Value Model With Many Economies

¶ … Value Model

With many economies worldwide in a financial tailspin this paper will seek to determine whether the fair value model or the cost model is more efficient especially in regards to the valuation of real estate assets in Hong Kong. The paper will specifically seek to determine whether the fair value model is a good representation of the true value of investments so that investors can make decisions that are both timely and effective in their nature. Comparing the fair value model to the cost model should provide for a clear picture since both models are used extensively in the Hong Kong market and there is a very distinct difference between the two models. The paper is especially concerned about the reliability of the fair value model as it is used in the valuation of assets for financial statements.

Introduction

Hong Kong is an international market that sports an excellent legal system, offers companies low tax rates, and due to the limited available land for development usually offers a good real estate investment value. Since 2004 the Hong Kong real estate market has doubled in value. Much of that gain is perceived in value especially when the entity perceiving the value uses the fair value model to assign a value to the property.

In Hong Kong, the government controls the land. The island of Hong Kong is approximately 425 square miles and those miles are home to approximately seven million citizens. Land is valuable and limited. One of the best investments a citizen of Hong Kong has been able to make throughout the years is to purchase land, oftentimes seeing a double, triple or even quadruple in value over a short number of years.

Lately, however, Hong Kong's real estate market, like many markets around the world, is being pummeled by quickly falling asset prices, falling demand for exports and a financial industry that could see in the near future, large layoffs. One recent Reuters report states, "The territory is in recession, with exports hit by weakening global demand and consumers jolted by falling asset prices" (Whiting, 2008). Many of the high-paying jobs to be found on Hong Kong are in the financial services industry, and Hong Kong workers fear that companies in Hong Kong will follow the lead of American and global financial companies by cutting many jobs and slicing employment.

The Reuters report defines how Hong Kong is "dependent on the financial industry, (and) people are now bracing for large-scale job cuts at investment banks and hedge funds" (Whiting, 2008). Landlords in Hong Kong are especially worried that their tenants will be unable to afford the rent or lease payments and many of the landlords are dumping their real estate investments as quickly as they are able. Chris Van Beek, a vice president with GFI Colliers, states that many landlords are eager to switch to cash and that they are "dropping prices because buyers were scarce" (Whiting, 2008). He believes that buyers are reluctant to part with down payments of 30-40% that the banks are now demanding, as compared to the 10% down payments required before the financial crisis took place. "Some (landlords) are off-loading at 30% discounts, but struggling to sell, Beek said. Many buyers think they might as well wait another four or five months for prices to come down more" (Whiting, 2008).

Waiting might not be a bad idea for the buyers, but it just adds more fuel to the fire for the sellers. The Reuters report states that many experts believe the Hong Kong real estate market will suffer even more drastically in 2009. GFI Colliers, a Hong Kong brokerage firm said "the market indicates that property investors are betting that Hong Kong prices will reach a bottom in December 2009, falling at least 25% below present prices" (Whiting, 2008). A twenty five percent drop in value during 2009, especially on top of the already large 2008 drops will be devastating to the Hong Kong economy. Individual investors and companies will be affected.

Many of the affected companies are public in nature, and are listed on the Hong Kong Stock Exchange. If companies see a large drop in the value of their portfolios, then investors will see the same drop, thereby lessening the chance of a rise in stock value. Therefore, a drop in the real estate market could well portend a drop in the stock market as well. Hong Kong, and global investors, are skittish about investing when the prospects of a good return on their investments are dismal. The problem seems to be the perceived value of both the real estate holdings as well as the inherent value of the company holding the real estate. To be listed on the Hong Kong exchange companies must meet certain accounting requirements as spelled out by the Hong Kong Accounting Standards (HKAS). Similar to other exchange's standards and accounting practices, the HKAS requires a company to meet standards in three areas. Those areas are recognition, measurement and presentation. For this paper's purposes the focus will be maintained on the measurement aspect of the companies assets. The HKAS uses two separate models to measure value. Those two models are; the fair value model and the cost model. The fair value model is applied using two methods; the HKAS 39 standard for financial instruments, and the HKAS 40 standard for investment properties. Much of the decline in value of various financial instruments (especially derivatives) bought and sold on the Hong Kong exchange is due to the volatility of the underlying value of real estate and mortgages. This is especially true regarding mortgage derivatives.

Part of the cause for the volatility is the implementation of fair value recognition of the real estate and mortgage investments. HKAS 40 provides the following definitions for cost; "cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognized in accordance with the specific requirements with other HKFRS, eg. HKFRS 2 Share-based payment" (HKAS 40, 2008, pg. 3). HKAS 40's definition for fair value is; "fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction" (HKAS 40, 2008, pg. 3). The definitions are clear in scope and as different as two methods could possibly be.

The difference in the fair value model, whether it is used for financial instruments or investment properties, as compared to the cost value, is that the fair value is a much more objective valuation. Oftentimes it is based on a perceived value, whereas the cost model valuation is based on how much the investment or investment property actually cost. The question becomes, therefore, whether the fair value model should be continued or whether a switch to the cost model might make more sense for Hong Kong investors.

This paper will seek to ascertain the answer to that question by comparing the advantages and disadvantages of the two models, while primarily focusing on the components of the fair value model as it is used in the Hong Kong financial industry.

This paper will also seek to provide a literature review in the relevant areas. The author will also provide a questionnaire to be used in a future study. The questionnaire will contain items for response from the creators and users of financial statements in regards to the differences between the two models. Finally, this paper will provide recommendations and conclusions based on the literature analysis concerning both the fair value model and the cost model as it is used in Hong Kong financial statements.

Literature Review

The literature available on fair value and cost models is not as abundant as what would seem likely. Both models are used extensively throughout the world with a number of financial exchanges requiring that either, both, or one of the models be used as a requirement for a listing with that particular exchange. The prevalence of the two models might be the reason why there is no abundance of literature. Studies on required standards may be seen as redundant and therefore researchers shy away from conducting those studies.

Especially scarce are studies on the models as regards to financial industries concerning company stocks or listings and, of course, on the mortgage derivatives that have caused much of the worldwide havoc during the last year. There are a number of studies that can be included in the literature regarding insurance companies and the policies that they issue, as well as other types of investment contracts, but very little in regards to mortgage derivatives and the underlying real estate holdings found in those investment vehicles. One article espoused the importance of a correct valuation for insurance companies by stating, "Fair valuation...as well as an accurate assessment of the cash surrender values, are clearly crucial topics in the management of a life insurance company, both on the solvency and on the competitiveness sides" (Bacinello, 2003, pg. 462). It is small wonder that some insurance companies understand the risks of insuring lives and the accompanying cash surrender values of a life insurance policy.

In a prime example of how some insurance companies were caught up in the evaluation game is the case of AIG, the company that forgot that the value of its stock, or the value of the company was based primarily on a fair value, that might not have been fair at all. The harbinger of disaster was when the financial marketplace placed a fair value on AIG that was far below what the company believed it should be. This scarcity could be one of the primary reasons why the financial industries around the world are in the torrents they are currently swimming.

Some of the literature available touched on the primary causes of the current financial crisis before it took place. One recent study reiterated the conclusions of other studies by stating, "many previous studies identify loan, property, borrower and environmental factors that impact the probability of foreclosure" (Ong, Neo, Spieler, 2006, pg. 212). The article continued with a prophetic statement, "implicit in these studies is the assumption that the property was purchased at fair value" (Ong, et al., pg. 212). As the investors watched skyrocketing values on not only the mortgage derivatives but on the underlying properties, more and more individuals, companies and entities came to the conclusion that the prices would go up forever. After all, the fair value was what any two parties decided it would be, and with Wall Street and other exchanges rushing to bring more of these sub-prime investment vehicles to market, and the banks being even more willing to loan to anyone who could sign their name, it seemed as if real estate would only be more and more profitable.

The study conducted by Ong et al. rang a warning bell. Their research showed "we find that the premium paid at purchase significantly increases the probability of foreclosure" (Ong, et al., pg. 213). The researchers concluded that the results of the study were not dependent on "other property-specific factors, time-varying macroeconomic conditions, alternative model specifications and definitions of price premium" (Ong, et al., pg. 213).

In essence, the Ong study showed that a primary factor in the risk of foreclosure was due to the premium paid for the property at the time of purchase. If this finding is true, then one can only imagine what the effects would be in a scenario of ever-increasing fair value valuations.

In the mad rush to ensure a profit for their respective firms, what the financiers and bankers forgot was that an effective market is one that has some form of rationing implemented. Just as the technology bubble was bursting in the early 2000's a study was published that espoused the fact that "economists praise the virtues of price as a mechanism to equate supply and demand, but markets often clear by non-price means" (Gilbert, Klemperer, 2000, pg. 1). The study showed that if the real estate market had continued to hold steady values, or had been subject to a mild form of rationing, much of the pain currently being experienced in the financial industry would likely have not been felt. This is likely because fewer buyers would have been interested in jumping into the market without that added incentive of rising real estate values.

When Congress changed the rules, virtually stating that 'everyone deserves a home of their own' and the banks realized that the government would guarantee the viability of the higher risk loans through Freddie Mac and Fannie Mae, they immediately started making more high-risk loans. Builders responded by building additional and bigger houses. Property owners responded by selling their smaller and medium sized homes, and purchasing the bigger and more expensive homes. and, of course, many exchanges around the world responded by snapping up the high-risk mortgages and packaging them for resale to investors searching for higher returns. If someone had someone taken a deep breath early on in the process, perhaps remembering the HKAS directive that states 'fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction" (HKAS 40, pg. 3) and perhaps realizing that many of these arm's length transactions were not really at arm's length, then this entire mess could have likely been avoided. Another method of measuring the value could have been implemented such as the cost model that would have reminded investors of what the real value of the investment was, not the fair value.

Gilbert and Klemperer concluded "in our main analysis, rationing does not affect the number of consumers who enter (i.e., invest) but does induce them (the consumers) to enter at a lower cost to the seller" (Gilbert, Klemperer, pg. 2). Sometimes it makes sense to lower costs even if the result is a lower value for the property.

Another article on fair value concerns the solvency of a company, in this particular case it is an insurance company. The articles shares a method of defining solvency of a company and the financial impact the lack of solvency has on a company's operations. The reason such information is important is because of the value of the insurer's balance statements. Since many large, and even small, insurance companies maintain real estate portfolios the underpinnings of the solvency or lack thereof for certain companies remains a concern. The articles describes "a method to allocate capital in insurance to lines of business is developed based on an economic definition of solvency and the market value of the insurer balance sheet" (Sherris, 2006, pg. 72). Therefore, it is safe to assume that with the volatility inherent in a fair value evaluation can affect the solvency of companies large and small, especially if the company is holding large portfolios of real estate. The article does not compare insurance companies in Hong Kong, and in fact, does not mention Hong Kong in any form whatsoever. However, it can be inferred that a large percentage of the financial services offered in Hong Kong deal with insurances of one type or the other, and that at least a number of the insurance companies located there currently hold real estate as part of their investment portfolios.

If that assumption is held true, then publicly traded shares of those companies will likely be affected by the use of a fair value valuation, and in all likelihood, the very solvency of some companies can be affected as well.

In the Sherris article can be found the statement "solvency, and its financial impact, is determined by the value of the insolvency exchange option" (Sherris, pg. 72). This reinforces the fact that how an investment or holding is valued can be a determinant in how well a company is managed, or even if the company would be the type of company that would generate profits for its shareholders.

The available literature does take into consideration other areas where the fair value model is implemented along with the use of the cost model. One area that has been covered is data that is produced by companies who wish to either protect the value of that information or protect the information itself (in the event of a loss). Ralph Poore writes for Information Systems Security and he states, "information security professionals are often asked by management to balance the cost of controls, against the value of the information assets that the controls protect" (Poore, 2000, pg. 18). Poore continues by stating, "cost-based valuations (often used to determine a "book" value for intellectual property) also fall short for risk management purposes" (pg. 18). This literature displays the inherent problem with cost-based evaluations. A book value for information as compared to a book value for real estate property or investment property is comparable based on what it costs, but suppose the cost of the item, whether it be data, or whether it be real estate, does not reflect its true value?

At what price, then, should such an investment be valued? The question of placing a 'fair value' on the investment, whether it is insurance, information or physical land holdings, should make no difference whatsoever.

One would think that a fair evaluation agreed upon by all parties would then make the most sense. Poore, however, might disagree. He wrote, "nonetheless, relying on opinion averaging or similar highly subjective techniques rarely results in defensible valuations" (pg. 19). The limited available literature shows that subjective techniques such as the 'fair value' model may, oftentimes, come up short on offering defensible valuations, and in the worst case scenario cause the valuations to spiral upward until they hit a ceiling that quickly forces them back down.

One of the forerunners of the packaged mortgage investment vehicles was the Real Estate Investment Trust (REIT). These investments vehicles were introduced to the public nearly four decades ago and have been a staple to investors since that time. Recent literature compares the differences between old time REIT's and the new REIT which are considered to be the parent of the packaged mortgage investment. One study declared "financial policies were much more stable in the new-REIT era than in the old-REIT era" (Ott, Riddiough, Yi, 2005, pg. 204). According to the study, the espoused stability "occurred in response to concerns of outside investors and rating agencies" (Ott, et al., pg. 204).

These investors and rating agencies were "looking for consistent and disciplined financing policy to sustain the high investment growth rates" (Ott, et al., pg. 204).

If investors and rating agencies had enough influence throughout the years to demand, and receive, more stringent policies regarding REIT's the question could be asked as to why more stringent regulations were not enacted in regards to the mortgage backed investments. Decisions as to the use of fair value models compared to cost models should probably have been more directly scrutinized, especially since the rating agencies job was to track the increased issuing of such investments.

Available literature also provides alternatives to using either the fair value model or the cost model. One study touts a real option model for deciding the value of retail shopping leases. The real option model takes into account "stochastic sales externalities" (Cho, Shilling, 2007, pg. 623). The study also takes into account the possibility of a tenant default, as well as multiple defaults and even defaults of the 'anchor' tenant. The study also presents a final sum "across all tenants to determine the value of the shopping center" (Cho, pg. 623). This is an interesting study because it provides an entirely different alternative to those who are charged with the responsibility of tracking value of different real estate, and other portfolio holdings. This type of study could easily be implemented in Hong Kong in regards to large real estate developments or holdings.

Further studies on this particular option could be undertaken to determine whether it is any more effective than either the cost model or the fair value model that is currently in use.

According to Cho, the real option model "generates a number of new predictions, including why a Jorgensonian user cost of capital may overestimate shopping center values" (Cho, et al., pg. 623). This type of value's overestimate seems very similar to what took place in the packaged mortgage debacle. Cho's model asks a number of questions that seem to be the same type of questions that should have been asked regarding the current fiasco. Cho's study also asked "why the general industry practice is to ignore percentage rent payments and tenant default risk in commercial mortgage underwriting and why shopping center owners may not act opportunistically as most observers seem to think they do" (Cho, et al., pg. 623). The literature is clear that other models offer advantages or benefits that could be incorporated into both the discussed models. At the very least, available literature is providing additional questions that are being asked for various models and probably should have been asked in regards to valuation of real estate. This clarity is true for both models, but it would seem to be providing more veracity in regards to the fair value model due to its tendencies towards subjectivity.

One reason why it is so important that a study of the fair value model, as well as additional studies on other methods of valuation is so that mistakes from the past will not be made again in the future.

A recent study showed why that was so important. The study concentrated on both rising and falling values in the housing market and how that fluctuation would affect the FHA and the many programs it offers to citizens.

Because there are many stochastic factors in the pricing of the housing market it is important that standards be set that will benefit the owners, the investors, and the government entities that offer programs in the housing market. One of those programs is the Home Equity Conversion Mortgage (HECM) program. This program is a Federal Housing Administration that allows owners to sell their houses while still living in them, and receive payments on the 'mortgage'. A recent article explained the program in the following manner; "Through this program, homeowners aged 62 and above can receive a loan backed by the equity, in their homes" (Rodda, Young, 2004, pg. 589). Once the owner moves out, or in many cases the owner dies, then the house is sold and the proceeds pay back the loan. Owners are paid either monthly or as a line of credit. "Loan payments come from the lender either as regularly scheduled monthly payments or as unscheduled line-of-credit payments by request of the borrower" (Rodda, Young, pg. 590). The problem is evident in that if the house is valued at a high level and then drops drastically in value, or vice versa, then either the owner or the FHA will end up owning a property that is upside down in value.

As anyone can tell by reading the available literature, there is a perceived problem with fair value valuations and with cost valuations.

If the problem is not addressed in a sensible manner, the fallout could affect many individual investors as well as many companies and government entities charged with maintaining the economy. Investors are not the only ones to be affected by this problem; homeowners, the elderly, the poor and the wealthy can all be affected by incorrect valuations. Whether those persons are buying or selling a residence, investing funds in companies with real estate portfolios, or even relying on insurance company to cover any losses, the correct valuation is of vital importance.

Available literature explains the problem in a variety of ways, although many times secondary in nature, the literature does show how fair value evaluations can affect a vast array of individuals and entities and the ripple effect it has in the financial industry. It is hoped that the information contained herein can become a part of the literature available as well as being an impetus to further studies in how the fair value model and the cost model can be implemented or tweaked in order to provide a stronger foundation and provide further data to assist accountants in their endeavors to verify values of investments.

Methodology

What this paper is seeking to ascertain is whether using the fair value model of evaluation is the best model to use for the Hong Kong financial market. To accomplish this objective, the methodology the paper will use is to create, disseminate and evaluate a questionnaire designed to elicit responses from those closest to the problem, that is the company accountants as well as the investors who are directly affected by the HKAS accounting standards. The questionnaire will be distributed to 20 accounting managers from medium and large investment companies and brokerage houses, as well as 20 high net worth individuals who are knowledgeable and comfortable with investing parameters and the requirements necessary for a company to be profitable in a consistent manner. The questionnaire will contain questions that will require objective responses on a 1-5 point scale. The points will then be added to compile a snapshot of the trends and thinking amongst those investors and accountants who are most familiar with the situation. Required participation standards for the accountants are that they must work (or previously worked) for a financial services company using the fair value model accounting standards.

Although this paper will not seek to complete focus group on the subject, it could be undertaken in the future as part of a more comprehensive effort. Complementing the questionnaire is the literature review contained in this paper, as well as defining and an analysis of the two models, also contained herein.

Employing this type of methodology is the correct choice because it allows for a critical analysis of current data. Additionally, this methodology allows for generating additional data for discussion. A qualitative study such as this requires the gathering of important data through the available research and an analysis of the same. Presenting the data in a comprehensive and clear manner is one of the keys of success and it is hoped that this paper will be viewed as such. One of the final steps taken in regards to methodology is to sit back and evaluate whether there are any discrepancies in the employed method. Discovering and gaps between what the paper is seeking to achieve and what achievements actually come to fruition is all part of the analytical process. Questions about the objectivity and satisfaction levels of analysis must always be addressed as part of the methodology and therefore, this paper will seek to do that as well as accomplish the other previously stated objectives.

Feedback from those who peruse this paper will also be important as to any revisions that might take place. It is always important to gauge reactions to data and the presentation of material in order to progress, and a part of the methodology process for this paper will include this feedback.