The Council of Ministers of the European Union approved regulation on applying FIRS for all companies, so Sells, a France-based Investment property company, also faces the substantial impact on their accounting standards, needs to choose between historical-cost or fair-value accounting to report its investment properties according to SASS 40. Silica was a major and historical player on the French commercial-property market.
It had over 700 individual tenants, ranging from small and medium-sized impasses to major multinationals in Paris and surrounding areas. Additionally, Silica had a largely institutional and relatively stable shareholders community. At December 31, 2004, Silica had over 1. 5 billion Euro of investment properties, including building at over 1. 1 billion and land at close to 449 million, the company was also constructing new office buildings at 62 million. Since 2001, France represented Rupee’s third largest real estate management and development Industry, generating 19. 9% of the European Industry value.
And Paris represented the largest commercial real estate market in Europe. By the end of 2004, a cusp of an upswing with sales prices rising on the year by 1. 5% appeared in commercial property market. Before introduction of FIRS in France, Silica reported its property assets with the French general accounting plan at historical cost. The depreciation of its office and light industrial buildings on a straight-line basis with average period of 40 years. In year 2003, Silica adopted SIC status. Within SIC, Silica had a tax exemptions of at least 85% of rental earning and 50% of capital gains to shareholders.
Furthermore, the revaluation of buildings gives a 70% value increase of company’s investment repertories. But Silica needs to pay an “exit tax” which is 16. 5% of latent capital gains on the buildings. In the face of implementation of FIRS, Skill faced important cultural sector and strategic dilemmas, as noted from CEO of Sells, Dominique Schlesinger. The company’s Board of Directors met on Issue of Implementation of FIRS, met numerous times during 2003 and 2004 to better understand SASS 40 so as to choose an appropriate method to measure the investment properties of the company.
Problem: When applying FIRS in year 2005 for Silica company, which method(fair-value method r historical-cost method according to SASS 40) should be used for most transparently reflecting Silica’s real value? Cast of characters: A) People: 1 . Dominique Schlesinger, Silica’s Chairman and Chief Executive Officer, needs to decide the method to adopt FIRS. B) Institutions: 1 . Council of Minister of the European Union: approved regulation that all company should use FIRS from January 1, 2005. 2. Sells: A French Investment property company which will adopt FIRS In year 2005. 3.
Cell’s Board of Directors: to better understand SASS 40 so that to choose the appropriate method to apply FIRS. Events: requiring all companies quoted on European stock exchanges to use FIRS from January 1, 2005 as the basis for their financial statement instead of using their domestic accounting standards for financial reporting purpose. A France-based investment property company Silica has to choose between historical cost or fair value accounting to report its investment properties in order to meet the requirement of the regulation approved. 2. In year 2003, Silica adopted SIC status.
Within SIC, Silica had a tax exemptions of at least 85% of rental earning and 50% of capital gains to hardliners. Furthermore, the revaluation of buildings gives a 70% value increase of company’s investment properties. But Silica needs to pay an “exit tax” which is 16. 5% of latent capital gains on the buildings. 3. The company’s Board of Directors met on issue of implementation of FIRS, met numerous times during 2003 and 2004 to better understand SASS 40. Issues: 1. Net profit 2. Price volatile 3. Market reflecting 4. Reliability 5. Convertible 6. Cost Options: A) Historical cost method Advantages: 1.
Prudence. The historical-cost model deems more prudent and more aligned. Indeed with the satirical-cost method, there is no revaluation each year and no introduction of an exogenous factor. So, the firm with this method can have a constant(almost a parallel line to the X axis) operating profit which doesn’t depend on the fair-value valuation(which can be reflected from Exhibit 9) as shown on Exhibit 6 and 7. The increase of the operating is not a consequence of a reevaluation of the investment properties. So, the main advantage of using historical costs is simplicity and certainty. 2.
Self-protection The historical-cost method enables to protect the company itself from unpredictable upward and downward movements on the commercial-property market and avoid contaminating its financial results with exogenous elements over which it had no control. The fair-value increases volatility and potential risks in highly volatile markets. As we can see from Exhibit 9, from 1979 to 2003, the commercial property prices in Paris and surrounding area is highly volatile, for example, the commercial property prices in Paris is in a range from 3,000 Euro to 14,000 Euro, and by the end of 2004 will arrive a new upswing cusp.
Disadvantages: 1. Fairness of reflecting market value. The main disadvantage is that historical cost model doesn’t reflect the market value and can be outdated. It’s not a relevant measurement and don’t enable to evaluate precisely the value of the company. Historical cost tells the user the acquisition cost of an asset and its depreciation in the following years, it ignores the possibility that the current market value of that asset may be higher or lower than it suggests. 2. Historical cost accounts do not measure the loss of value of monetary assets as a result of inflation.
So in case of high inflation, the assets could be misprinting and revoke disturbances in the analysts. The validity of historical-cost accounting is based on the assumption that the currency in which transactions are recorded remains stable, that is to say its purchasing power remains the same over a period of time. B) Fair-value method: 1. Comparison. Each company has the data fairly estimated at the same date, so the comparison is possible. Thus, there is a better quality in the information disclosed. The fair-value model enables the comparisons with the financial statements of other property companies.
So, fair-value measurement which shows current market conditions revises comparability of the value of financial instruments bought at different times. 2. Relevance for investors Fair-value measurement and presentation of an entity’s assets and liabilities result in increasing relevancy of financial statements information, so that readers of the financial statements will not have to make complex adjustments in analyzing the entity. Furthermore, the fair-value model also provides an easier understanding of the fair-value by showing the real value of the assets.
So, fair value provides important information about financial assets and liabilities as compared to values based only on their historical cost. Historical-cost financial statements are not relevant because they do not provide information about current values. 3. Positive affection on financial results. The use of fair-value could drastically help a company get approved for loans because it increases results. If the company has appreciated assets, it is able to obtain greater lines of credit or more favorable borrowing terms given the more current information under provisions. 4. No need to switch.
When a company uses historical cost, they have to disclose the fair-value of its investment property. So, the switching to fair value method reduces this inconvenience. Disadvantages: 1. Reliability. Market information can’t be available or sufficient information can be difficult to obtain. Obtain reliable information relevant to fair values has been one of the greatest challenges faced by preparers and consequently by auditors. The nature and reliability of information to estimate the fair value vary widely and thereby affect the degree of estimation uncertainty associated. 2. Lack of consistency in the financial statements.
It will be important to demonstrate consistency in how they’ve applied the fair value principles and developed the valuations to enable the company to maintain reducibility with investors, lenders and auditors. But in some financial statements items are presented at fair-value while others are presented at cost, this will lead to confusion for the investors. 3. Early recognition of unrealized profits result of an increase in market value. Then fair-value measurement could be considered as arbitrary. Its financial results would be dependent on the assessments of third party valuation firms and it could create volatility according to Silica. . Cost of training and development The fair-value may generate the cost of training and development. The difficulty of assortment can oblige to hire more staff include one or more member sufficiently skilled and knowledgeable about fair value accounting to comply with the standards. 5. Unrealized capital gain. Fair value could artificially inflate the group’s financial results and subject them to variations in market value. It could increase results and takes and creates more volatility or uncertainty for the investors.
So, recognize an unrealized capital gain would increase shareholders’ equity. To sum up, fair-value, while not perfect, is the best method to reflect market conditions when accompanied by appropriate disclosure. Although it has generated controversy, fair-value continues to represent the best available methodology for determining and reporting the value of investment properties. But as we explained in previous, the market price of the commercial properties in Paris during 5 years is in heavy volatility, and the fair-value increases volatility and potential risks in highly volatile markets.
Furthermore, at the end of year 2004, the price of commercial properties would go to a new cusp, that means the net profit from year 2004, 32,841 thousands Euro will be assessed at a much higher value with fair-value measurement. This important change could create a high volatility in the stock price and a doubt about the real value of Silica for investors which could be prejudicial. Recommendations: Finally, our team think the using of historical-cost method has more advantages and less disadvantages and it is appropriate to the commercial properties price of Paris.
Plan of action The company should have major phases to prepare for the transition to FIRS from French generally accepted accounting principles. 1. First Phase: Initial Assessment. A meeting should be held by the Audit Committee in order to have a detailed review f the differences between international standards and the standards currently used by Silica, and their impact to financial statements. The Board of Directors will review the main conclusions and discuss the key accounting options. 2. Second Phase: Designing the Change Process all significant relevant information has been gathered and analyzed.
The company now understands the scope of the effort, its costs, and its benefits. The formal change management process, including a timeline, can be designed and staffed. Training can begin in all relevant segments of the company for financial and operational managers and key personnel. Internal and external auditors will have concurred with both accounting conclusions and the impact on internal controls over financial reporting. International accounting standards provide for specific treatment of investment property (SASS 40), which covers virtually the portfolio of Silica.
Completed buildings and land may be valued either at cost less accumulated depreciation (cost measure investment property, in this case we will use the cost model in order to limit, as far as possible, the impact of changes in fair value on results and preserve Silica’s current operating structure as reflected in the profit and loss account. 3. Third hash: Managing the Change Process This phase includes all changes to information flows and processes, both manual and automated, in anticipation of the conversion dates.
Thus, changes are made and tested, but at least some aren’t yet made operational. Implementation training continues. The Coffs office drafts appropriate external communications, such as investor relations. 4. Fourth phase: Full implementation with ongoing testing of quality and accuracy. Remaining communications, internal and external, are completed. Enterprise risk management and other strategic processes are adjusted in light of the new model of measurement and disclosure.