This is an area where there has been a significant change from UK GAAP to IFRS, and this is explained succinctly in UNITE Group plc’s annual accounts for 2005.
UNITE Group plc is a company based in Bristol, which has a core strat- egy of building and maintaining student accommodation at universities. The company’s primary focus is to build modern and safe student accommodation in a relaxed atmosphere, thereby creating a community environment. Typical of this vision is ‘The Heights’ complex in Birmingham, a new concept of stu- dent village that houses 911 students and incorporates a large common room, a quiet room and a gym. The company is expanding and has property under development as well as completed property.
UNITE Group plc’s 2005 accounts explain the following.
Investment property and investment property under development
Under IFRS, completed investment property (accounted for under IAS 40) is held separately from investment property under development (accounted for under IAS 16).
Completed investment property is carried at fair value under IAS 40, which equates to the market value previously applied under UK GAAP. There is therefore no equity impact arising from the change to IFRS in respect of these properties.
Investment property under development is carried at fair value under IAS 16, which differs slightly from the directors’ valuations previously applied under UK GAAP. This has resulted in additional value being recognised in both opening and closing balance sheets. IFRS fair values for both the above classes of property have been calculated by the Group’s external valuers.
Under UK GAAP, all revaluations of property were made directly in equity (unless values fell below cost). Under IFRS, investment properties under devel- opment continue to be accounted for this way but completed property valuation movements are recognised in the Income Statement. In addition, when a prop- erty under development is completed and transferred to investment property, the difference between its fair value at that date and its previous carrying value is recognised in the Income Statement. This has resulted in an increase in the profit of £20.869 million under IFRS (2004).
(Source: Reproduced from UNITE Group plc’s 2005 accounts, with kind permission from the Board of UNITE Group plc.)
UNITE Group plc’s accounts for 2005 showed a revaluation surplus in the Income Statement of £23.377 million, so that the overall profit of £32.310 for the year equated to an earnings per share of 28.7 pence. When this calculation was adjusted by removing valuation gains, movements in ineffective hedges and movements in deferred tax, brought about by IFRS (as against UK GAAP) earnings per share, fell to just 3.0 pence (Figures 3.4 and 3.5).
These accounting standards do raise issues that are worthy of debate. Based on UNITE Group plc’s accounts, it would seem that UK GAAP is more prudent than IFRS, but far more importantly, in recording a profit before it is earned, the concept of prudence is thrown out of the window.
Consolidated Income Statement for the year ended
Unite Group plc
31 Dec 2004 31 Dec 2005
31 Dec 2006 Notes
£’000
£’000
£’000
Revenue 1 [U2] 110,636 113,799 74,623
Cost of sales 1 [U2] (49,889) (54,864) (24,678)
Administrative expense – goodwill impairment (2,515)
Administrative expense – other (19,751) (15,671) (14,284)
Profit/(loss) on disposal of property (5,397) 2,534 23
Net valuation gains on investment property 1 & 2 [U8] 60,817 23,377 20,869
Net operating profit before net financing costs 96,416 69,175 54,038
Loan interest and similar charges 1 [U6] (53,599) (44,212) (38,098)
Changes in fair value of ineffective hedges 1 [U6] 5,014 (4,317) 0
Finance income 1,551 1,541 1,137
Net financing costs 1 [U6] (47,034) (46,988) (36,961)
Share of joint venture profit 1 [U11] 9,180 5,944 30
Profit before tax 58,562 28,131 17,107
Tax credit 1 [U7] 12,921 4,179 233
Profit for the year 71,483 32,310 17,340
Earnings per share – Basic 1 [U20] 58.4 28.7 15.8
Earnings per share – Diluted 1 [U20] 57.8 28.3 15.6
Note 1. In Unite Group plc’s accounts various notes explain the above figures. The number in (square brackets) is the note
number in this company’s accounts for 2005, as follows: Figures in (brackets) below indicate corresponding note numbers in 2006.
Note 2 gives segmental analysis for sales and cost of sales;
Note 6 (7) provides details of interest costs, including amounts capitalised
Note 7 (8) demonstrates how the tax charge and deferred tax is calculated, including showing that tax on unrealised gains is deferred;
Consolidated Balance Sheet as at
Unite Group plc
31 Dec 2004 31 Dec 2005
31 Dec 2006
£’000
£’000
£’000 Assets
Investment property
Investment property under construction Property, plant and equipment Investments in joint ventures Intangible assets
Other receivables Total non-current assets
656,969 124,980 9,533 106,287 5,216 4,973 907,958
1,028,747 80,004 19,303 18,861 5,465 8,618 1,160,998
991,460 119,732 15,971 817 4,753 6,079 1,138,812 Property under development
Inventories
Trade and other receivables Cash and cash equivalents Total current assets
Note 1 12,093
22,982 70,165 55,143 160,383
0 13,418 66,011 30,297 109,726
0 13,401 26,246 37,582 77,229
Total assets 1,068,341 1,270,724 1,216,041
Liabilitites
Borrowings and financial derivatives Trade and other payables Total current liabilities
(63,563) (78,594) (142,157)
(124,541) (73,559) (198,100)
(106,153) (71,675) (177,828) Borrowings and financial derivatives
Deferred tax liabilities Total non-current liabilities
(403,181) (41,816) (444,997)
(644,671) (45,255) (689,926)
(665,925) (50,479) (716,404)
Total liabilities (587,154) (888,026) (894,232)
Net Assets 481,187 382,698 321,809
Equity
Issued share capital Share premium Merger reserve Retained earnings Revaluation reserve Hedging reserve
30,763 173,008 40,177 218,035 18,053 1,151
30,435 169,957 40,177 129,508 17,531 (4,910)
27,825 141,324 40,177 96,113 16,370 0
Total equity 481,187 382,698 321,809
Note that In Unite Group plc’s Balance Sheets (as reproduced above) there are acompanying notes providing details of each line.
Note 1. In 2006, UNITE Group plc created the a ‘UK Student Accommodation Fund’ in which the company owns a 39% stake and acts as a property and fund manager. It is likely that this fund will acquire the Groups future developments and accordingly property under development that will be sold to this fund are classified as current assets. This revised business model will allow the group to reduce its borrowings.
Unite Plc’s Balance Sheets for 2004 to 2006 are reproduced by kind permission of the Unite Group plc Board
Figure 3.5 UNITE Group plc – Balance Sheet for 2004 to 2006
The issues here are that the Income Statement should reflect the profit gener- ated in the period, while the Balance Sheet should show a true and fair valu- ation for assets and liabilities. Given that judgements are required to calculate fair value, it will be relatively certain that the figure calculated will turn out to be incorrect.
Anyone who has ever tried to sell a house will know that no two estate agents or valuers will come up with the same valuation on the property. Establishing the true market price is not an exact science and coming up with the answer relies upon educated guesswork. The problem under IFRS is that if traditional company valuation methods are used; a small error in property valuation will lead to completely unrealistic company valuations. This can be illustrated below with UNITE plc’s 2005 accounts:
Average no. of Earnings Net Assets
shares (‘000) (£’000) (£’000)
Properties 1 108 751
Other (726 053)
112 633 32 310 382 698
Earnings per share 28.7 pence Asset value per share 339.8 pence Price of share at 31 December 2005=400 pence
P/E ratio 13.9 Goodwill in share valuation 60.2 pence Now if the property valuation had overvalued the properties by a mere 2.5%, then the picture would change:
Average no. of Earnings Net Assets
shares (‘000) (£’000) (£’000)
Properties 1 081 032
Other (726 053)
112 633 4591 354 979
Earnings per share 4.1 pence Asset value per share 315.2 pence Price of share at 31 December 2005=400 pence
Price of share based on P/E ratio of 13.9=57 pence Price of share based on maintaining goodwill=375 pence
What this shows is that even very minor errors in valuation can have a dra- matic effect on the Income Statement, and given the uncertainties in valuation,
is merely to show the dramatic effect that minor variations in valuations can have on these types of company’s accounts.
In addition, it should be noted that investors would base their valuation of companies such as UNITE Group plc on asset values, rather than on income.
Nevertheless, this does demonstrate that including unrealised profits in Income Statements does not help investors to make rational decisions.