Property and international accounting standards

Copyright: David Lawson - Real Finance 2003

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Bricks and mortar are the strangest thing. Solid, dependable, weatherproof, secure. And almost totally invisible to shareholders. The costs and benefits of the meanest photocopier and company car gets rolled into the books, but not the vast resources tied up in buildings. It’s enough to make any accountant jump on his pocket calculator with rage. Which is exactly what’s happening, as they draw up new rules for global accounting practices to include more transparent figures for property.

  But there’s one tiny problem. They can’t figure out how to do it. The EU says  every public company must conform to international accounting standards by the end of 2005 yet no-one knows how buildings will be handled. ‘They’ve made a complete horlicks of it all,’ says one top property valuer, who will have to try and implement any changes. Why is it so crucial? The average occupier hardly notices their surroundings. They are like electricity and water – an underlying service essential but peripheral to the  core business. But one suggestion could bring those buildings crashing down to crush the most well-ordered balance sheets.

   Analysts hate the fact that the meanest photocopier is rolled into the books because it is held on a financial lease while bricks and mortar are virtually invisible because they are considered operational leases and get scant mention. The UK’s Accounting Standards Board was set to lump them together. At first sight it might seem neutral to put the projected rents over the life of a lease on one side of the balance sheet and the present value of the building on the other. But gearing would soar and solvency whither, possibly breaching banking covenants. And once property is anchored to the accounts, all those thoughts of raising cheap capital through sale-and-leaseback fly out of the window.

  Fears that financially healthy companies would be dragged into the mire eased when the EU barged in with its own plans for unifying international accounting standards. Property went back on the farthest burner. But not far enough. Battles continue to rage behind closed doors about how to handle this awkward conundrum, and some of the potential solutions could bring a spate of early retirement among sitting finance directors.

  One calls for the land and building elements of a lease to be separated. Land owners eventually get their asset back, just like a rented photocopier, so this would go in the books. The buildings would remain financially invisible, as international accounting standards cannot cope with occupational leases. Cue for property experts to fall about laughing. No-one knows how to separate the two. But the prospect remains that accounts will need to be drawn up with part of the property on the balance sheet as a finance lease and the rest hidden away. So much for clarifying financial reporting.

 When this happens is anybody’s guess. Most insiders dismiss any chance of implementation by 2005 along with the rest of the changes being drawn up by the International Accounting Standards Board. But it is still likely within the lifetime of most of the current leases which last an average of 15 years in the UK and must be considered for any new ones signed in the normal course of business over the next few years.

   Of course, all those occupiers who own their buildings can ignore this miasma of uncertainty, can’t they? No chance. Corporate occupiers currently list their freeholds  by what they cost, amended to take account of depreciation,  or by revaluation to existing use/replacement value. Under the new international standards they can continue with the first but would be mad to do so. Predators can pay for a takeover merely by the surplus generated by revaluing your own property. So they may revalue, and that’s where the fog again begins to descend.

  How much is the building or site worth? Possibly more than existing use, so the IASB will insist on a ‘fair use’ value. The site may be revealed as worth more than the business, again ringing bells for potential predators.   Valuations must also be done on all property at the same time by outside valuers rather than the current tendency to do bits and pieces as and when convenient.

 Many may cringe from such a heavyweight task and want to fall back on historic valuation. That would normally be impossible, as companies would need detailed records of acquisitions that may have taken place decades or more ago. But the IASB seems to be encouraging it by a ruling allowing any listed firm to use current existing use valuation as a basis for historic cost.

 In other words, it is not forcing companies to be more transparent if they don’t like the idea, which seems to blur the whole issue. Shareholders may have different ideas, though. Anyone retreating into the mists of time should prepare for some biting questions at annual general meetings about why their assets are not being fully recognised.

  The chairman may also have a different agenda. The best way to fend off takeover bids can be to get your retaliation in first, revaluing historic property to a level higher than predators are willing to pay. Or it may be merely to ensure they come up with a reasonable price. Debenhams, Safeway and Somerfield have all recently been down this course.  And where does all this leave the poor finance director? Perhaps an early retirement before the bricks, and brickbats, start to fall.