In addition to the financial statements and balance sheet, an investor should also go through the notes and understand their content, says Juha Mäki, MSc (Eng), MSc (Econ & Bus Adm), who is defending his doctoral dissertation in University of Vaasa.
For example, the valuation of a company’s investment properties in the financial statements may bring surprises depending on whether the company has performed the valuation itself or used an external party for it.
According to Mäki’s dissertation, an external appraiser provides more conservative, that is, more careful values for investment properties than when the company prepares the valuation.
In this case, the financial statements of companies that value their investment properties themselves may give a more positive impression about the financial situation.
“Indeed, it will be interesting to see measures after the current pandemic, when, as a result of possibly changed buying behaviour, the values of shopping centres and, because of increased recommendations for remote working, the values of office real estate, should be decreased”, says Mäki.
In his dissertation, Mäki has reviewed the possibility to select the valuation and reporting of the value of investment properties between the traditional depreciation method or the so-called fair value method.
“When applying the fair value method, the consequences of changes in the valuation of investment properties can be significant, because a decreased value is recorded directly as ‘expense’ in the financial statements and correspondingly, an increase as ‘income’. In the investment property business, there are examples of companies whose result exceeds their turnover,” says Mäki.
In the European Union, publicly listed companies prepare their financial statements in accordance with the IFRS standards (International Financial Reporting Standards).
The guidelines regulate about the basic principles for preparing financial statements but also provide opportunities for selecting between various reporting methods.
Reporting requirements a compromise between the best and excessive information as well as the expenses incurred
According to Mäki, the easiest solution from the standpoint of stakeholders, such as investors and financers, would be a requirement to only use an external party for determining fair value in the preparation of financial statements and reporting all the relevant information in the notes.
The preparers of the IFRS standards must, however, take into account the amount of reporting costs and readers of annual reports possibly getting tired of excessive information. The key is to identify the most essential information for investors and to present it in a concise way.
The purpose of the balancing is, after all, to increase the ease of adopting IFRS and therefore increase its use globally.
Use of IFRS is the sum of a company’s internal and external factors
It was also discovered in Mäki’s dissertation that companies tend to select the traditional depreciation method in cases where the annual report does not have a significant impact with regard to communication with stakeholders.
In other words, a company’s diversified ownership has a positive impact on selecting the fair value model in the valuation of real estate investments. The same phenomenon is to an extent visible in financial sector companies.
On the other hand, companies in Scandinavia and Great Britain use fair value reporting more often compared with the rest of the European Union. The reason for this is likely to be legislation history before the adoption of the IFRS standards.
Development of the guidelines (here, IFRS 13) has, on the other hand improved the quality of financial statements, however, a simple, briefer reporting may be as effective from the standpoint of stakeholders.
“Using external parties for determining fair value seems to also have a positive impact on the amount of information asymmetry, i.e., on how equal a position investors at different levels are as regards the necessary underlying information. Therefore, the impact of external valuators as experts is similar to that of large audit firms (Big 4),” Mäki estimates.
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