Article by Morne Janssen
Understanding the concept of "fair value" is essential, as you may need to have adjustments made to your assets or investments, and a mistake here could cost you dearly.
Fair value is the price agreed upon between the buyer and seller for the sale/purchase of an asset. The fair value would be the amount reflected on your financial statements.
We can determine an asset's fair value by analysing sales and purchases of similar assets, growth potential, and replacement costs. In the instance of a property sale, this will get done by the agent valuing the property.
Due to several factors relating to growth and loss (impairment loss), an asset's fair value and current book value could differ substantially.
Let's take, for instance, the recent looting in KZN as an example of fair value that needed adjustment. As a result of the looting and destruction, many people lost some value in their property. The value captured in the books then had to be adjusted as they overstated the property's value in the last annual financial statements. Even though they were not necessarily affected by the strikes, the value of similar properties in the surrounding areas was also diminished.
Fair value adjustments are not necessarily a requirement when the difference is minimal but more when the movements in the market are substantial.
The process of fair value adjustments is as follows, and we will use the example above to illustrate the process:
The property is a two-bedroom apartment bought seven years ago by Peter, and the fair value is R1 000 000,00 in the financial statements. Over time the property slowly increased in value and could be sold for approximately R1 200 000,00 due to improvements or fair value. Suddenly mass unrest took place in Durban, which destroyed the local market, causing the value to hit an all-time low. The drop in value pushed homeowners of similar properties to sell at a reduced rate of R700 000,00. Peter noticed the drop in prices around the vicinity of his property and realised he had to make a fair value adjustment on his property to keep it in line with the current market value, even though he decided not to sell it.
The fair value adjustment doesn't always need to be included in your income statement if the adjustment is insignificant but should get included when the amount is substantial. Alternatively, you can decide to have the adjustment in your annual financial statements when the asset gets sold, and there is a profit or loss that will be realised on the sale. Fair value adjustments have no impact on the property's purchase price, as this will stay the same. A fair value adjustment is made to adapt your property's value so as not to overstate or understate it in your annual financial statements.
An example of a fair value adjustment done on investment would be, for instance, owning shares in a non-listed company that deals with a lot of stock. What would happen if a natural disaster struck one of the company's warehouses and they lost half of their stock? The company would suffer from stock losses, hurting its share price. In this case, it would get classified as an impairment loss, and the fair value would decrease. It is important to note that fair value adjustments cannot be made on listed shares, as the JSE constantly regulates these amounts.
With regards to your accounting, the entries would get done as follows:
If the fair value of the property increases, your Accountant should debit your valuation account, and your income should be credited. Still, we will debit your income and credit the valuation account when the fair value decreases.
An impairment loss is when the fair value adjustment decreases due to a sudden asset or investment value loss. Be aware that this differs from the depreciation of an asset. Depreciation is the steady decline of value over the expected life of an asset. It would help if you thought of impairment loss as a sudden "turbo" depreciation over a certain period.
It is crucial to ensure that the value of your assets and investments is always correct, as this can impact the solvency of your Trust. If the liabilities in your Trust are more than the assets, it will not be solvent and will affect your Trust's ability to apply for loans.
If you are required or need to make a fair value adjustment on any asset in your trust or company, contact your Accountant to assist you with the process. However, keep your paperwork to back up any assertions to avoid audits.
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