Fair value of investment property and a subsequent comparable sale
Lattice Property Trust is a listed trust with investment property of $1.42 billion measured at fair value. At 31 December 20X5 management's independent valuer values the portfolio using a capitalisation approach, with capitalisation rates of 4.75%-5.40% and market rents. Northgate Tower represents 18% of the portfolio ($256 million) and is valued at 4.75%, the lowest rate in the portfolio, despite 22% of lettable area being vacant and a tenant contributing 31% of income having a lease expiring 30 June 20X6 with no renewal signed. In February 20X6, before the audit report is signed, the trust sold a comparable nearby building at a 5.30% capitalisation rate. The valuer's report is dated 14 January 20X6 and uses data as at 31 December 20X5. Management refuses to adjust, arguing the sale is a 'different asset class'. Audit materiality is $14 million.
1. Evaluate the valuation evidence and quantify whether a material misstatement exists.
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Assess the evidence. Northgate is 18% of the portfolio and is valued at the lowest cap rate in the portfolio despite 22% vacancy and a tenant representing 31% of income expiring within six months. Those facts point to higher risk and therefore a higher cap rate, not the lowest. The February sale at 5.30% is a market transaction before the report date and, under ISA 560 and IAS 10, provides evidence about market conditions at 31 December, although comparability must be tested for location, lease profile and quality.
Quantify. At a 4.75% cap rate, $256m implies net operating income of about $12.16m. At 5.30%, the value is about $229.4m - an overstatement of roughly $26.6m, against materiality of $14m.
Conclusion. There is sufficient evidence of a material misstatement. The valuer's use of the lowest cap rate is inconsistent with the asset's specific risk factors and with the subsequent sale. Management should adjust to a supportable rate; if it refuses, the financial statements are misstated.
2. Should the auditor engage an auditor's expert, and what is the effect if management's valuer refuses to discuss assumptions?
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Engage an auditor's expert - yes. Property valuation is a specialised field, and ISA 620 allows the auditor to use an expert to obtain sufficient appropriate evidence. Before engaging:
- Assess the expert's competence, capabilities and objectivity (professional body, experience with this asset class, no relationship with the trust or its valuer).
- Agree the scope: review the valuer's methodology, test the cap rate against market evidence including the February sale, and assess vacancy and lease-up assumptions.
- Evaluate whether the expert's work is adequate and whether its conclusions are consistent with other audit evidence.
If management's valuer refuses to discuss assumptions. That is not, by itself, a scope limitation if the auditor can obtain evidence elsewhere (the auditor's expert, market data, the sale). But refusal to cooperate is a governance and fraud-risk indicator and may limit the evidence over the valuer's inputs. Document the refusal, escalate to the audit committee, and consider whether the refusal prevents sufficient evidence being obtained. If it does, the opinion may need to be modified.
3. What opinion is appropriate if management refuses to adjust and the estimated overstatement is $26.6 million?
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Materiality and pervasiveness. The estimated overstatement is about $26.6m against $14m materiality, so it is material. It is confined to one investment property and the related fair value movements; it does not affect the financial statements as a whole, so it is not pervasive. A qualified 'except for' opinion is the appropriate starting point.
If management refuses to adjust. Issue a qualified opinion under ISA 705, describing the property, the cap rate used, the comparable sale and the quantified effect. If the trust's net asset value, distributions or debt covenants are affected, disclose that too.
If the auditor cannot obtain sufficient evidence at all - for example, management blocks access to the valuer and the auditor's expert cannot form a conclusion - the issue becomes a scope limitation. A disclaimer may be appropriate if the possible effect is pervasive. Do not use an Emphasis of Matter to compensate for a misstatement.
Also consider whether the audit committee needs to be told, and whether the matter is a Key Audit Matter (it would be, for a listed trust).