Fair value implications for the real estate sector and example disclosures for real estate entities. Applying IFRS in Real Estate

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1 Applying IFRS in Real Estate IFRS 13 Fair Value Measurement Fair value implications for the real estate sector and example disclosures for real estate entities January 2013

2 Contents Introduction... 2 Section A IFRS 13 Fair Value Measurement: implications for the real estate sector... 3 A1. Background... 3 A2. Principal impacts... 3 A3. The definition of fair value... 4 A4. The concept of highest and best use... 5 A4.1 Assessment... 5 A4.2 Valuing the highest and best use alternative use and asset modifications... 6 A4.3 Highest and best use and impairment testing... 6 A5. The valuation premise for property interests... 7 A6. Assessing whether an appraisal complies with IFRS A7. Appropriate valuation techniques... 8 A8. Applying the fair value hierarchy to real estate appraisals A9. Expanded disclosure requirements A9.1 General A9.2 Asset classes A10. Final thoughts Section B Illustrative set of disclosures required under IFRS 13 for a real estate entity with investment properties B1. Introduction B2. Illustrative disclosures Overview B3. Illustrative disclosure Early adoption B4. Illustrative disclosure Classes of investment property B5. Illustrative disclosure Fair value measurement, valuation techniques, changes in valuation techniques, inputs and other key information B6. Illustrative disclosure Reconciliation of balances of classes of investment property B7. Illustrative disclosure Valuation process B8. Illustrative disclosure Sensitivity information B9. Illustrative disclosure Highest and best use Fair value implications for the real estate sector and example disclosures for real estate entities

3 Introduction IFRS 13 Fair Value Measurement is effective for annual periods on or after 1 January IFRS 13 establishes a single framework for fair value measurement when it is required or permitted by IFRS. In Section A, we focus on a number of the implications of IFRS 13 for the real estate sector. This section includes recent discussions on critical issues on fair value measurement of real property and supersedes our previous publication, IFRS 13 Fair value measurement 21st century real estate values Implications for the real estate and construction industries issued in In Section B, we provide selected illustrative disclosures of a real estate entity, which has investment properties measured at fair value, in its first set of financial statements after adoption of IFRS 13. This publication should be read in conjunction with Good Real Estate Group (International) Limited Illustrative financial statements for the year ended 31 December 2012 (Good Real Estate). 1 IFRS 13 prescribes the minimum disclosures required. It is often necessary to provide additional disclosures to explain significant transactions or unusual circumstances. In addition, accounting policy choices need to be disclosed to help the user understand the financial statements. The challenge for any entity is to produce financial statements with disclosures that are useful for decision-making. This publication focuses on IFRS 13 disclosures, which rely heavily on the judgement of management. While the disclosures that are included in Section B are for illustrative purposes only, we believe that they are a good example of how the disclosure objectives of IFRS 13 can be met by a real estate entity. 2 IFRS 13 at a glance IFRS 13 does not change when an entity is required to use fair value. Instead, IFRS 13 describes how to measure fair value under IFRS when it is required or permitted by IFRS. The current requirements in IAS 40 Investment Property relating to fair value determination will be replaced by the requirements in IFRS 13. The definition of fair value in IFRS 13 is consistent with market value as defined in International Valuation Standards (IVS). But, perhaps confusingly, it differs from the IVS definition of fair value. IFRS 13 includes concepts of highest and best use, valuation premise and requires application of a fair value hierarchy. Whilst, in most cases, IFRS 13 does not differ from existing practice, management does need to be aware of the conceptual differences between IFRS 13 and IVS to ensure any values used for financial reporting that are obtained from appraisals, whether external or internal, are consistent with the objective of fair value measurement in accordance with IFRS 13. A challenge for any entity is to produce financial statements with disclosures that are useful for decision-making. IFRS 13 significantly expands disclosure requirements and the extent and nature of IFRS 13 disclosures will rely heavily on the judgement of management. IFRS 13 is effective for annual periods commencing on or after 1 January This publication is available at 2 For a more complete discussion of the implications of IFRS 13, refer to Applying IFRS: IFRS 13 Fair value measurement (November, 2012), which is available at Fair value implications for the real estate sector and example disclosures for real estate entities 2

4 Section A IFRS 13 Fair Value Measurement: implications for the real estate sector A1. Background IFRS 13 was issued by the IASB 3 in May IFRS 13 describes how to measure fair value under IFRS when it is required or permitted by IFRS. The standard does not change when an entity is required to use fair value. It also sets out certain requirements for disclosures related to fair value. As a result of the consequential amendments to other standards upon the adoption of IFRS 13, the current requirements in IAS 40 for determining fair value will be replaced by the requirements in IFRS 13. A2. Principal impacts For real estate entities, the adoption of IFRS 13 could result in significant changes to processes and procedures for determining fair value and providing the required disclosures. While the requirement to determine fair value by reference to market participants is not new, the definition of fair value in IFRS 13 differs from that proposed by IVS, which are the generally accepted standards for professional appraisal practice in valuing real estate internationally. The fair value framework set out in IFRS 13 contains specific requirements relating to highest and best use, valuation premise, and principal (or most advantageous) market. This may require entities and their appraisers to re-evaluate and reconsider their methods, assumptions, processes and procedures for determining fair value. The use of external appraisers, as is common for property interests (including investment property interests), does not reduce management s ultimate responsibility for the fair value measurements and related disclosures in the entity s financial statements. Therefore, regardless of whether valuations are performed externally or internally, management must understand the methodologies and assumptions used in the valuations and determine whether the assumptions are reasonable and consistent with the requirements of IFRS 13. Real estate entities may be affected by IFRS 13 in various aspects of their business when: Measuring property interests at fair value Testing property interests for impairment Determining the fair value of identifiable assets and liabilities as part of the purchase price allocation applied in a business combination Measuring an interest in a real estate joint venture or associate at fair value using the exception under IAS 28 Investments in Associates and Joint Ventures Compiling and disclosing information on the fair values of property interests, including but not limited to significant assumptions, adjustments to unobservable inputs and qualitative and quantitative sensitivity analysis. The principal elements of IFRS 13 that affect real estate entities are dealt with in the following sections. 3 International Accounting Standard Board. 3 Fair value implications for the real estate sector and example disclosures for real estate entities

5 A3. The definition of fair value In IFRS 13, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. 4 Accordingly, this price is an exit price. The definition of fair value in IFRS 13 includes the assumption that fair value is measured based on a hypothetical and orderly transaction and, until IFRS 13 was published, these concepts were not explicitly stated in IFRS. IFRS 13 states, The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. 5 Transaction costs are defined as the costs to sell an asset (or transfer a liability) that are directly attributable to the disposal of an asset (or the transfer of the liability), i.e., the costs the seller would incur. However, IFRS 13 discusses transaction costs only from the perspective of the holder of the asset (i.e., the seller). It does not discuss the costs that might be incurred by a potential buyer of the asset or whether such costs might influence the price a buyer would be willing to pay to acquire the asset. The definition in IFRS 13 differs from IVS, which states in its revised IVS Framework 6 : Fair value is the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties. And: For purposes other than use in financial statements, fair value can be distinguished from market value. Fair value requires the assessment of the price that is fair between two identified parties taking into account the respective advantages or disadvantages that each will gain from the transaction. It is commonly applied in judicial contexts. In contrast, market value requires any advantages that would not be available to market participants generally to be disregarded. How we see it IFRS requires any advantages that would not be available to market participants generally to be disregarded. This is different from IVS. Management needs to be aware of this conceptual difference to ensure any values used for financial reporting that are obtained from appraisals, whether external or internal, are consistent with the objective of a fair value measurement in accordance with IFRS IFRS 13, Appendix A 5 IFRS 13, paragraph 25 6 International Valuation Standards Council (IVSC), International Valuation Standards, July 2011, paragraphs Fair value implications for the real estate sector and example disclosures for real estate entities 4

6 A4. The concept of highest and best use A4.1 Assessment Under IFRS 13, an entity s current use of an asset is generally taken to be its highest and best use, unless market or other factors suggest that a different use of that asset by market participants would maximise its value. If such factors exist, management is required to consider all relevant information in determining whether the highest and best use of a property is different from its current use at the measurement date. IFRS 13 states 7 : A fair value measurement of a non-financial asset takes into account a market participant s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use. The highest and best use of a non-financial asset takes into account the use of the asset that is physically possible, legally permissible and financially feasible, as follows: (a) A use that is physically possible takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (eg the location or size of a property). (b) A use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (eg the zoning regulations applicable to a property). (c) A use that is financially feasible takes into account whether a use of the asset that is physically possible and legally permissible generates adequate income or cash flows (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use. The IASB states that to be taken into account to determine the fair value, the use of an asset does not need to be legal at the measurement date, but it must not be legally prohibited in the jurisdiction. 8 For example, if the government of a particular country has prohibited building or development in a protected area, the highest and best use of the land in that area cannot be to develop it for industrial use. The Royal Institute of Chartered Surveyors (RICS) does not make any reference to the IFRS 13 concept of highest and best use in its definition of fair value. Instead, its valuation concepts state:...where the price offered by prospective buyers generally in the market would reflect an expectation of a change in the circumstances of the property in the future, this element of hope value is reflected in market value. Examples of hope value include: The prospect of development when there is no current permission for development The prospect of synergistic value arising from a merger with another property The European Group of Valuers Association (TEGoVA) followed the RICS methodology in its European Valuation Standards 2012 (EVS 2012). EVS 2012 emphasises that the market value of a property reflects the full potential of that property so far as it is recognised by others in the market. As the full potential of a property may reflect possible uses that are not legally permissible at the valuation date, but may become so in the future, the TEGoVA s market value seems to include an element of hope value. For over 30 years, the real estate valuation profession has sought to harmonise its standards and methodologies, as evident in the development of a common definition for market value that is now endorsed by the IVSC, TEGoVA and RICS. Unfortunately, a common definition has not led to a common interpretation. The problem has been further complicated by the introduction of a new definition of fair value in IFRS 13. At least two of the recognised international valuation standard setters, RICS and TEGoVA, advocate that the hope value should be considered in the assessment of market value. However, it is unclear whether or to what extent including the hope value would be in line with the concept of highest and best use set out in IFRS IFRS 13, paragraphs 27 and 28 8 IFRS 13, Basis for Conclusions, paragraph 69 5 Fair value implications for the real estate sector and example disclosures for real estate entities

7 How we see it Considerable judgement may have to be applied in determining when an anticipated change in use is legally permissible. For example, if approval is required for re-zoning land or for an alternative use of existing property interests, it may be necessary to assess whether such approval is perfunctory or not. Entities should document the evidence to support their view on market participants assumptions about the ability to obtain the required approvals. In particular, caution should be given to any legal restrictions. A4.2 Valuing the highest and best use alternative use and asset modifications When management has determined that the highest and best use of an asset is something other than its current use, certain valuation matters must be considered. Appraisals that reflect the effect of a reasonably anticipated change in what is legally permissible should be carefully evaluated. If the appraised value assumes that a change in use can be obtained, the valuation should be reduced to reflect market participant assumptions regarding the cost and profit margin associated with obtaining approval for the change in use and transforming the asset, in addition to capturing the risk that the approval might not be granted (i.e., uncertainty regarding the probability and timing of the approval). An entity should also evaluate inputs used in the valuation of similar assets that do not have similar uncertainties, for example, uncertainty related to obtaining a permit. Refer to Section A6 for considerations in assessing whether an appraisal complies with IFRS 13. Expectations about future improvements or modifications to be made to the property interest to reflect its highest and best use may be considered in the appraisal, e.g., the renovation of the property interest or the conversion of an office into condominiums, but only if and when other market participants would also consider making these investments. The cash flows used should reflect only the cash flows that market participants would take into account when assessing fair value. This includes both the type of cash flows (e.g., future capital expenditure) and the estimated amount of cash flows. Only if this hurdle is met would the fair value of the property interest be determined on the basis of the expected future cash flows of the renovated or transformed asset. However, as noted above, when this is the case, the fair value measurement needs to also capture the cost and profit margin that market participants would demand for transforming the asset. The fair value measurement assumes that the asset is sold in its current condition with any renovation or transformation being performed by the market participants who acquire the asset. Accordingly, management should evaluate whether transformation costs and any associated profits resulting from the transformation process have been included in the appraised value and if the inclusion of such amounts is appropriate. A4.3 Highest and best use and impairment testing The highest and best use concept is not only relevant for property interests carried at fair value. It is also relevant to the impairment testing of investment property interests carried at cost and other non-financial assets held by real estate entities when impairment is measured on the basis of fair value less costs of disposal. IAS 36 Impairment of Assets stipulates that impairment arises if the recoverable amount of an asset is lower than its carrying value. The recoverable amount is the higher of an asset s or cash generating unit s fair value less costs of disposal and its value in use. IFRS also states that: If either of these amounts exceeds the asset s carrying amount, the asset is not impaired and it is not necessary to estimate the other amount 9 Fair value differs from value in use, as defined in IAS Fair value reflects the assumptions market participants would use when pricing the asset; it assumes that market participants will pay a price that reflects the highest and best use of the asset. Consequently, the highest and best use concept applies when fair value less costs of disposal is the basis of the impairment test. In contrast, the value in use concept reflects the reporting entity s estimates based on its expected use of the asset, including the effects of factors that may be specific to the entity and not applicable to entities in general. IAS 36 states 11 : 9 IAS 36, paragraph IAS 36, paragraph 53A 11 IAS 36, paragraph 45 Fair value implications for the real estate sector and example disclosures for real estate entities 6

8 Because future cash flows are estimated for the asset in its current condition, value in use does not reflect: (a) future cash outflows or related cost savings (for example reductions in staff costs) or benefits that are expected to arise from a future restructuring to which an entity is not yet committed; or (b) future cash outflows that will improve or enhance the asset's performance or the related cash inflows that are expected to arise from such outflows. How we see it Only in rare circumstances will it be possible to determine the fair value of an investment property based on current prices in an active market. Accordingly, if fair value is used for impairment testing, it may have to be estimated using other valuation techniques, such as discounted cash flow projections. If fair value is estimated using discounted cash flow projections, care is needed to ensure the projections reflect the asset s highest and best use. A5. The valuation premise for property interests When determining the highest and best use for non-financial assets, such as property interests, it is important to determine whether the highest and best use of that property interest is its use in combination with other assets and/or liabilities, or on a stand-alone basis. If the fair value of an asset for which highest and best use is its use in combination with other assets and/or liabilities, fair value is determined assuming the asset is sold for use by market participants in combination with those other complementary assets and/or liabilities. Market participants are assumed to hold those complementary assets and/or liabilities already. In contrast, the fair value of a property interest that provides maximum value on a stand-alone basis is measured based on the price that would be received to sell that property interest on a stand-alone basis. To illustrate, consider a mixed-use property interest that has residential housing, a hotel and retail space. If the aggregate fair value of the mixed-use property interest is higher to market participants than the sum of the fair value of the individual property interests because of synergies and complementary cash flows, the fair value of that mixed-use property interest would be maximised as a group. That is, the fair value is determined for the mixed-use property interest as a whole. While the mixed-use property interest is one example in which fair value would be maximised as a group, in most cases, it would not be appropriate to estimate fair value of property interests as a group or portfolio of assets. Entities generally should not assume the fair value of a property interest is maximised through its use with other assets, unless there is sufficient evidence to support this assertion. In many instances when valuing property interests, fair value is determined based on the price that would be received in a current transaction to sell the asset on a stand-alone basis. Determining whether the maximum value to market participants would be achieved by using a real estate asset in combination with other real estate assets and/or liabilities, or by using the real estate asset on a stand-alone basis requires considerable judgement of the specific facts and circumstances. IFRS 13 sets out that the unit of account for the asset to be measured at fair value must be determined in accordance with the IFRS that requires or permits the fair value measurement. 12 If, for example, a real estate entity owns a portfolio of several office buildings located in different cities and all of them have been classified as investment properties under IAS 40, then each building would probably present a separate unit of account (rather than the whole portfolio being considered as one unit of account). A block discount, which would be incurred if the portfolio of properties were sold as a whole, cannot be considered in the fair value measurement of the individual properties IFRS 13, paragraph IFRS 13, paragraph 69 7 Fair value implications for the real estate sector and example disclosures for real estate entities

9 A6. Assessing whether an appraisal complies with IFRS 13 Although certain of the concepts of IFRS 13 may be similar to concepts in IVS, an assessment of the appraisal should be performed to determine that the appraised value is an appropriate measure of fair value for financial reporting (i.e., the appraisal has been performed in accordance with the principles of IFRS 13). As a result, management may conclude that an adjustment to the valuation is necessary to comply with IFRS 13. Assessing compliance with IFRS 13 would include, but is not limited to, determining whether: The appraisal value contemplates that the property is sold in an orderly transaction as at the measurement date, taking into consideration current market conditions (i.e., a fair value measurement inherently assumes that as of the measurement date market participants have the knowledge and awareness of the asset that would be customary in a market transaction, despite the fact that in actuality this process may not have yet begun) The principal market (or, in its absence, the most advantageous market) has been appropriately considered Appropriate market participants (or characteristics of market participants) have been identified and the assumptions that market participants would utilise in pricing the asset have been used Adjustments to valuation input data are (a) based on observable or unobservable inputs, or (b) significant to the overall fair value measurement (see Section A8 below) All appropriate valuation approaches and techniques have been used; if multiple valuation techniques are used, the merits of each valuation technique and the underlying assumptions embedded in each of the techniques should be considered in evaluating and assessing the results (see Section A7 below) Appropriate judgement has been applied in determining the highest and best use; in situations where the highest and best use is not its current use, whether the expected future cash flows associated with this use are appropriately adjusted for the cash out flows associated with the transformation or renovation costs adjusted for a normal profit margin All relevant disclosures have been provided A7. Appropriate valuation techniques IFRS 13 does not prescribe which valuation technique must be used in a particular circumstance. The valuation technique used to measure fair value should be appropriate for the circumstances, and one for which sufficient data is available. Valuation techniques that are typically used include the market approach, the income approach and the cost approach, all of which are summarised in Table 1, with the comparative IVS guidance provided by the IVSC. As described in Section A3 above, management needs to be aware that there is a conceptual difference between the definition of fair value under IFRS 13 and under IVS. Accordingly, management should ensure that any values used for financial reporting that are obtained from appraisals, whether external or internal, are consistent with the objective of a fair value measurement in accordance with IFRS 13. Fair value implications for the real estate sector and example disclosures for real estate entities 8

10 Table 1: Valuation techniques under IFRS 13 and IVS Approaches described in IFRS 13 IVS equivalent Application guidance provided by IVSC 14 Market approach Uses prices and other relevant information generated by market transactions involving identical or comparable assets Market approach (or market comparison approach) Under the market approach, the value is determined based on comparable transactions. Although property interests are not homogeneous, the IVSC considers the market approach most commonly applied. In order to compare the subject of the valuation with the price of other real property interests that have been recently exchanged or that may be currently available in the market, it is usual to adopt a suitable unit of comparison. Units of comparison that are commonly used include analysing sales prices by calculating the price per square meter of a building or per hectare for land. Other units used for price comparison where there is sufficient homogeneity between the physical characteristics include a price per room or a price per unit of output, eg, crop yields. A unit of comparison is only useful when it is consistently selected and applied to the subject property and the comparable property interests in each analysis. Income approach Converts future amounts (e.g., cash flows or income and expenses) to a single current (discounted) amount Income approach (e.g., the income capitalisation and discounted cash flow methods) Various valuation methods can be captured under this valuation technique. They all have in common that the valuation is based on estimated future income and profits or cash flows. Most commonly recognised are the income capitalisation method and the discounted cash flow method: Under the income capitalisation method, an income stream that is likely to remain constant is capitalised using a single multiplier. This method is quick and simple, but cannot be reliably used when the income is expected to change in future periods to an extent greater than that generally expected in the market or when a more sophisticated analysis of risk is required. In cases in which the income capitalisation method is not reliable, various forms of the discounted cash flow method can be used. These vary significantly in detail, but share the basic characteristic that the net income for a defined future period is adjusted to a present day value using a discount rate. 14 IVSC, International Valuations Standards, July 2011, IVS 230 Real Property Interests C12 C24. 9 Fair value implications for the real estate sector and example disclosures for real estate entities

11 Table 1: Valuation techniques under IFRS 13 and IVS (continued) Approaches described in IFRS 13 IVS equivalent Application guidance provided by IVSC 15 Cost approach Reflects the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost) Cost approach (e.g., the depreciated replacement cost method) IVSC considers that this method should be applied by exception only: It is normally used when there is either no evidence of transaction prices for similar property or no identifiable actual or notional income stream that would accrue to the owner of the relevant interest. It is principally used for the valuation of specialised property, which is property that is rarely if ever sold in the market, except by way of sale of the business or entity of which it is part. In practice, the cost approach is seldom used to establish the fair value of investment property, but is sometimes used to measure fair value for owner-occupied property (if the revaluation option under IAS 16 Property, Plant and Equipment is used). The decision to use more than one valuation technique, or place more weight on one indication of value over another, depends on the specific facts and circumstances. But, in all cases, a fair value measurement should maximise the use of observable market inputs. When available, observable market transactions should be considered in the determination of fair value, unless these transactions are determined not to be orderly. The objective is to use the valuation technique (or combination of valuation techniques) that is appropriate in the circumstances and for which there is sufficient data. IFRS 13 requires that valuation techniques used to measure fair value should be consistently applied. Changes in valuation techniques (or their application) are appropriate only if the change results in a measurement that is equally or more representative of fair value in the circumstances. When it is determined that use of multiple valuation techniques is appropriate, as is often the case for real estate (e.g., using the results from both a market approach and an income approach), IFRS 13 indicates that the results should be evaluated and weighted considering the reasonableness of the range indicated by those results. A fair value measurement is the point within the range that is most representative of fair value in the circumstances. However, before determining this point, management should gain an understanding of the differences in results. Applying a percentage weighting to the results of each technique to determine fair value may only be appropriate in limited circumstances. A8. Applying the fair value hierarchy to real estate appraisals When measuring fair value, an entity is required to maximize the use of relevant observable inputs and minimise the use of unobservable inputs. IFRS 13 includes a fair value hierarchy (described in Table 2) that prioritises the inputs in a fair value measurement. The inputs used in measuring fair value drive categorisation of the fair value measurement (as a whole) within the fair value hierarchy for disclosure purposes. Significant differences in disclosure requirements apply to fair value measurements categorised within each level of the hierarchy in order to provide users with insight into the reliability of the fair value measurement. Table 2: Fair value hierarchy Fair Value Hierarchy Level 1 Level 2 Level 3 Quoted prices, which are not adjusted, in an active market for identical assets and liabilities that the entity can access at the measurement date Inputs, other than quoted prices in Level 1, that are observable, either directly or indirectly Unobservable inputs 15 IVSC, International Valuations Standards, July 2011, IVS 230 Real Property Interests C12 C24. Fair value implications for the real estate sector and example disclosures for real estate entities 10

12 The fair value hierarchy is based on the relative reliability and relevance of the information used in the valuation. Regardless of whether the valuation was compiled internally or externally, the reporting entity should review and understand the inputs used in the valuation to determine the appropriate classification of those inputs in the fair value hierarchy. It may be appropriate to classify a market-corroborated input, which is supported by observable market data of a similar asset, in Level 2, even though the input itself is not directly observable. This is because such an input is less subjective than an unobservable input in Level 3. However, unless the assets are essentially the same, judgement is needed to determine whether an adjustment is required to the corroborating observable input. For example, if there is no recent transaction for apartments in a small residential building, Building A, an entity may consider a price per unit area data that is derived from recent transaction prices of comparable apartments in a nearby residential building, Building B, to determine the fair value of an apartment in Building A. However, an analysis must be performed to determine whether an adjustment is required to the price per unit area of an apartment in Building B to determine the fair value for an apartment in Building A. IFRS 13 requires that the significance of adjustments to observable data be considered in the context of the overall fair value measurement. That is, when an observable input is adjusted to reflect differences between the asset being valued and the observed transaction, the adjustment may render the entire measurement a lower level in the fair value hierarchy, that is a Level 3 measurement instead of a Level 2 measurement. Examples of fair value measurements categorised within Level 2 could include: Residential units in an apartment block or street with a sufficient number of comparable units and a sufficient volume of recent sales transactions for which prices could be observed Office stock in a business district with many similar buildings with comparable office space and a sufficient volume of recent sales transactions for which prices could be observed For such properties, one would expect that the fair value would be determined using a market comparable approach with the price per square metre as the most significant observable input. However, this should not lead to the conclusion that the existence of any published market price per square metre will automatically result in a fair value measurement categorised within Level 2. In the illustrative example 17 accompanying IFRS 13, for example, commercial properties measured using the market comparable approach are categorised within Level 3 (rather than Level 2) 16. When selecting the most appropriate inputs to a fair value measurement from multiple available values, those that maximise the use of observable data, rather than unobservable data, should be selected. Even in a market that is inactive, an entity should not presume that the transactions in that market do not represent fair value or that the market is not orderly. Entities will need to consider the individual facts and circumstances in making this assessment. Notwithstanding the need for judgement, an entity should have sufficient evidence for concluding that a current observable market price can be ignored based on a view that it represents a liquidation or distressed sale value. How we see it: In market conditions in which real estate is actively purchased and sold and that have a stock of sufficient comparable (i.e., similar but not identical) properties, the fair value measurement may be classified within Level 2. However, that determination will depend on the facts and circumstances, including the significance of adjustments to observable data. Accordingly, in active and transparent markets, there may be real estate valuations that are classified within Level 2, provided that no significant adjustments have been made to the observable data of identical properties. However, very few properties are identical. Consequently, in many cases, valuers have to make adjustments to observable data of similar properties to determine the fair value of a property. Since significant adjustments to observable data will result in a Level 3 measurement, considerable judgement may be required to determine whether the adjustments are significant. 16 IFRS 13, Illustrative Example, paragraph Fair value implications for the real estate sector and example disclosures for real estate entities

13 Notwithstanding the foregoing, in inactive or less transparent real estate markets, we believe that it is unlikely that real estate will be classified within Level 2. Rather, it will be classified within Level 3. Accordingly, in consecutive years, a valuation may move up or down in the hierarchy, depending on the liquidity of the market. Therefore, care should be taken in classifying a property valuation within Level 2. A9. Expanded disclosure requirements A9.1 General The IASB significantly expanded the required disclosures related to fair value measurement to enable users of financial statements to understand the valuation techniques and inputs used to develop fair value measurements. For each of the disclosure requirements under IFRS 13, Table 3 below indicates whether it is currently required under IFRS. Although the table below focuses on a comparison between the disclosure requirements in IAS 40 and IFRS 13, it is important to note that, in most cases where fair value is used or disclosed, the disclosure requirements have been significantly expanded as compared to current IFRS. For example, entities that measure interests in a real estate joint venture or associate at fair value, or measure other financial instruments at fair value, will need to comply with increased disclosure requirements for such items as well. The additional disclosures required by IFRS 13 are mainly dependent on: Whether the fair value measurement for a property (as a whole) is categorised within Level 3 or within Level 1 or Level 2 of the fair value hierarchy How the property is grouped into classes of assets for disclosure purposes Certain IFRS 13 disclosures are only required for fair value measurements categorised within Level 3 and not for those within Level 1 or Level 2. For example, a description of the valuation processes used by an entity is required for fair value measurements categorised within Level 3, but not for those within Level 1 or Level 2. A9.2 Asset classes Many of the IFRS 13 disclosures are required for each class of assets (and liabilities). IFRS 13 requires these classes of assets (and liabilities) be determined based on: (a) the nature, characteristics and risks of the asset or liability; and (b) the level of the fair value hierarchy within which the fair value measurement is categorised. The determination of the appropriate class of assets will require significant judgement. At one end of the spectrum, the properties in an operating segment (as defined by IFRS 8 Operating Segments) may be a class of assets for the purpose of the disclosures required by IFRS 13. This may be the case even if there is a large number of properties in the segment, if the properties have the same risk profile (e.g., the segment comprises residential properties in countries with property markets of similar characteristics). At the other end of the spectrum, IFRS 13 disclosures may be required for individual properties or small groups of properties if the individual properties or groups of properties have different risk profiles (e.g., a real estate entity with two properties an office building in a developed country and a shopping centre in a developing country). In light of this, we expect that real estate entities may define a class of assets to include only fair value measurements that are in a single level of the fair value hierarchy. The number of classes may need to be greater for fair value measurements categorised within Level 3 of the fair value hierarchy because those measurements have a greater degree of uncertainty and subjectivity. Determining appropriate classes of assets and liabilities for which disclosures about fair value measurements should be provided requires judgement. A class of assets and liabilities will often require greater disaggregation than the line items presented in the statement of financial position. However, an entity is required to provide information sufficient to permit reconciliation to the line items presented in the statement of financial position. Fair value implications for the real estate sector and example disclosures for real estate entities 12

14 When determining the appropriate classes, entities should also take note of the requirements in paragraph 92 of IFRS 13, which require entities to consider all of the following: (a) (b) (c) (d) the level of detail necessary to satisfy the disclosure requirements; how much emphasis to place on each of the various requirements; how much aggregation or disaggregation to undertake; and whether users of financial statements need additional information to evaluate the quantitative information disclosed. In addition, the same paragraph requires entities to disclose additional information if the disclosures provided in accordance with IFRS 13 (and other standards) are insufficient to meet the objectives of the disclosure requirements set out in paragraph 91 of IFRS 13: An entity shall disclose information that helps users of its financial statements assess both of the following: (a) for assets and liabilities that are measured at fair value on a recurring or non-recurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements. (b) for recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on profit or loss or other comprehensive income for the period. As highlighted in paragraph 94 of IFRS 13, determination of the appropriate classes will, in many cases, require judgement. This judgment needs to be carefully exercised, as the meaningfulness of the disclosure of quantitative information used in Level 3 fair value measurements will depend on an entity's determination of its asset and liability classes and the level of aggregation for each class of assets and liabilities IFRS 13, Basis for Conclusions, paragraph Fair value implications for the real estate sector and example disclosures for real estate entities

15 Table 3: Disclosure requirements in IFRS 13 Disclosures Investment property at fair value (measured at fair value on a recurring basis) Investment property at cost (for which fair value is disclosed) IFRS 13 IAS 40 Current requirements IFRS 13 IAS 40 Current requirements Fair value at the end of the reporting period Level of the fair value hierarchy within which the fair value measurement in its entirety is categorised For Level 2 and Level 3 measurements, valuation technique and the inputs used, and changes in the valuation technique, if applicable, and the reasons for those changes For Level 3 measurements, quantitative information regarding the significant unobservable inputs Amount of transfers between Level 1 and Level 2, the reasons and related accounting policies For Level 3 measurements, reconciliation from the opening balances to the closing balances (including gains and losses, purchases, sales, issues, settlements, transfers in and out of Level 3 and reasons and policies for transfer and where all such amounts are recognised) For Level 3 measurements, the total gains or losses included in profit or loss that are attributable to the change in unrealised gains or losses relating to those assets and liabilities held at the reporting date, and a description of where such amounts are recognised For Level 3 measurements, a description of the valuation processes used by the entity Not required Not required Not required Not required Not required Not required Not required Not required Not required Not required Not required Not required** Not required Not required Not required Not required Not required Fair value implications for the real estate sector and example disclosures for real estate entities 14

16 Table 3: Disclosure requirements in IFRS 13 (continued) Disclosures Investment property at fair value (measured at fair value on a recurring basis) Investment property at cost (for which fair value is disclosed) IFRS 13 IAS 40 Current requirements IFRS 13 IAS 40 Current requirements For Level 3 measurements, a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs might result in a significantly different amount and, if applicable, a description of interrelationships between those inputs and other unobservable inputs and of how they might magnify or mitigate the effect of changes in the unobservable inputs * disclosure may also be required by IAS 1*** Not required by IAS 40, but disclosure may be required by IAS 1*** Not required Not required If the highest and best use of a non-financial asset differs from its current use, disclose that fact and the reason for it Not required Not required * The IASB decided not to require a quantitative sensitivity analysis for non-financial assets and liabilities at the time IFRS 13 was issued. The proposals, which had been included in the exposure draft and which required the presentation of a quantitative sensitivity analysis, had been heavily criticised by preparers, who were concerned about the additional cost, among other concerns. Instead, the Boards decided to defer adding this requirement until additional outreach could be completed (see IFRS 13, BC ). ** A reconciliation of the opening and closing balances of investment properties measured at fair value amounts is required. However, a reconciliation of the opening and closing balances of investment properties measured at cost is not required. *** IAS 1 Presentation of Financial Statements, paragraphs 125 and 129 require disclosure of information about assumptions an entity makes, and other sources of estimation uncertainty, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities. Hence, notwithstanding the fact that IFRS 13 does not require a quantitative sensitivity analysis, IAS 1 may still require it. Determining when to disclose such information requires judgement. An example of such a disclosure is included in Good Real Estate. A10. Final thoughts While many of the concepts in IFRS 13 are consistent with current practice, certain principles and disclosure requirements could have a significant impact on real estate entities. Careful consideration is required to identify situations in which there may be a significant change to current practice. Although the descriptions of valuation approaches in IFRS 13 are generally consistent with definitions in IVS, there are still differences in fair value concepts between IFRS and IVS. For example, IVS does not include a fair value hierarchy and IVS applies a different fair value definition. Management should be aware of these differences when assessing appraisals prepared pursuant to IVS. Considerable judgement may be required when applying the fair value measurement concepts included in IFRS 13. Management needs to have a good understanding of the concepts when making judgements related to its fair value measurements. 15 Fair value implications for the real estate sector and example disclosures for real estate entities

17 Section B Illustrative set of disclosures required under IFRS 13 for a real estate entity with investment properties B1. Introduction This section sets out an illustrative set of disclosures for a real estate entity that has investment properties measured at fair value on its statement of financial position, in its first set of financial statements following the adoption of IFRS 13. In determining the information to be disclosed in its financial statements, an entity uses judgement in light of the principles of materiality and aggregation in IAS 1. Hence, depending on an entity s circumstances, more detail or more aggregation than is contained in these illustrative disclosures may be required. This section includes only disclosures related to investment properties that are measured at fair value. Disclosures of fair value measurements of other assets and liabilities (e.g., financial instruments) are not covered. Entities in the real estate sector often use derivatives (e.g., swaps or interest collars) to hedge cash flow risks that result from variable interest loans. These derivatives are measured at fair value and are generally categorised within Level 2 of the fair value hierarchy. IFRS 13 requires disclosures for these derivatives in addition to those required under IFRS 7 Financial Instruments: Disclosures. However, we do not expect the amount of additional disclosures to be provided under IFRS 13 for such derivatives to be significant for many real estate entities compared with the level of additional disclosures required for the property interests held by these entities. Commentary 1: Where in the notes should the disclosures be made? We recommend that entities include all the fair value disclosures for investment properties in one note (or as part of one note) in the financial statements, rather than throughout and in the annual report. If such information was previously included in the Management s Discussion and Analysis or the Director s report, it may have to be transferred to the notes to the financial statements. Disclosures that are required by IFRS 13 need to be included in the financial statements. Commentary 2: Presenting information required under different standards in one table Paragraph 99 of IFRS 13 requires an entity to present the necessary quantitative disclosures in a tabular format unless another format is more appropriate. In some cases, it may be useful to present the information required by IFRS 13 together with the information required by IAS 40, to avoid replicating information in the financial statements and to provide comprehensive integrated user-friendly analysis. An example would be the combination of disclosures required under paragraph 93 (e) of IFRS 13 with the disclosures required under paragraph 76 of IAS 40. Paragraph 93 (e) of IFRS 13 requires an entity with recurring fair value measurements categorised within Level 3 of the fair value hierarchy to reconcile the opening balances to the closing balances. Paragraph 76 of IAS 40 requires an entity that applies the fair value model to its investment property to provide a reconciliation between the carrying amounts of investment property at the beginning and the end of the period. If most or all of the entity s investment property is categorised within Level 3, the information above could be presented in the same table instead of separate tables. B2. Illustrative disclosures Overview In the remaining sections of this document we provide illustrative disclosures on the following: B3 Early adoption B4 Classes of investment property B5 Fair value measurement, valuation techniques, changes in valuation techniques, inputs and other key information B6 Reconciliation of balances of classes of investment property Fair value implications for the real estate sector and example disclosures for real estate entities 16