International Accounting Task 2: Case APT, Inc. - An Application of Fair Value (15 p) Please provide answers to the following questions (approximately 5 pages text + Excel file). 1 a) Calculate the fair value of the rental property based upon comparable market values less the cost of disposal. b) What are the limitations of using the market value approach? c) Do the limitations apply to this case? d) Is the market value approach appropriate for this type of asset valuation? 2 Calculate the value in use of the rental property. As you do so, be sure to clearly note all assumptions you make. Also explain how you determined the appropriate discount rate(s). 3 Determine if the asset is impaired. If you determine that the asset is impaired, propose the appropriate year-end adjusting entry. Deadline: Sunday 3 October by 4:00 p.m. via Moodle

CASE

Introduction Ed Smith is the Director of Accounting at APT, Inc., a US-based subsidiary of a Canadian holding company1 . Consistent with its parent company, APT, Inc. prepares its financial statements in accordance with International Financial Reporting Standards (IFRS)2 . Ed and the accounting staff are working on the June 30, 20x2 year-end adjusting entries. Once the entries are complete, they can prepare a draft of the IFRS-based annual financial statements for their external auditors to audit. As part of the year-end process, Ed faces one of his most challenging assignments to date. He must determine whether or not the carrying value of the Ithaca, New York student rental property is impaired, and also provide a fair value estimate of that property. Because of the judgment involved in determining the recoverable amount of the asset as defined by IAS 36, and the determination of the asset's fair value required by that standard and IAS 40 (2005), Ed is particularly concerned that his estimates are well-supported and easy to explain to the company's independent public accounting firm's audit staff. Ed graduated seven years ago with a degree in accounting from a large US university. After graduation he worked for a US-based commercial real estate company. He's well versed in US generally accepted accounting principles (GAAP), but finds his recent move to APT, Inc. includes the challenges of becoming familiar with the requirements of IFRS. In his prior position he reviewed each of the company's rental properties for possible impairment, but these reviews never resulted in any impairment losses even during the worst of the real estate crisis. He's sure this is because of the US GAAP provision that undiscounted cash flows associated with the properties be compared to their book values. The undiscounted cash flows were always greater than the book values. From what Ed has read, property impairments are more likely when IFRS 1 This case is based upon an actual student housing project. The case facts have been significantly changed to present the facts in a manner that allows students to assess impairment and fair value issues when using International Financial Reporting Standards. 2 Effective January 1, 2011 Canadian publicly-accountable enterprises were required to adopt IFRS. Because the focus of the case is the application of the IFRS impairment and fair value standards, we omit any references to or case requirements that include first-time adoption issues as required by IFRS 1 (IASB 2008b). is used. Just this week he read a Wall Street Journal article that reported BP recognized impairment losses of approximately $5 billion on its US assets during the second quarter (Flynn 2012). General Commercial Real Estate Market Conditions The commercial real estate market has been severely impacted by a lingering recession. In the last two years, commercial real estate prices in the area have fallen by 10%.3 The market is not expected to recover within the next year, with vacancy rates set to rise and rents forecasted to fall. The general feeling in the real estate industry is that even commercial properties in prime markets will need to make rent concessions. In addition, there are persistent and continuing concerns about unemployment, consumer confidence and other economic conditions. All of these factors have the potential to negatively impact university enrollment which would likely reduce the occupancy rate of student apartment complexes. Company Background Information APT, Inc. is a real estate holding company that specializes in providing residential housing for college students. Its business is limited to the following activities: to acquire, own, develop, build, operate, lease, mortgage, sell and/or otherwise deal with certain college student rental properties located in the United States. Such activities include making improvements to any acquired properties and doing any and all things necessary to carry out and further the business of APT, Inc. The bylaws of the company state that other than the initial mortgage on the properties, the company can only incur indebtedness in an amount necessary to acquire, operate and maintain any of the properties. Each of APT, Inc.'s rental properties is treated as a standalone entity for financing and decision-making purposes. At the time Ed is determining the fair value of the apartment complex, the total book value of APT, Inc.'s assets is approximately $200 million and its annual after-tax net income is approximately $15 million. Because the real estate market, including the segment dealing with residential apartment complexes, has been very weak for the last several years, the assessment of the fair value of all APT, Inc.'s properties 3 For purposes of this case, this should be considered evidence of a "triggering" event for asset impairment valuation purposes. is a sensitive area with both senior executives at corporate headquarters and the independent auditors. Property Information The Ithaca, New York property is an apartment complex designed to house 800 junior, senior and graduate students. First and second year students are not allowed to live in the complex. APT, Inc. worked with the local university to determine the location and design of the apartments. The project's goal is to encourage more upper-level and graduate students to live on campus, rather than in off-campus housing with less convenient access to the university. The town of Ithaca approved the project in an attempt to relieve some of the neighborhood pressures associated with off-campus student living. APT, Inc. leases the land on which the complex is built from the university. The company owns and operates the apartment buildings. The land lease is written for a thirty-year term beginning with the complex's first full year of operation. At the end of each year, the lease automatically renews for a new thirty-year term unless otherwise indicated by either party. As APT, Inc. does not own the land that the complex is built on, the ownership of the building transfers back to the university at the end of the contract. The contract calls for a payment to be made to APT, Inc. based on the residual value calculated as the average after-tax cash flows of the last ten years discounted at a rate equal to the yield on a ten-year US Treasury bond plus 200 basis points.4 Students view APT, Inc.'s on-campus apartment complex as having advantages and disadvantages over other off-campus housing options. The apartments are new and close to campus facilities such as classrooms, the library, the athletic complex, and the student center. However, the students believe there is a "dormitory" feel to the housing complex and find their "freedom" to engage in typical off-campus activities is more limited than in other housing. Thus, a high occupancy rate is not guaranteed, especially as the complex starts to show the physical deterioration associated with having a transient population occupy the facility. 4 This provision is not meant to imply the asset's fair value at the termination date. It is simply a contractual agreement as to the cash payout should the land contract not be continually renewed. Basis points are a unit of measure equal to 1/100th of one percent. Thus, one basis point equals .01% and 200 basis points equals 2%. There are a large number of apartment rentals within 2 miles of the university. Many of the apartments are suitable for groups of two or four students; the apartments rent for $1,000 to $2,400 per month, depending on the number of students living in the apartment. Although many of these apartments are in older buildings that have not been well-maintained and show the wear and tear from having college students as prior tenants, the occupancy rate of these apartments is close to 100%. Two well-maintained apartment complexes within walking distance of campus charge monthly rents comparable to that of APT. These complexes have average occupancy rates of 85%. Construction Costs and Funding Information The construction costs associated with the Ithaca apartment complex totaled $44,800,000. An additional $1.8 million in costs associated with the project were expensed as incurred during the construction phase.5 The complex has 400 identical apartment units. Each apartment is designed to accommodate two students. The construction cost per unit is $112,000. A private equity firm contributed $9,000,000 of capital to the entity for purposes of financing this project; APT, Inc. borrowed an additional $38,800,000. Thus, total funding for the project was $47,800,000, of which $46,600,000 was used for construction-related costs or operating costs incurred during the construction period and $1,200,000 is available as working capital. At the end of the complex's second year of operation, APT, Inc. paid a $90,000 dividend to the private equity firm that made the capital investment. APT, Inc. expects to continue to pay an annual dividend of $90,000, an amount that is comparable to dividends paid on other projects recently placed into service by both APT, Inc. and other publicly-traded companies that invest in large residential rental properties. The private equity firm expects to retain its investment in the common stock of APT, Inc. The $38,800,000, 30-year mortgage was obtained from a local bank. The loan is secured by the building and the interest rate is fixed at 6% for the duration of the loan. The loan terms do not allow for any refinancing within the first five years. The total annual mortgage payments are 5 Costs that were expensed as incurred include legal fees associated with negotiating contract terms with the university, non-construction employee costs, office rent, utilities, etc. $2,818,778. The terms of the loan require monthly loan payments to begin as of the first day of the month after the certificate of occupancy is issued. The certificate of occupancy was issued June 2, 20x0 and APT, Inc. began making loan payments on July 1, 20x0. Apartment Operations Each apartment unit generates $1,400 of rental revenue per month for each of the nine months in the University's academic year. Construction issues with some of the apartments prevented immediate occupancy in its first year of operations. As a result, the apartment complex occupancy rate was approximately 80% in the first year and 85% in the second year. APT believes the occupancy rate will stay at 85% over the coming years. Additional Financial Information The city of Ithaca assessed the property's value at $38,800,000 for property tax purposes. The city conducts these assessments every ten years. Property taxes for the first year were billed at $300,000. While the assessment value stayed the same, the city significantly increased the tax rate for the second year, and the property taxes increased to $350,000 per year. The city stated it has no current plans to further increase the rate anytime in the foreseeable future. Rather than pay for insurance coverage for the full replacement cost of the building, APT, Inc. elected to pay for insurance that would cover 80% of its replacement cost. The remaining 20% will be covered by a "self-insurance plan." To fund the self-insurance plan, APT, Inc. set aside $15,000 in the first year and $20,000 in the second year of operations. APT, Inc. expects to continue to set aside $20,000 each year for the foreseeable future. The company also expects to evaluate the replacement cost of the building every five years in order to insure there is adequate insurance coverage on the property. Since the complex is only in its third year of operation, no such assessment has been made on the property. Based on its prior experience, APT, Inc. estimates the annual insurance premiums will increase from 2-5% per year. The terms of the insurance contract specifically state that the current replacement cost of the apartment complex is only 90% of its construction cost. Based upon discussions with the management group, Ed is convinced this replacement cost is realistic as material costs have decreased as a result of declining demand for building products. Engineering advances have also reduced the structural costs associated with this type of construction project. The poor economic conditions that have persisted in the Ithaca area continue to pressure contractors to reduce the labor costs associated with construction projects, thereby keeping the cost of new construction lower than in the past. In years 1 and 2 the complex generated pre-tax net operating cash flow (i.e., before mortgage payments) of $2,857,000 and $2,902,000, respectively. The book value of the apartment complex at the end of year 2, assuming straight-line depreciation over 30 years with no expected salvage value, is $41,813,3336 . A summary of the apartment complex's cash flow data for its first two years of operation is included in Table 1. Cash flow closely approximates accrual-based revenues and expenses, exclusive of the effect of depreciation and financing costs. Table 1: APT, Inc. cash flow details year 1 and year 2 of operations Actual Actual 6/30/x1 6/30/x2 Year 1 Year 2 Total cash receipts $4,032,000 $4,284,000 Cash disbursements: Operating expenses 785,000 900,000 Insurance premiums 65,000 85,000 Self-insurance 15,000 20,000 Nonreimbursed student damages - 2,000 Property taxes 300,000 350,000 Maintenance 10,000 25,000 Total cash disbursements 1,175,000 1,382,000 Pretax cash flows 2,857,000 2,902,000 Interest and Principle Payments 2,818,778 2,818,778 Income tax payments 0 0 6 Although IAS 16 (IASB 2008a) paragraph 43 requires that "Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately," Ed determined that, on average, 30 years represent an appropriate life for the component parts of the building. Ed also recognizes that maintenance costs are expensed as incurred and thus have no impact on book value calculations. Financial Projections APT, Inc.'s accounts receivable manager analyzed the data from its other large residential rental units and found that over the past ten years, annual rent increases averaged 4%. The manager is concerned that APT, Inc. may have difficulty raising rents at the Ithaca location. Based on this information and the information provided on the general market conditions, the accounts receivable manager projects only a 10% probability that rents will increase 4% annually, a 60% probability that there will be no annual rent increase, and a 30% probability that rents will decrease 3% over the next 3 years. Thereafter, the employee predicts a 50% probability that rents will increase 4% annually and a 50% probability rents will not increase at all. APT, Inc.'s accounts payable manager analyzed the past ten years' actual expenses associated with APT, Inc.'s other large residential rental properties. Based on that analysis, the manager projects that there is a 60% probability that expenses other than taxes, insurance, nonreimbursed student damage assessments, and maintenance will increase 4% annually, a 30% probability these same expenses will increase 3% annually, and a 10% probability these expenses will increase 5% annually. The manager separately projects that there is a 50% probability that maintenance and repairs will increase 5% annually and a 50% probability those expenses will increase 10% annually. These amounts are based on the historical rates of other properties that APT, Inc. owns. Finally, the complex has had little experience with estimating the amount of student damages it will be unable to collect, but the projection for the current and future years, not included in any numbers above, is 0.25% of projected cash revenues. All of the estimated financial information has been approved by management and incorporated into its financial forecast. Fair Value of "Like" Properties Although there are many rental properties in the city of Ithaca, the majority of these properties have between 4-20 units each. Over the past year, eight of the residential income properties that are within a two-mile radius of the university were sold at an average sales price of $95,000 per unit. There is no reliable source of information for determining the average vacancy rates on the properties that were recently sold. Most of those properties are at least twenty years old and many were not well maintained. Two years ago a competitor to APT, Inc. sold an apartment complex with 200 units used to house university students in Syracuse, NY for $21,000,000. At the time the complex was in its seventh year of operation. Ed realizes there are fewer buyers now than even a year ago, but as evidenced by the sale of the Syracuse property, student-focused rental real estate continues to sell. In the two years after the sale, commercial real estate values in the Syracuse region have dropped approximately 10%. Commercial real estate agents generally charge the seller a commission computed at 3% of the agreed selling price. In discussions with the property manager at APT, Inc., Ed determined that anywhere from 5-15% of the selling price of the Syracuse property could be attributed to the land. The percentage is quite low because of strict zoning restrictions on that property. Accounting Guidance Provided by the Corporate Controller and Treasurer Since this is Ed's first IFRS fair value assessment, he participated in a conference call with the corporate controller to make sure he understands how APT's parent company applies the IFRS standards. His notes include the following: 1. Cash flow projections should not be impacted by how the asset is financed. As such, principle and interest payments are excluded from cash flow projections. Projected dividend payments to the private equity firm should also be excluded. 2. When assessing whether or not an impairment loss should be recognized, IFRS compares the carrying value of the asset to its "recoverable amount," which is defined as the 1) greater of the fair value of the asset less costs of disposal or 2) the asset's "value in use," i.e., the present value of pre-tax future cash flows7 . 7 When measuring the value in use, IAS 36 paragraphs 53 (a) - (b) (IASB 2005a) provide specific guidance as to the estimates of the cash flow that will be received at the end of the asset's life. The amounts represent the entity's estimates of the amounts that would be received for comparable assets that reached the end of their useful lives, adjusted for general and specific future price increases. Comparable assets are not available in the local market and including this information would further complicate the case. As such, participants should rely on the cash flow information provided on Table 1 when determining value in use and the fair value estimates using the income approach. 3. When determining the fair value less the costs of disposal Ed should remember that IAS 36.BCZ29 precludes the use of the cost method. Further, under IFRS, the discount rate used to determine the present value of future cash flows is a pre-tax, asset-specific rate adjusted for risks specific to the assets for which the cash flows were not previously adjusted. Ed should compute the present value of the anticipated cash flows using both the pre-tax weighted average cost of capital and his best assessment of the asset specific discount rate. The concern is that the pre-tax weighted average cost of capital is based on interest rates that no longer prevail in the market. 4. Projected cash flows should be limited to five years unless further projections can be established as reliable. A residual value calculation should capture projections past five years8 (note - this is not the same residual value calculation that is specified in the contract if the lease is terminated). 5. IFRS13.14 (IASB 2011) refers users to the appropriate individual IFRS to determine the unit of account when determining the fair value estimate. IAS 40 (IASB 2005b) is the appropriate standard, and per that standard the apartment complex is the appropriate unit of account.9 6. The Controller prepared a summary of significant concepts underlying both the impairment and fair value standards. The controller will email these if Ed decides he needs them.10 7. Ed should carefully consider if the estimates provided by others within the organization are likely to occur in the future. APT, Inc. has only two years of cash flow data for this property, so they have little historic basis for forming expectations for the future. 8. The controller explained to Ed that the income approach to valuation for disclosure purposes is based on discounted cash flow models prepared by a market participant (e.g., a potential buyer of the asset). The VIU calculation is based on management's discounted cash flow projections. The controller indicated that for purposes of this exercise, Ed can 8 Instructors who wish to provide students with instructional guidance on the computation of terminal values will find that material in Appendix B of the Teaching Notes that accompany this case. 9 This approach is consistent with the guidance included in the PwC's IFRS Manual of Account (PwC 2012). 10 Definitions of fair value less costs of disposal and value in use as defined in IAS 36 as well as an overview of the fair value hierarchy and the cost, market, and income approaches defined in IFRS 13 are included as Appendix A of the Teaching Notes. Instructors may or may not want to distribute the Appendix as part of the APT, Inc. case. assume that the discounted cash flows calculated by a market participant are the same as those prepared by management. Later in the day, Ed received the following rate information in an email from the treasurer: pre-tax 10-year US Treasury bond rate 5.00% APT, Inc. risk adjusted rate 8.00% Initial mortgage rate 6.00% Industry average borrowing rate 9.00% After receiving the rate information, Ed took some time to review his notes from the recent phone call and reread IAS 36 and IFRS 13, including Appendices A and B of both standards. He believes he has a basic understanding of the impairment test required by IFRS, and the ways in which the fair value less costs of disposal and value in use required by the impairment test may be calculated. Although he is aware that IAS 36 clearly states it may not be possible or necessary to determine both the fair value and value in use, he believes it is important to compile as much supportive evidence of the apartment's current value as possible. As such, he plans to determine the value in use and the fair value using the methods described in the standards. He realizes that he should also determine the fair value using the cost, market and income approaches described in IFRS 13 for fair value disclosure purposes. DISCUSSION QUESTIONS FOCUSED ON DETERMINING IF AN IMPAIRMENT LOSS SHOULD BE RECOGNIZED 1. Fair value less costs of disposal is easiest to determine if there is a signed purchase and sale contract. Ed obviously doesn't have a document of this nature, so he must estimate fair value using various estimates. Calculate the fair value of the rental property based upon comparable market values less the cost of disposal. What are the limitations of using the market value approach? Do the limitations apply to this case? Is the market value approach appropriate for this type of asset valuation? 2. Calculate the value in use of the rental property. As you do so, be sure to clearly note all assumptions you make. Also explain how you determined the appropriate discount rates. 3. Determine if the asset is impaired. If you determine the asset is impaired, clearly show your calculation of the impairment charge and propose the appropriate year-end adjusting entry. Prepare an Excel worksheet that summarizes your calculations. - - - - - - REFERENCES Flynn, A. 2012. BP profit tumbles on write-downs. The Wall Street Journal (August 1), B4. International Accounting Standards Board (IASB). 2011. International Financial Reporting Standard 13 - Fair Value Measurement. London: IASB. _____. 2008a. International Accounting Standard 16 - Property, Plant and Equipment. London: IASB. _____. 2008b. International Financial Reporting Standard 1 First Time Adoption of International Financial Reporting Standards. London: IASB. _____. 2005a. International Accounting Standard 36 - Impairment of Assets. London: IASB. _____. 2005b. International Accounting Standard 40 - Investment Property. London: IASB PricewaterhouseCoopers (PwC). 2012. 17 - Investment property (IAS 40). IFRS Manual of Accounting. Downloaded from PWCComperio (www.pwccomperio.com).