Hipercept

Conversion to IFRS

and the impact on Real Estate

By Howard Cohen

hcohen@hipercept.com

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Conversion to IFRS promises to be the single biggest change to accounting policies and procedures ever undertaken by those involved in U.S. Real Estate. Beyond the accounting changes, conversion to IFRS will impact everything from systems design to investor relations to compensation practices.

On February 24, 2010, the SEC held an Open Meeting to discuss the timeline of incorporating IRFS into the U.S. Financial System. The outcome of the meeting was that the SEC agreed to publish a statement of continued support for a single set of global accounting standards and acknowledged that IFRS is best positioned to meet these standards.

With Japan planning to convert to IFRS in 2012 all major economies will be using IFRS with the exception of the U.S.

The SEC acknowledgement was recognition of the fact that conversion to IFRS is accelerating globally. Over 100 countries have already adopted IFRS with another 50 countries expected to adopt IFRS by the end of this year including Brazil, Canada and South Korea. With Japan planning to convert to IFRS in 2012 all major economies will be using IFRS with the exception of the U.S. However, according to a recent PWC report, there are already over 130 foreign private issuers (FPI’s) in the U.S. who file Financial Statements using IFRS guidelines and some U.S. based companies have begun using IFRS guidelines to raise capital through Private Placements. With this kind of momentum, it is clear that adoption of IFRS by the U.S. is a matter of when, not if.

Fair value reporting — not an option?

Upon conversion to IFRS, real estate firms will have the “option” to record the value of their investment property using the Fair-Value method. Under this method adjustments to the carrying value of the property are made each quarter with all changes in value reflected in either a profit or a loss. Additionally, investment property is not depreciated and impairments are not assessed as the property is “marked to market” each period.

For many real estate firms, converting to Fair Value will not be an option at all but an absolute requirement. Investors have long been critical of the lack of market value information reflected in financial statements and firms that choose to stick with an At Cost model may find themselves at a competitive disadvantage in the Capital Markets. Moreover, even if a firm doesn’t change to a Fair Value method for P&L purposes, it will still be required to disclose the Fair Value of their real estate in the footnotes to their financial statements.

Firms that choose to stick with an At Cost model may find themselves at a competitive disadvantage in the Capital Markets

Changing to a Fair-Value model will have wide-ranging implications for firms, among them:

• Identifying the resources, either internal or external, who are capable of determining fair value each period. Included in this is the establishment of the system processes and procedures needed to handle these calculations and subsequent reporting;
• Use of Fair Value may result in significant fluctuations in net income each period. This could cause some firms to decrease their use of leverage to ensure that asset value volatility due to interest rate fluctuations can be minimized;
• Management‘s judgment will be placed under increased scrutiny. IFRS is more principles based than GAAP and thus requires more judgment and narrative. The assumptions used to calculate measures such as cost of capital, discount rates, capitalization rates, rental and expense growth rates, etc. will all need to be detailed in the financial statements. In addition, legal areas such as debt covenants, partnership agreements and joint venture agreements will likely be affected as well. Finally, the disclosures included in the financial statements take on increased importance to analysts and investors as they provide vital information about how decisions were made regarding various accounting alternatives.

What Real Estate companies can do to get ready

A conversion on the scale of IFRS is complex, time consuming and requires real commitment. Fortunately, enough non-U.S. or multinational companies have been through it to have established a set of best practices. Among which are the following:

1. Establish a Steering Committee

   Set up this committee at the outset with a strong leader who has the right mix of Accounting and Business experience. The committee should have regular interaction with the Board and Audit Committees as well as external auditors.

2. Set a realistic timetable

   When creating the timetable, particular focus should be paid to additional disclosure requirements, including restated financial statements. A Deloitte study of European Real Estate firms found that financial statements grew by 50-100% on conversion to IFRS and that presentation and disclosure took an unexpectedly significant amount of time to get right.

3. Include IFRS as part of your technology roadmap

   A conversion to IFRS offers a great opportunity to revamp financial processes and policies and the technology that supports them. For some companies, it will serve as the business case for eliminating disparate legacy systems.

   International experience has shown that firms that get a late start on conversion are not able to fully integrate IFRS into their systems and processes up front. As a result, first-year financials are often produced under a labor intensive and unsustainable environment. One of the more common problems is the inability to embed transactions into their General Ledger sub-ledger and sub-systems due to time constraints.

   Additionally, IFRS will undoubtedly impact more than just accounting systems but will require changes to supplemental systems such as project management systems, sales tracking systems, etc.

4. Don‘t ignore human resources issues

   A conversion to IFRS is likely to impact hiring and compensation practices. In addition to the obvious need to have the Accounting and Finance staff trained in IFRS, there are more subtle issues such as paying commissions to agents based upon sales or rental revenue or net asset value, all of which involve revenue recognition criteria that differ between GAAP and IFRS. Bonuses that are paid based upon profits are another issue to consider as in many cases reporting under IFRS will impact the bottom line.

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