:3 Question 2

Question answered Result based on respondents Comments from interviewees Conversant with requirement to apply IAS/IFRS by 2005:

Yes.............................................13 No ..............................................3

“We follow the law!” (None interviewee)

Table 7.4:4 Questions 3 & 5

Question answered Result based on respondents Comments from interviewees If company has started preparations:

Yes.............................................8 No ..............................................9 (3 non listed!)

If project has separate budget: Yes.............................................1 No ..............................................9

“We have a budget for IAS 39. For the rest, we are reading on.”

Table 7.4:5 Questions 6 &7

Question answered Result based on respondents Comments from interviewees How company has prepared for conversion:

Internally....................................4 (seminars) External help..............................3 (auditors + courses) Not answered .............................2

“ We have had help from our auditors”

How far in conversion process company is:

Just started .................................3 Well underway...........................4 Not answered .............................3

“Started right now!”

Table 7.4:6 Questions 8 & 9

Question answered Result based on respondents Comments from interviewees If company is experiencing any problems with the conversion process

Yes.............................................4 No ..............................................0 Not answered .............................6

“ How does this fit in with the Swedish Company Act? Who will be responsible for the effects?”

If company has carried out a simulation test:

Yes.............................................0 Not answered .............................8 Partly .........................................2


Question answered Result based on respondents Comments from interviewees Plans to change financial structure: Yes.............................................1

No ..............................................4 Do not know ..............................3 Will depend on banks, etc .........1

“Changes in the financial structure would depend a lot on what the banks or other users of the financial statements want”.

43 Summation in column ‘ Results’ is based on those that actually answered that particular question.

39

Ernst & Young

Wallenstam, Drott, Tornet and Castellum


Summary of the results on preparedness for IAS/IFRS

The responsibility to oversee the conversion process has been delegated to the Chief Financial Officer in seven of the 17 companies studied, and the Controller in another seven. Companies are aware of the requirement on applying IAS/IFRS by the year 2005 but the conversion process in the companies is slow and only eight of the 16 companies concerned have started preparations. 2003 is seen as the year in which a lot of the preparations for conversion to IAS/IFRS will be carried out. Only four of the respondents mentioned effects of the other IAS/IFRS as of concern during the interviews! Of great concern was the question of First time application and how far back comparative data on the fair values would be required. Another of the questions that arose was that of how and when the Swedish Annual Accounts Act will change to fully accommodate for all the IAS/IFRS.44 There are a number of major differences between some of the RRs and IAS.45 The companies would not like to make unnecessary changes. Though Swedish property companies will be affected by the costs of adjusting their accounting systems to IAS/IFRS only one company of the 10 interviewed had a specific budget for the conversion process. According to the answers received, the main conversion problems encountered so far by the companies were mainly related to interpreting the effects of the standards, like IAS 39 (financial instruments) and IAS 12 (income taxes) that do not correspond fully to the RRs. Another problem was considered to be the fact that IASB is still working on changes in some of the standards (like IAS 40 and IAS 39). Responsibility for the changes in the company’s reported financial performance due to applying IAS/IFRS falls on the board of directors. However, this study has not been broad enough so as to find out how well the board members have prepared themselves for these changes. A majority of the interviewees (eight of nine respondents) feel that though applying IAS 40 will have a noticeable effect on solidity, this is not enough to warrant a change in the financial structure unless the creditors demand a restructuring. A change in the companies’ financial structure will depend more on IAS 39 (financial instruments) linking the loans and derivatives than on IAS 40. The financial analysts contacted during the study46 have not yet prepared themselves enough so as to give an opinion on whether they will consider the effects of the fair value model or not in their analysis.

44 An investigation by the Swedish justice department is under way on this issue and a report is expected in August 2003. 45 The EU regulation will override the Annual Accounts Act. Therefore this will not be an issue after 2005. 46 See Appendix 4

40


Discussion on preparedness for IAS/IFRS Results from these interviews are in line with a study done by PriceWaterhouseCoopers (2002) in which only 38% of the surveyed Swedish companies (total 53) had any working knowledge of the operational elements of IAS. 55% had already started or were planning to start preparing themselves during 2002. Among current users of IAS/IFRS, 64% of the surveyed companies in the financial services sector reported that conversion had taken longer than expected. Table 7.4:8: IAS/IFRS countdown

Timetable for companies with 31 December year-ends: Months left Deadline Action 1 month 1 January 2003: Opening balance for those who present 2 years of comparatives.

Start IAS/IFRS record keeping, e.g. financial instruments hedge 12 months 1 January 2004: Opening balance for those who present 1 year of comparatives.

Start IAS/IFRS record keeping, e.g. financial instruments hedge 28 months 31 March 2005: First IAS/IFRS interim quarterly statements 37months 31 December 2005 First IAS/IFRS financial statements Source: PricewaterhouseCoopers Many of the interviewees were under the wrong impression that Swedish law needs to be changed before the requirement on IAS/IFRS comes into effect and this seems to be one of the reasons as to the slow preparation process.

7.4.2 Effects of fair value accounting Table 7.4:9 Question 11

Question answered Result based on respondents Comments from interviewees If company is aware of the consequences that the application of fair value will have on equity and net income:

Yes.............................................6 Not answered .............................2 Not sure .....................................2

“Yes, and I do not like it.”


Question answered Result based on respondents Comments from interviewees If these consequences will lead to any changes in company policies, for example dividend payouts

Yes.............................................1 No ..............................................5 Do not know yet ........................2 Does not matter..........................147

“Companies will most probably increase their share of less volatile property like housing”


Question answered Result based on respondents Comments from interviewees If the recognition of unrealised gains and losses under fair value accounting will lead to changes in the remuneration system? How?

Yes.............................................0 No ..............................................8

“Bonuses are based on benchmarked management performance”

47 Dividend would go to the parent company.

41


Summary of the results on the effects of using the fair value model

If the fair value model is chosen then changes in the fair value will be included in the P/L account. Six of the 10 interviewees were aware of the effects on net income but they felt that even though IAS 40 affects the reported profit and loss it does not affect the underlying cash flow, which is a major factor in determining the “health” of the company. According to Carlsson, R and Hyltefors, A. (2000), pp 54, financial analysts preferred that property companies concentrate on reporting a good cash flow in order to increase the company’s market value. The financial analysts contacted during the study48 have not yet prepared themselves enough so as to give an opinion on whether they will consider the effects of the fair value model or not in their analysis. In order to smooth the volatility in the net income Swedish companies might increase the percentage of housing property in their portfolios. According to one of the eight interviewees, using the fair value model will result in a change of the dividend policy in that particular company. However the majority, five out of eight, felt that the use of the fair value model would not affect dividend payouts. They were sceptical to whether “unrealised gains” would be included in the dividend policy or in any remunerations policies and incentives that are currently based mainly on profit from ongoing property management operations. Discussion on the effects of using the fair value model One of the major accounting changes that will take place on applying the fair value model in IAS 40 will be the statement of the fair values directly in the P/L account. The merits, or not, of this change have been and are still a source of heated international discussion by professionals active in the real estate market. In countries like UK and Hong Kong lease structures have lead to classification problems and substantial loss of equity under the current49 IAS 40 definition of investment property50. “IAS 40 companies that adopt a fair value approach to investment property are required to revalue freehold investment properties but not allowed to report long leasehold property investments at fair value in the balance sheet. Instead they will be required to account for the long leasehold interest in accordance with IAS 17, Leases. As most, if not all, long-term leases are operating leases, this means that amount paid for a lease must be amortised over the period of the lease, in other words long leasehold properties must be carried at depreciated cost. This issue is particularly relevant to companies in the U.K, Hong Kong, Singapore, Netherlands, Sweden and Ireland.”(IVSC, 2001) Generally the interviewees are aware of the effects that using the fair value model will have on net income but as it does not appear to impact on the dividend policy or the remuneration policies, they do not seem to worry so much about it. The use of the fair value model is expected to lead to more focus on macroeconomic factors that affect the property market as well as to more effective property management so as to smooth the volatility in the net income.

48 See Appendix 4 49October 2002 50 www.hongkongland.com (annual report 2001) gives a very good example of the effect this might have on a company’s balance sheet. US$ 6.1 billion (88%) of shareholders’ equity was eliminated from the balance sheet at 31December 2000 on applying IAS 40 in its current form!

42

http://www.hongkongland.com/


7.4.3 Measurement of the fair value of investment property Table 7.4:12 Question 14

Question answered Result based on respondents Comments from interviewees Percentage of the company’s total holdings that is investment property?

80% →100.................................10 Less than 80...............................0

Table 7.4:13 Question 15 & 18

Question answered Result based on respondents Comments from interviewees If the company currently uses internal or external valuers?51

100% external ............................4 100% internal.............................2 Do not know ..............................2 No need for valuation ................1 Not answered .............................1

“ No one knows the value of our properties better than us.”

If the company has plans to increase its level of internal valuations?

Yes.............................................0 No ..............................................3 Do not know ..............................252 Not answered .............................5

“This has not been discussed.”


Question answered Result based on respondents Comments from interviewees How often the company carries out valuations on the properties?

Annually ....................................6 More frequently .........................153 Other ..........................................254 Not answered .............................1

“Frequent valuations of properties that are not for sale is just a waste of time. The reported valuation lags the market by up to 6 months!”


Question answered Result based on respondents Comments from interviewees The method used in the valuation55 of the company’s properties:

Only DCF method .....................3 Only Sales comparison ..............0 Hybrid56 .....................................3 Only income capitalisation ........2


Question answered Result based on respondents Comments from interviewees If the company’s current disclosure of the market value of its properties has had any noticeable consequences?57

Yes.............................................2 No ..............................................0 Do not know ..............................3 Not answered .............................1

“Analysts think this is good! But they all make their own calculations anyway.”

51 This information was corroborated with that in the annual reports. 52 One of the companies has just got a new management board. 53 Quarterly valuations of the same properties. (Approx. 50 and not intended for sale) 54 When needed or once every 3 years. 55 Corroborated with the information provided in the companies’ annual reports. 56 By “hybrid” I mean a combination of the DCF method and the sales comparable method. In some of the annual reports it is difficult to tell exactly what method is used in valuing the properties! 57 I started by reading the annual reports. Only those with information on market value were asked this question.

43



Question answered Result based on respondents Comments from interviewees Given the fact that the company already discloses market values, whether they see any disadvantages in continuing with the cost model?

Yes.............................................1 No ..............................................2 Not answered .............................2


Question answered Result based on respondents Comments from interviewees Do you see any advantages in using the fair value model?

Yes.............................................7 No ..............................................1 Do not know ..............................2


Question answered Result based on respondents Comments from interviewees Has your company decided on whether to use the fair value model or not?

Yes.............................................1 Not yet .......................................7 Not answered .............................2

““Not yet decided but most probably it will be the fair value model”

If yes, what was the main reason behind your choice?

Not answered .............................9 There is no choice......................1

“The fair value model is dangerous and misleading.”

Table 7.4:20 Question 22.2

Question answered Result based on respondents Comments from interviewees If no, what is stopping your company from making a choice?

Waiting to see what the market decides .......................................3 We have not discussed it yet......3 We have not yet analysed the alternative ..................................1 Not answered .............................2

Table 7.4:21 Question 22a

Question answered Result based on respondents Comments from interviewees Will the company use the fair value model?

Yes.............................................0 No ..............................................1 Do not know ..............................5 Most probably not......................2

“We are already practically in between the cost model and the fair value model in our reports.”

44


Summary of the results on the measurement of the fair value

According to the interviewees, all of the studied companies classify close to 100% of their holdings as investment properties! However the requirements on recognition of investment property in IAS 40 are such that all owner-occupied property is not investment property. Though valuation of the properties is annual in seven of the 10 companies studied, only four of the 10 listed companies practise a 100% external valuation of all of the property. The companies in the study that carried out internal valuations contracted external valuers to cross check the accuracy of the internal valuations. However discussions with the interviewees revealed reluctance towards a 100% external valuation of the investment properties despite the recommendation in IAS 40 to do so. This reluctance was claimed to be due to the uncertainty related to the valuation of real estate. According to three of the eight interviewees the DCF method was used exclusively in the valuation of the properties. The income capitalisation method was claimed to be the valuation method used exclusively by two of the companies while the remaining three companies utilise a hybrid method that combines the DCF method and the sales comparable method. Though one of the interviewees could not see any benefits in choosing the fair value model and actually considered it to be dangerous and misleading, use of the fair value model was considered by seven of the ten interviewees to have a lot of advantages as compared to the cost model. The following advantages of using the fair value model were identified: • The use of fair values will remove the current problem in which write-downs and write-ups are confused with actual value changes. • The use of fair values will remove capital gains in relation to book values. This will lead to a better judgement of how well property managers have done their job. • The use of fair values will increase the transparency between company reports. • The use of fair values will present a more truthful picture of what the company is “worth”. • The use of fair values will present the investment property at a monetary value. • Stating the changes of the fair values direct in the net income will highlight the consequences of the economic factors affecting the property values. In spite of the advantages identified, none of the studied companies is prepared to choose the fair value model instead of the cost model. All of the interviewees expressed concern over the fact that the size of the net income of the company would to a large extent be left in the hands of the valuers. According to one interviewee, “the Swedish property market was too thin to entrust external valuers”. The interviewees feel that the decision as to whether the companies should use the fair value model or not lies with the banks and the other users of the financial reports. Another factor that will determine whether companies choose to use the fair value model or not is uniformity and generally accepted practise in the branch in Sweden, as well as in the other European countries.

45


According to the respondents in the companies that have been publishing the market value of their properties58, users of the current financial reports were already being supplied with the information that comes with the use of the fair value model. However no major advantages had been noted because of this. Financial analysts make their own calculations and most probably will continue to do so even when companies use the fair value model. In their study of financial analysts’ choice of valuation models, factors and information sources, Malmer C. and Pettersson, J. (1999) conclude that “the fundamental factors that financial analysts give priority to is the P/E ratio, cash flow reports and management skill.” The only interviewee who had decided on whether to use the fair value model or not, was against it. Only one of the interviewees expressed the fact that the company would “most probably choose the fair value model”. Discussion on the measurement of the fair value

The interviewees expressed concern over the fact that companies using the fair value model will be overexposed to the “assumptions” used by the valuers. Though according to IAS 40 §26 “the use of an independent valuer is encouraged but not required” on the other hand, the principal-agency problem is known to occur in the real estate market and there is concern as to how members on the board of directors might react in a situation where they do not agree with the fair values presented to them. In their study of how valuations for the property reported to the Swedish property index were done, Simon, R and Rickardsson, L. (2002) reported a 78% use of external valuers and 22% internal valuations with 5% of the internally valued properties being controlled by external valuer! During a seminar arranged by The Swedish Society of Financial Analysts on the effects of the EU regulation on investment property valuations, professionals in the Swedish real estate market expressed concern not over the quality of the valuations but over the insufficient number of independent authorised valuers. This is a problem that might be encountered by Swedish property companies wishing to have an exclusive external evaluation of their investment property.

Some of the other effects of using the fair value model identified by the interviewees are: • The Balance sheet will appear to be more solid. This will be of interest to the capital markets and the investors. • Using the fair value model will introduce volatility in the net income. The question is whether Swedish property companies will diversify into more housing property so as to minimise the volatility. • The P/L account is going to be even more disconnected from the cash flow account than before.

58 Drott, Realia, Kungsleden, Wallenstam, Tornet, and Mandamus

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8.0 CONCLUSION

This chapter presents the conclusions from the study and some suggestions to further research on the subject. The aim of this study has been to find out how well Swedish property companies have prepared themselves to implement the EU requirement on IAS/IFRS by 2005 and whether or not these companies, in comparison to their counterparts in the UK and the Netherlands, would choose to use the fair value model in IAS 40. The study has also looked into how the measurement of the fair values of the investment properties will be done in Sweden.

8.1 Preparedness for IAS/IFRS by listed Swedish property companies

Though awareness of the requirement on applying IAS/IFRS by the year 2005 was high only approx. 57% of the studied companies had started preparations to convert to IAS/IFRS by 200559. Most of the property companies see 2003 as the year in which the preparations for conversion to IAS/IFRS will be carried out. Currently there is significant divergence between some of the IAS and the RRs, which is causing some problems in the conversion process. Also of great concern was the question of First time application and how far back comparative data on the fair values would be required. There is a general misconception that Swedish laws will have to be revised before the EU regulation on IAS/IFRS can be implemented! However the EU regulation will override Swedish law as of the 1st January 2005. Though responsibility for the changes in the company’s reported financial performance due to applying IAS/IFRS falls on the board of directors the responsibility to oversee the conversion process itself has been delegated mainly to the Chief Financial Officers or the Controllers in the property companies. This study has not been broad enough so as to find out how well the board members have prepared themselves for the effects of applying IAS/IFRS in the company’s financial reports. According to the interviewees, the advantages due to conversion outweigh the disadvantages, but none of the studied Swedish companies is likely to adopt IAS/IFRS before the year 2005. Companies feel that the requirement to apply IAS/IFRS in company reports is still a few years away and that a lot might change between now and 2005. Therefore the attitude is that of “wait and see” before making changes so as to avoid multiple costs. Studied companies in the UK and the Netherlands were generally more prepared for the conversion to IAS/IFRS than their Swedish counterparts. However they too had adopted a “ wait and see” attitude as the ASB in the UK is currently reviewing SSAP 19 at the same time as IASB is reviewing IAS 40! Through waiting for these changes companies hope to save time and conversion costs.

59 At the time interviews for this study were carried out (Sept. 2002- December 2002).

47


8.2 Use of fair value accounting One of the major accounting changes that will take place on applying the fair value model in IAS 40 will be the statement of the fair values directly in the P/L account. Of interest in this study was to find out whether choice of the fair value model in IAS 40 would lead to any structural or major policy changes by the property companies. The interviewees in all of the three countries were aware of the effects that using the fair value model would have on net income and were in agreement that this does not affect the underlying cash flow. However in Sweden, unlike in the other two countries, this would not affect the dividend payouts or remuneration policies that are currently based mainly on profit from ongoing property management operations. Though applying IAS 40 will have a noticeable effect on solidity this is not going to lead to any financial structural changes. A change in the companies’ financial structure will depend more on IAS 39 (financial instruments) than on IAS 40. The financial analysts contacted during the study have not yet prepared themselves enough so as to give an opinion on whether they will consider the effects of the fair value model or not in their analysis. A notable effect in Sweden of applying the fair value model in IAS 40 could be that of an increase in the percentage of housing property in the portfolios of some of the property companies. This will be done in order to smooth the volatility in the net income due to sector focusing. In the UK, a notable effect of applying IAS 40 will be the accelerated recognition of lease expenses as well as a change in the dividend policy so that it is not directly related to reported profit but to realizable profit. In the Netherlands applying IAS 40 will on average lower EPS by 4.3% and subsequently the dividends paid. Property companies in the three countries are affected by the fact that they are not allowed to report long leasehold property investments at fair value, which could wipe tens of billions of SEK off the value of land and buildings in the companies’ balance sheets. However IASB is working on an amendment in IAS 40, paragraph 4, so that will enable a lessee to account for the lease as if it were a financial lease.

8.3 Measurement of the fair values The use of the fair value model will increase the focus on the accuracy of the reported values and the valuation procedure as the fair values will be stated directly in the P/L account. Therefore, it was of interest to find out how the measurement of the fair values would be done and how this would affect the use of the fair value model in Sweden. In Sweden, measurement of the fair values will be based mainly on the analysis of cash flows. To minimise valuation inaccuracy an increased disclosure of the underlying valuation assumptions as well as the use of multiple valuers will be employed.

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From the 1st of January 2003 all of the listed Swedish property companies will have to carry out and report annual valuations according to RR 24. Previously, not all companies carried out or revealed results from the valuation of the investment properties. Though recommended both by the IASB and RR, only 40% of the studied Swedish companies have an exclusive use of external valuers. Interviews revealed a strong reluctance by the Swedish companies towards a 100% external valuation of the investment properties and currently none of the companies has any intentions of changing its valuation procedures. The fair value model is considered to have a number of qualities that will help to present a better and fairer picture of the companies. However the uncertainty associated with the measurement of the fair values and the volatility in the P/L account scares the Swedish interviewees from committing themselves to the fair value model. None of the studied Swedish property companies feels ready to adopt the use of the fair value model. Swedish property companies are going to wait to see what the users of the financial reports demand before they decide to commit themselves to the fair value model. Studied companies in the UK and the Netherlands, though against stating the fair values in the P/L account, are going to use the fair value model.

8.4 Discussion The Swedish real estate market is quite transparent and with highly educated practitioners as noted by McParland et al (2002). Therefore it was surprising to note the level of distrust towards external valuations expressed by the Swedish property managers in contrast to the companies studied in the UK and the Netherlands. The real estate market in Sweden is just a fraction of that in the above-mentioned countries but this does not in any way undermine the quality of the valuations performed in Sweden. According to IAS 40 §26 “the use of an independent valuer is encouraged but not required.” EPRA’s recommendation is that “ all valuations should be conducted by external valuers to maximise investor’s level of confidence in the objective nature of the valuation”. (EPRA, 2001, pp12). A positive effect of applying IAS 40 is deemed to be the increased focus on property management and the understanding of the strategies and economic factors that will affect the fair values and thus the company’s profit. Due to the changes in solidity and net income caused by the use of the fair values, company management will have to focus a lot more on informing investors and other users of the financial statements about the management strategies undertaken to minimise the volatility in the fair values. Focus on the effect of business decisions on the P/L account will increase.

49


Respondents in the three countries agreed that the use of fair values would increase the transparency between the reports. However caution is advised as the sense of transparency is undermined by the lack of a standardised valuation procedure, terminology and methodology that is in practise in all of the concerned countries. In its exposure draft form IAS 40 allowed only the fair value model! When passed, the cost model was retained as one of the alternatives in IAS 40. According to the IASB, “ this is the first time that the board has introduced a fair value accounting model for non-financial assets60and “the board believes that it is desirable to permit a fair value model. This evolutionary step forward will allow prepares and users to gain greater experience working with the fair value model and will allow time for certain property markets to achieve greater maturity.” It is most probable that the cost model will disappear as an alternative. Therefore, Swedish property companies should prepare themselves as if they were to use the fair value model. Despite the many positive effects of using the fair value model, I did not find any respondent that was happy with the decision to state the fair values directly in the P/L account.

8.5 Closing remarks Work on this study has been very educative and I am extremely grateful for all the help I have received and the chance to understand the workings of the valuation procedures in the property market at a deeper level. One of the difficulties in carrying out this study was the attitude in some of the property companies that the year 2005 was still a long way off and thus not of major importance just now. Furthermore the question of using fair values in the P/L account for non-financial assets is new and thus I found myself often answering or discussing questions on the use and effects of the fair value model rather than receiving answers about the companies’ intentions or actions.

8.6 Suggestions for further studies

A major reason behind the requirement on the use of IAS/IFRS in the EU is the need to ease cross-border investments through the presentation of transparent and comparable financial reports by the companies. A follow up study in 2007 could analyse the conversion process and whether the EU requirement actually led a more integrated European capital market and harmonised financial reporting. The use of fair value accounting in the real estate market is new and not yet very well studied. However it is probable that the cost model will disappear as an alternative. Will there be any Swedish property companies using the fair value model by 2007? A surprising result from this study was the low level of trust in the use of external appraisers in Sweden. According to McParland et al (2002, pp130) “ 81% of the Swedish (property) appraisers had a Real estate postgraduate degree, only 16% in Germany.” Why are the managers in Sweden, in comparison to the Germans, Dutch or English, so sceptical to an exclusive use of external valuations?

60 §7 in the introduction to IAS 40

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APPENDICES

Appendix 1: Listed property companies

* Global Industry Classification Standard (GICS) for the Stockholmsbörsen Universe of Securities* as of Friday, November 1, 2002Security Name Sector SubindustryCastellum Financials Real Estate Management & DevelopmentCeltica Fastighet Financials Real Estate Management & DevelopmentDrott A Financials Real Estate Management & DevelopmentDrott B Financials Real Estate Management & DevelopmentFast Partner Financials Real Estate Management & DevelopmentHeba Fastighets B Financials Real Estate Management & DevelopmentHufvudstaden A Financials Real Estate Management & DevelopmentHufvudstaden C Financials Real Estate Management & DevelopmentJM Financials Real Estate Management & DevelopmentKungsleden Financials Real Estate Management & DevelopmentKlövern AB Financials Real Estate Management & DevelopmentKlövern AB Financials Real Estate Management & DevelopmentLjungbergGruppen B Financials Real Estate Management & DevelopmentLundbergföretagen B Financials Real Estate Management & DevelopmentMandamus Fastigheter Financials Real Estate Management & DevelopmentTornet Fastighets Financials Real Estate Management & DevelopmentWallenstam Byggnads B Financials Real Estate Management & DevelopmentWihlborgs Fastigheter Financials Real Estate Management & Development Source: www.stockholmsborsen.se

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Appendix 2: Interview questions

Preparation for application of IAS in consolidated financial statements: From the 1st of January 2005 all registered companies in EU are required to apply IAS in consolidated financial reports. The purpose of these questions is to find out how and to what extent your company has prepared itself for this change in accounting standards. 1 What is your position in the company? 2 Are you conversant with the requirement for all listed companies in the EU to prepare consolidated accounts in accordance with International Accounting Standards (IAS)? 3 Has your company started preparations for the conversion to IAS application?

3.1. If yes, how? 3.2. If no, when do you plan to start? (Go on to question 11)

4 Who in your company is in charge of this conversion project and what is his position in the company? (How high in the hierarchy?) 5 Has the conversion project a separate budget and if yes how big? 6 How did you go about preparing for the conversion?

6.1. Did you use internal or external resources? Which/Who? 7 How far in the conversion process is your company? 8 Have you experienced any problems with the conversion work?

8.1. If yes, what sort of problems? 8.2. How have you solved these problems?

9 Has your company carried out a simulation test of your financial reports after conversion? 9.1. Were the results what you expected?

10 Does your company have any plans to change its financial structure on account of IAS application?

10.1. If yes, how? Fair value accounting: The vision of IAS is that of a balance sheet oriented, fair value model in which the accounting process focuses extensively on the recognition, derecognising and measurement at fair value of a company’s assets and liabilities. The measurement of income will rely heavily on changes in the fair value of net assets. (Fair value is often defined as synonymous with market value) 11 Is your company aware of the consequences that the application of fair value will have on equity and net income? 12 Will these consequences lead to any changes in your company policies, for example dividend payouts? 13 Does your company have any performance related bonuses, incentives or other remunerations?

13.1. If yes, which financial ratio is used in determining this performance? 13.2. Given the recognition of unrealised gains and losses under fair value accounting, will your company change/revise this remuneration system? How?

55


Accounting for investment property - IAS 40: RR 2461 is based on IAS 40 with the exception that the later allows for a choice between a cost model and a fair value model. The fair value model measures property at fair value and changes in fair value should be recognised in the income statement. By 2005 this option will be available for Swedish property companies. 14 Investment property has been defined as property held to earn rentals or for capital appreciation or both. What percentage of your company’s total holdings is investment property? 15 The use of an independent valuer is encouraged but not required. (IAS 40 ¶ 26). Does your company currently use internal or external valuers? 16 How often has your company carried out valuations on your properties? 17 Which method is used in the valuation of your company’s properties? If several please rank them.) 18 With fair value application the frequency of valuations will increase. Does your company have plans to increase its level of internal valuations? 19 Has your company’s disclosure of the market value of its properties had any noticeable consequences?

19.1. Which? How have they been noticeable? (Net worth?) 20 Given the fact that your company already discloses market values, do you see any advantages/disadvantages in continuing with the cost model? 21 Do you see any advantages in using the fair value model? 22 Has your company decided on whether to use the fair value model or not?

22.1. If yes, what was the main reason behind your choice? 22.2. If no, what is stopping your company from making a choice?

61RR 24 (förvaltningsfastigheter)

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Appendix 3: IAS/IFRS and their corresponding RRs62

IAS RR63 IAS 1 22 Presentation of Financial statements IAS 2 2 Inventories IAS 7 7 Cash Flow Statements IAS 8 4 & 5 Net Profit or loss for the period, Fundamental Errors and Change in

Accounting Policies IAS 10 26 Events after the Balance sheet IAS 11 10 Construction Contracts IAS 12 9 Income Taxes IAS 14 25 Segment Reporting IAS 15 * Information Reflecting The Effects of Changing Prices IAS 16 12 Property, Plant and Equipment IAS 17 6:99 Leases IAS 18 11 Revenue IAS 19 *** Employee Benefits IAS 20 28 Accounting for Government Grants and Disclosure of Government

Assistance IAS 21 8 The Effects of Changes in Foreign Exchange Rates IAS 22 1:00 Business Combinations IAS 23 21 Borrowing Costs IAS 24 23 Related Party Disclosures IAS 26 * Accounting and Reporting by Retirement Benefit Plans IAS 27 (1:00) Consolidated Financial Statements IAS 28 13 Investments in Associates IAS 29 * Financial reporting in Hyperinflationary Economies IAS 30 * Disclosures in the Financial Statements of Banks and Similar Financial

Institutions IAS 31 14 Financial Reporting of Interests in Joint Ventures IAS 32 27 Financial Instruments: Disclosure and Presentation IAS 33 18 Earnings per Share IAS 34 20 Interim Financial Reporting IAS 35 19 Discontinuing Operations IAS 36 17 Impairment of Assets IAS 37 16 Provisions, Contingent Liabilities and Contingent Assets IAS 38 15 Intangible Assets IAS 39 *** Financial Instruments: Recognition and Measurement IAS 40 24 Investment Property IAS 41 *** Agriculture Source: www.stockholmsborsen.se

62 Some of the IAS have been superseded by newer ones and the old ones withdrawn. Not all of the IAS have corresponding RR. 63 * Are not prioritised whereas those marked *** are under progress.

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Appendix 4: Decision tree for investment property

The following decision tree, reproduced from the appendix to IAS 40 provides a useful summary of the process of deciding on the appropriate IAS treatment of a property.

YES

NO

YES

NO

YES

NO

Is the property held for sale in ordinary course of business?

Use IAS 12 (inventories)

Use IAS 16 (benchmark or allowed alternative)

Is the property being constructed or developed?

Use IAS 16 (benchmark) with disclosure from IAS 40

The property is an investment property

FAIR VALUE MODEL

Which model is chosen for all investment property?

COST MODEL

Use IAS 40

Use IAS 16 (benchmark or allowed alternative) until completion.

Is the property owner-occupied?

Start

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Appendix 5: Property Companies and Financial analysts contacted:

Property Companies: Property company Website Person contacted Title AP Fastigheter www.apfastigheter.se Christer Nerlich CFO Castellum AB www.castellum.se Håkan Hellström CFO Fastighet AB Celtica www.celtica.se Ulf Holmlund Managing Director Drott AB www.drott.se Roger Johansson Controller Fast Partner AB www.fastpartner.se Anders Larsson Controller Heba Fastighets AB www.hebafast.se Frank Sadleir Controller Hufvudstaden AB www.hufvudstaden.se Magnus Jacobson CFO JM AB www.jm.se Hans Ekbom Kungsleden AB www.kungsleden.se Johan Risberg CFO LjungbergGruppen AB www.ljungberggruppen.se IngaLill Berglund Controller

Mandamus Fastigheter AB www.mandamus.se Bengt Evaldsson + Thomas Broberger

CFO + Controller

Realia AB www.realia.se Erik Turai Controller Skandia Fastighet AB www.skandia.se/fastighet Thomas Davidsson CFO Fastighets AB Tornet www.tornet.se Soren Andersson Accounting manager Vasakronan AB www.vasakronan.se Thomas Kristoffersson CFO

Lennart Wallenstam Byggnads AB www.wallenstam.se Marie Ideström Controller

Wihlborgs Fastigheter www.wihlborgs.se Olle Knaust CFO ***(UK)*** The British Land Company PLC www.britishlnd.co.uk Andrew Berman Senior Accountant Land Securities PLC www.landsecurities.com Akhtar Shah Director- Accounting *** (NL) ***

Rodamco Nederland www.rodamco.com Ingrid van Heerde-Hogenkamp

Wereldhave N.V www.wereldhave.com C.F Bloema Corporate Treasurer Redevco www.redevco.com Engin Filiz Accounting VastNed www.vastned.com Financial analysts: Company Website Person contacted Alfred Berg Fondkommission AB www.alfredberg.se Christian Roos Swedbank Markets www.foreningssparbanken.se Tobias Kaj Enskilda Securities www.enskilda.se Erik Nyman D. Carnegie & Co AB www.carnegie.se Christian Brunlid *** Amsterdam Effectenkantoor (NL) www.aek.ws Gert-Jan Kapiteyn

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http://www.apfastigheter.se/

http://www.castellum.se/

http://www.celtica.se/

http://www.drott.se/

http://www.fastpartner.se/

http://www.hebafast.se/

http://www.hufvudstaden.se/

http://www.jm.se/

http://www.kungsleden.se/

http://www.ljungberggruppen.se/

http://www.mandamus.se/

http://www.realia.se/

http://www.skandia.se/fastighet

http://www.tornet.se/

http://www.vasakronan.se/

http://www.wallenstam.se/

http://www.wihlborgs.se/

http://www.britishlnd.co.uk/

http://www.landsecurities.com/

http://www.rodamco.com/

http://www.wereldhave.com/

http://www.redevco.com/

http://www.vastned.com/

http://www.alfredberg.se/

http://www.foreningssparbanken.se/

http://www.enskilda.se/

http://www.carnegie.se/

http://www.aek.ws/


Others: Company Person contacted Forum Fastighetsekonomi AB Rolf Simon Valuer ERNST & YOUNG (UK) Ray Bosswell Valuer KPMG Bo Nordlund Public Accountant Deloitte & Touche Ingemar Nilsson Public Accountant ERNST & YOUNG Dan Phillips Partner University of Amsterdam (NL) Dr Dick van Offeren Accounting Department Netherlands Property Index (NL) Aart C. Hordijk Director Kingston University, Surrey (UK) Anthony Holt Senior lecturer SBV School of Real Estate (NL) Gerjan A. Vos Research Director University of Amsterdam (NL) Dirk Brounen Faculty of Economics

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