The adoption of IFRS in the US will have significant ramifications for the way investors evaluate their opportunities, says Robert O'Brien
Real estate has long benefited from a steady international flow of capital despite the bumps and friction caused by different currencies, languages and accounting from one country to the next. However, one of those friction points may soon be removed as the US moves rapidly towards adopting International Financial Reporting Standards (IFRS), a set of accounting and financial reporting standards that are already used in the EU and throughout the world.
IFRS focuses on transparency of financial information using extensive disclosure. IFRS is more principles-based than the heavily rules-based US generally accepted accounting principles (US GAAP). There is less guidance on accounting for matters under IFRS, allowing more judgment and choices in the application of accounting principles, but also requiring more disclosure to make the accounting clear and transparent to investors and others.
The adoption of IFRS in the US will have a significant impact on US real estate companies and global real estate investors. IFRS provides US real estate companies with enhanced comparability to global peers and competitors and perhaps greater opportunity to raise capital globally. For global real estate investors, the adoption of IFRS by US real estate companies can provide more consistency and comparable information in financial reporting, and enhanced ability to benchmark and compare performance across their global real estate investments.
Moving to a global financial reporting model may open up access to new sources of capital for US real estate companies. Many global lenders, global private equity firms and international exchanges require, or prefer, IFRS reporting due, in part, to its increased transparency into fair values and comparability to other investments or companies. Thus, these sources potentially become new avenues for capital funding, particularly in the current US capital markets environment. However, greater use of fair value of underlying investment properties may create more volatility in a company's access to capital. Not only can reporting under IFRS potentially open up access to additional capital in a favourable fair value environment, but can also serve to limit the availability of additional capital in an unfavourable fair value environment. Furthermore, with reporting or disclosure of the fair values of investment properties, management will likely need to understand, evaluate and manage the expected market reactions to reported volatility in property values. This will represent new territory for most US real estate companies.
On 14 November 2008, the US Securities & Exchange Commission (SEC) issued its long-awaited proposed IFRS roadmap outlining milestones that, if achieved, could lead to mandatory transition to IFRS by US issuers starting in fiscal years ending on or after 15 December 2014. The roadmap also contains proposed rule changes that would give certain US issuers the early option to use IFRS in financial statements for fiscal years ending on or after 15 December 2009.
According to the SEC, "the use of a single, widely accepted set of high-quality accounting standards would benefit both the global capital markets and US investors by providing a common basis for investors, issuers and others to evaluate investment opportunities and prospects in different jurisdictions". The SEC also notes that IFRS has the potential "to best provide the common platform on which companies can report and investors can compare financial information."
A number of characteristics of the real estate industry make it a prime candidate for early conversion to IFRS. Major real estate investment trusts (REITs) and real estate private equity firms often have operations and assets that span several countries and continents. Accounting and financial reporting provides a vital link between real estate companies and their capital providers. In the US, some real estate entities, such as public REITs, report on a historical cost model under US GAAP, while other real estate entities, such as investment companies and real estate funds owned primarily by institutional investors, report on a fair value model, also under US GAAP. Real estate investors are looking for more consistency and comparable information in financial reporting from real estate companies, which IFRS can provide.
Under the proposed roadmap, US issuers that meet both of the following criteria would be eligible to use IFRS in financial statements for fiscal years ending on or after 15 December 2009. First, the US issuer must be among the 20 largest listed companies worldwide in its industry, as measured by market capitalisation. Second, IFRS must be used as the basis for financial reporting more often than any other basis of accounting by the 20 largest listed companies worldwide in the US issuer's industry, as measured by market capitalisation. A number of the larger US publicly traded REITs will likely meet this criteria, although it is currently unclear whether any will elect to early adopt IFRS.
US GAAP and IFRS differ in key ways, including their fundamental premise. Overall, US GAAP is rules-based, whereas IFRS is principles-based. Under US GAAP, voluminous guidance attempts to address every conceivable accounting issue that might arise. And if that guidance doesn't exist, it is created. Although IFRS is not without its rules, US accountants will have less interpretive guidance to use under it and so will be required to use more professional judgment than they are accustomed to.
However, it is not simply the dissimilarity between a rules-based approach and a principles-based approach that accounts for the differences between the two sets of standards. The standards differ on a number of points and can significantly affect a company's financial results. Although the extent of these differences is dwindling, as a result of ongoing convergence projects by US and international standards-setting bodies, significant differences remain in areas such as investment properties, plant and equipment, leasing, impairment, income taxes, and revenue recognition. Also, as IFRS generally allows for more choices than US GAAP, differences in accounting for similar transactions under IFRS may result. This is particularly evident in the accounting for investment properties under IFRS, which allows the choice of accounting using historical cost or fair value. Given that the principles-based approach and more choices may result in differences in accounting for what appear to be similar transactions, robust disclosures are required to assist in the comparability and transparency of the financial reporting.
For European real estate investors the advent of a standard reporting language across major regions, including the US, will change the way European investors evaluate investment opportunities and performance.