- Chris Thorne
The principle of highest and best use (HABU) should be well known to valuers, but some still struggle with the concept in practice. It has recently been highlighted as one of the main problems experienced in determining “fair value” for financial reporting. From my observations, confusion can often arise because HABU is treated as a distinct concept, rather than the logical outcome of applying the other conditions that are implicit in the valuation hypothesis. It may help to go back to basics.
Using a hypothesis, or “basis of value”, that is suitable for the purpose for which the valuation is required is fundamental. It is also highly desirable that where different valuations are being prepared for the same purpose that they use a consistent hypothesis, otherwise comparison of values becomes impossible. For this reason, the International Valuation Standards Council (IVSC) made the agreement and promulgation of a limited number of valuation bases one of its main objectives from its earliest days.
Most of the conceptual material that had been developed from worldwide debate between valuation professionals over the past thirty years or so has been removed from the latest version of the International Valuation Standards (IVS). However in previous versions, it was explained that all bases of value fell into one of three categories. At simplest these can be described as value to one, value between two and value between anyone. In the first two, the value reflects attributes, circumstances and motivation of specific parties; in the case of the third it will reflect those of all prospective participants in the relevant market. The IVS define a basis of value for each category, Investment Value, Equitable Value and Market Value, while acknowledging that there are many others that may need to be used to comply with statutory or regulatory requirements in different jurisdictions.
Where does the concept of HABU fit into this? In the case of Investment Value or Equitable Value the HABU will be defined from the perspective of specific parties, and cannot be distinguished from the value they place on their needs or aspirations generally. As such it is not something that requires specific consideration. In contrast, in the case of Market Value, HABU becomes a vital consideration. This is because the valuer is required to identify the price that would be agreed by any knowledgeable and willing party, each seeking the most advantageous price from their perspective. Both buyer and seller are deemed to be aware of the potential of the asset and therefore the value is not necessarily constrained by how one party has chosen to use it. HABU is therefore inherent in the application of Market Value; it is not an optional extra.
The IVS are clear that the HABU must be reasonably possible, legally permissible and financially feasible. These three conditions should eliminate excessive speculation as what other uses might be possible. It is worth revisiting the Market Value definition and its accompanying conceptual framework in the IVS. The buyer is deemed to purchase in accordance with the realities and expectations of the market on the valuation date. Only if it is clear that the majority of buyers and sellers will recognise the potential of an alternative use when settling a price will that potential be reflected in the Market Value.
A key point is that it is the value of the current potential which is reflected, which may be very different from the value when and if that potential is realised. The requirement for HABU to be financially feasible means the costs, risks and time involved in achieving an alternative use, which may be very considerable, are reflected in the Market Value. Similarly, a use may not be legally permissible at the valuation date, but if the consensus among market participants is that it will be at some point in the future, this will be reflected in the Market Value after due adjustment for timing and risk. So far, so good, so what are the problems?
The International Accounting Standards Board (IASB) has recently undertaken a consultation as part of its Post Implementation Review of IFRS13 Fair Value Measurements. Like IVS Market Value, Fair Value under IFRS is a market based concept and expressly requires HABU to be reflected in the Fair Value of non-financial assets. The IASB sought information on any challenges those preparing accounts had in applying the requirement to measure HABU. A majority of those who responded on this point indicated that they had experienced problems.
The problem that was identified by most respondents arises from an inherent contradiction between the presumption in most financial statements that a business will continue as a going concern and then valuing an asset used in that business on the assumption that it is used for another purpose. IFRS 13 tries to square this circle by making the starting presumption that an entity’s current use of an asset is presumed to be its HABU unless market or other factors suggest that a different use would maximise the value of the asset. It then indicates that an asset’s HABU may be for use in combination with other assets as a group or in combination with other assets and liabilities, ie as part of a business. However, this means that the possibility that the HABU may be for an alternative use still has to be considered, and if there are indications that it might be, its value as part of the business unit where it is used in conjunction with other assets also needs to be considered. This clearly could give rise to many different possible outcomes depending on the facts assumed.
This problem especially arises with real estate, where in the absence of the current business and the associated assets used in that business, the underlying land may have a higher value for an alternative use. The Illustrative Examples that the IASB produced to accompany IFRS 13 include a situation where land currently used for industry would, if sold separately, be acquired for redevelopment for high density residential use. The example explains that the HABU involves comparing the value for the current use in combination with all the other assets and liabilities of the business with the current value of the land for residential use taking into account all the costs, including any uncertainty, of enabling the land to be used for this purpose.
In some situations the answer will be clear. For example, if the business in occupation no longer needs to be in that location, is unprofitable or where the associated assets such as the buildings or equipment are near the end of their useful lives, the HABU will almost certainly reflect an alternative use. It becomes more difficult if the existing business is profitable and has strong reasons to remain in that location, as this raises conceptual questions as to the extent to which the circumstances of the actual business can be assumed to be shared by a typical market participant.
The concept of HABU is clearly explained in the IVS and, while slightly different words are used in IFRS 13, the principles are the same. There is no doubt that preparers of accounts are encountering problems, but I would argue that these are not problems with the concept of HABU itself but with the more fundamental question of what is the purpose of the Fair Value measurement within the context of an entity’s overall financial statements? In other words, what information about the value of individual assets within a business is relevant to investors and how and where should that be disclosed? This is an accounting rather than a valuation problem, and I hope that in considering whether amendments are required to IFRS 13, this is borne in mind by the IASB.
In the meantime, what are valuers to do when asked to prepare a valuation of an asset for financial reporting where it is apparent that the current use is sub-optimal? Fortunately, it is not the job of the valuer to decide which figure should be used in their client’s financial statements, but the valuer can provide relevant information to help the decision process. For example, it may be appropriate to provide the Fair Value (Market Value) on alternative assumptions, first that the asset is surplus to requirements and sold separately from the remainder of the business and, second that the asset is sold along with all other associated assets in the operational unit as a going concern. The client then has information that may help them decide whether the rebuttable presumption in IFRS 13 that the current use is the HABU is valid or not.
Finally, providing values on alternative assumptions should not be a default position for all financial reporting valuations, and even where circumstances suggest that this may be appropriate, it should not add greatly to complexity or cost. Remember, if it is not reasonably obvious that the HABU is probably for an alternative use, there is no need to undertake extensive research to prove this.