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'Material uncertainty' – impacts on financial reporting

James Fox James Fox

James Fox looks at the implications of the material valuation uncertainty clause when preparing and signing-off financial statements.

One of the far-reaching consequences of the material valuation uncertainty clause issued by the Royal Institution of Chartered Surveyors (RICS) will be the impact on preparing financial statements and conducting the audit process. Auditors will need to consider the inclusion of the statement that “less certainty – and a higher degree of caution – should be attached to our valuation than would normally be the case”.

This element of uncertainty and caution is particularly relevant for boards of directors, and auditors preparing and signing-off financial statements for March 2020 and later reporting periods. For the most part, we expect the approach should remain relatively close to normal practice. But there will be additional considerations, the extent of which will depend on the nature of the real estate asset, the tenant base and the sector in which the properties are held.

Primary additional considerations

There are likely to be significant changes and uncertainty in terms of underlying assumptions, both from previous real estate valuations and when comparing different assets within and across sectors generally. We are also expecting a wider spread of assumptions that will require additional review and challenge, by directors and auditors alike.

A ‘one size fits all’ approach won't be possible. Consideration will need to be given to a range of issues, such as:

  • future rent roll
  • vacancy levels within properties
  • rent holidays and risk of tenant default
  • likely impact on valuations
  • varying levels of uncertainty depending on the individual nature of the asset and the entity’s own specific circumstances.

Physical inspections

Physical inspection of properties will not have been possible at 31 March so questions will need to be asked relating to the assumptions made by the valuers on the state of repair of the asset. These will have to have been based on directors’ representations to the valuer. Of course, levels of uncertainty will be greater if the last physical inspections were completed some time ago.

Director’s valuations

In instances where valuations have been conducted in-house, directors will need to determine whether their skills, qualifications and experience remain appropriate. Auditors will also need to challenge this assessment. It may be more appropriate (or even necessary) for more or all assets to have third-party valuations at 31 March.

Where cyclical valuations have historically been used for a portfolio of similar assets, it may be necessary to make additional considerations as to whether this remains appropriate, or if the valuation should be performed for more or all assets.

Assessment of caveats included in valuation reports

Valuation reports will be subject to additional scrutiny alongside the usual procedures. For example, greater scrutiny and assessment of any additional caveats included within the valuation reports will be necessary for directors’ financial statement disclosures. These may also affect the audit opinion offered.

Impact on financial statements and balance sheet

Clearly, investment property businesses should be braced for a significant impact when it comes to reported results and balance sheet health. Falling valuations will affect net assets and net asset values, as well as reported statutory profits and earnings per share.

Enhanced disclosures will be required in financial statements, specifically in relation to:

  • underlying assumptions made within and the sensitivities applied to valuations
  • sensitivities supplied in the valuations, which will need to be included in the basis of preparation and notes to the accounts
  • sensitivities in the narrative commentary to be included in the strategic report, to ensure the accounts remain fair, balanced and understandable to the reader.

This will all need more detailed consideration than previously.

Finally, the classification of debt in the case of any covenant breaches (for example, loan-to-value) will also need to be considered.

Impact on the audit report and audit opinion

As a minimum, auditors are expecting to include an ‘emphasis of matter’ paragraph in the audit report. This is not a qualification to the audit opinion. Instead it is a section intended to draw the user’s attention to the material valuation uncertainty.

A detailed explanation of this material valuation uncertainty will need to be included within the basis of preparation section and the notes to the financial statements.

There may be some instances where the valuation report refers to additional uncertainties or limitations inherent in producing the valuation. If this is the case, auditors will need to consider whether any qualification to the audit opinion will be required. Doing so can obviously have a significant impact on lender covenants, as well as resultant additional shareholder and investor scrutiny.

Finally, it’s important to discuss the concept of ‘going concern’, as this is connected to all of the issues raised. Additional considerations in relation to liquidity and covenant compliance – and therefore going concern – will need to be made. For directors, it's important that assumptions applied in the valuation (for example, relating to the level of future rents) are consistently applied within forecasts prepared for going concern purposes.

To discuss any of these points or talk through any challenges you are experiencing around the material uncertainty clause, please contact James Fox.

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