Electronic copy available at: http://ssrn.com/abstract=1269515
Working Paper No. 09-12
Does fair value accounting for non-financial assets
pass the market test?
Hans B. Christensen
University of Chicago Booth School of Business
Valeri Nikolaev
University of Chicago Booth School of Business
This paper also can be downloaded without charge from the Social Science Research Network Electronic Paper Collection:
Electronic copy available at: http://ssrn.com/abstract=1269515
Does fair value accounting for non-financial assets
pass the market test?
Hans B. Christensen and Valeri V. Nikolaev
The University of Chicago Booth School of Business 5807 South Woodlawn Avenue
Chicago, IL 60637
Abstract: We study managers’ revealed preferences for fair value or historical cost accounting for non-financial assets when market forces, rather than regulators, determine the choice. We document that almost all managers pre-commit to historical cost accounting for plant, equipment, and intangible assets, suggesting that fair value for illiquid non-financial assets is associated with net firm-specific costs. However, for the more liquid assets groups, property and investment property, the observed choices suggest that fair value is often associated with net benefits. Indeed, the majority of real estate companies choose fair value over historical cost for investment property. We also find that fair value use is positively associated with reliance on debt financing. However, unlike prior studies, we conclude that this result is likely attributable to lower incremental costs of fair value reporting rather than an attempt to avoid covenant violations. Our findings contribute to the policy debate over fair value accounting for non-financial assets by documenting that the firm-specific cost of establishing reliable fair value estimates represents a barrier for fair value to become the primary valuation method on a voluntary basis.
Keywords: Fair value, IFRS, non-financial assets, illiquid assets. JEL Classification: M4, M41
First draft: August 2008 This version: August 2010
This paper previously circulated under the title: "Who uses fair-value accounting for non-financial assets after IFRS adoption?". This research was funded in part by the Initiative on Global Markets at the University of Chicago Booth School of Business. We benefited from helpful comments from Ray Ball, Philip Berger, Alexander Bleck, Christof Beuselinck, Johan van Helleman, S.P. Kothari, Laurence van Lent, Christian Leuz, Paul Madsen, Karl Muller, Edward Riedl, Douglas Skinner, Abbie Smith, Ross Watts, Li Zhang, and workshop participants at the EAA 2009 Annual Meeting, University of Chicago, University of North Carolina’s GIA Conference, Harvard University’s IMO Conference, ISCTE, and Tilburg University. Michelle Grise, SaeHanSol Kim, Shannon Kirwin, Ilona Ori, Russell Ruch, and Onur Surgit provided excellent research assistance.
Electronic copy available at: http://ssrn.com/abstract=1269515
1 1. Introduction
Academics, standard setters, and practitioners actively debate the use of fair value accounting for illiquid assets (e.g., Schipper 2005a, 2005b; Ball 2006; Watts 2006; Herrmann et al. 2006; Kothari et al. 2009; Hail et al. 2009; Laux and Leuz 2009). The debate dates back to the 1930s (e.g., Paton 1932, pp. 739-743) and has recently been fuelled by the financial crisis and the potential adoption of International Financial Reporting Standards (IFRS) in the United States. We contribute evidence to this debate by studying managers’ preferences, revealed by their choice between fair value and historical cost accounting for non-financial assets when market forces, rather than regulators, determine the outcome. Examining managers’ actual choices is useful in light of the policy debate as it reveals whether the firm-specific benefits of fair value accounting exceed the firm-specific costs. However, we do not evaluate the net social costs or benefits of fair value accounting due to potential externalities, which may be relevant to regulators’ decisions. While we are not the first study that examines the choice between fair value vs. historical cost (Brown et al. 1992; Whittred and Chan 1992; Cotter and Zimmer 1995), our setting is likely to be more revealing about the costs and benefits of fair value accounting than prior settings because of the requirement to pre-commit to one valuation practice, as discussed next.
We exploit the recent IFRS adoption in the European Union (EU) and focus on major and arguably the most controversial non-financial asset groups: (i) property, plant, and equipment (PPE), (ii) investment property, and (iii) intangible assets.1 IFRS requires that companies state
their valuation method in the accounting policy section of their annual reports and apply the
1 In this paper, we use the term asset group to describe the three types of assets we examine. Intangible assets,
investment property, and property, plant, and equipment each constitute one asset group. We use the term asset class to describe a subsection of an asset group. For instance, property constitutes an asset class under the asset group property, plant, and equipment. Our definition of an asset class is consistent with IAS 16.37.
2 chosen method consistently over time. This implies that companies need to pre-commit ex ante to one valuation practice, which differs from prior studies where managers had discretion to revalue selectively (from time to time). Pre-commitment is likely to reduce incentives for opportunistic use of fair value and, in turn, allows us to focus on more fundamental economic trade-offs. Out of the 28 EU countries adopting IFRS in 2005, we select the United Kingdom (UK) and Germany because they have the largest financial markets in the EU and, historically, are at the opposite ends of the spectrum in terms of using fair value accounting under local GAAP. Specifically, for non-financial assets, German GAAP allows only historical cost accounting, whereas UK GAAP either allows (for PPE) or mandates (for investment property) fair value accounting. IFRS expands the available valuation practices in both the UK and Germany. Indeed, under IFRS both fair value and historical cost are allowed for each of the three asset groups, which enables managers to reveal their preferences.2
Throughout this paper, we assume that managers’ ex ante choices of valuation practices primarily reflect capital markets’ reporting demands. From a capital markets’ viewpoint, the choice between historical cost and fair value involves a cost-benefit tradeoff. On the benefit side, fair value represents more relevant information used by investors in their capital allocation decisions (e.g., Barth and Clinch 1998; Schipper 2005a; Herrmann et al. 2006). On the cost side, construction of reliable fair value estimates is expensive due to their inherent lack of verifiability (Watts 2006). Subjectivity in non-verifiable fair value estimates can be exploited opportunistically to manipulate reported performance, and, therefore, translates into agency costs borne by shareholders (Jensen and Meckling 1976). To alleviate these agency costs managers need to pre-commit to accounting methods that reduce accounting discretion (Watts and
2 We use the term historical cost to describe accounting treatment under which assets are recognized at historical
3 Zimmerman 1979, 1986). For example, choosing historical cost serves as a commitment against discretionary upward asset revaluations. This tradeoff between relevance and reliability lies at the center of the controversy over fair value accounting (e.g., Sloan 1999; Wahlen et al. 2000; Dietrich et al. 2001; Schipper 2005a; Herrmann et al. 2006; Laux and Leuz 2009) and hence we argue that this tradeoff should largely determine the choice between the two accounting principles that we study.
We make three empirical predictions. First, the recent move towards fair value in accounting standards (e.g., Johnson 2005) suggests that standard setters believe the efficient solution to asset measurement has shifted towards the relevance side of the tradeoff (Watts and Zimmerman 1986). In other words, the relevance benefits of fair value are on average expected to outweigh the cost of lower reliability. Hence, we predict that IFRS adoption is associated with a significant shift towards fair value accounting for non-financial assets among firms that were constrained to historical cost accounting under local GAAP. Costs of constructing reliable fair value estimates, however, are expected to be an important cross-sectional determinant behind the choice to adopt fair value. Given this, our second prediction is that fair value accounting is more likely for assets that exhibit relatively more liquid markets (which serves as a source of verification and hence reduces the cost of establishing reliable fair value estimates). Property is more likely than other non-financial asset classes to be ―re-deployable‖ by other firms and therefore has relatively liquid markets (Shleifer and Vishny 1992). Hence we expect a more frequent use of fair value for property. Our third prediction is that fair value accounting is positively associated with reliance on debt financing. Companies that frequently and more heavily rely on debt are commonly required by creditors to invest in construction of reliable fair value estimates for the purposes of debt contracting and reporting to creditors. Given this, the
4 marginal cost of recognizing these estimates in financial statements is low (Holthausen and Watts 2001).
Another distinctive feature of our study is that we avoid drawing conclusions based on a particular industry or asset group. While prior studies mainly focus on a selected sample (e.g., investment property), preferences towards fair value use are likely to vary considerably across assets and industries, and understanding this variation can be useful from the policy perspective. We examine this variation to establish for which assets and in which industries fair value is associated with net firm-specific benefits. Our hand-collected sample consists of 1,539 companies, which approximates the population of publicly traded companies in Germany and the UK. We read the accounting policy sections in annual reports to identify the valuation practices.
We find that only 3% of the sample firms use fair value accounting for at least one asset class under the PPE asset group following IFRS adoption. With very few exceptions, these companies use fair value accounting for the property asset class only; members of the plant and equipment asset classes are valued at historical cost in almost all cases.3 An even more striking
observation emerges when we examine the post-IFRS choices of companies that recognized at least one PPE asset class at fair value under local GAAP (i.e., under UK GAAP). We find that 44% of these companies in fact switch to historical cost accounting upon IFRS adoption. In contrast, among companies that recognized all PPE asset classes at historical cost under local GAAP, only 1% switch to fair value for at least one asset class.
3 Total assets and shareholders’ equity are, respectively, 31% and 88% higher on average for companies that apply
fair value than for a matched sample of companies that use only historical cost accounting. This suggests that the choice between the valuation methods is not random and is economically important. This result cannot be interpreted as causal, however, because incentives to use fair value depend on how using fair value accounting versus historical cost accounting affects the outcome. See appendix C for the results.
5 We find that companies are equally likely to use historical cost and fair value accounting for investment property (i.e., property held for the purpose of earning rental income or for capital appreciation). The strongest determinant of fair value use for this asset group is whether real estate is one of the company's primary business activities. Namely, German companies, all of which were constrained to historical cost before IFRS adoption, are significantly more likely to switch to fair value accounting for investment property when real estate is among their primary activities. In contrast, in the UK, where all companies were constrained to fair value for investment property prior to IFRS, we observe more frequent switches to historical cost accounting when real estate is not among their primary activities. The results are consistent with managers revealing their preferences and switching accounting treatments once their choice is not constrained by accounting regulation. The preferences of real estate companies’ managers in the UK and Germany indicate that fair value accounting for investment property in this industry is generally associated with net firm-specific benefits, consistent with Muller et al. (2008). Since the real estate industry exhibits relatively liquid markets, the costs of constructing reliable fair value estimates are lower. In addition, changes in the value of investment property are directly linked to the performance of real estate business. This implies that benefits of fair value are more likely to outweigh its costs for real estate companies. Finally, we find that no companies in our sample use fair value accounting for intangible assets.
Logistic regression analysis of the decisions to use fair value reveals for both investment property and PPE that reliance on debt financing is positively associated with the use of fair value. This finding holds both when measuring reliance on debt by leverage and the frequency of accessing debt markets. Further analysis reveals that short-term debt is more important than long-term debt in explaining the fair value use. Given that we study pre-commitments to fair
6 value, and that accounting-based covenants are less common for short-term debt, the results are inconsistent with the conclusion that companies use fair value opportunistically to avoid covenant violations (opportunism is one proposed explanation for the results in prior literature, see Cotter and Zimmer 1999 for discussion).
Overall, our results do not support our first prediction that a significant fraction of firms shift towards fair value accounting upon IFRS adoption. Rather, the evidence indicates that almost all firms pre-commit against upward asset revaluations for the majority of illiquid (non-financial) asset groups and therefore stands in contrast to the standard setters' enthusiasm for fair value accounting. The cross-sectional tests of our second and third predictions suggest that fair value is used when the costs of obtaining reliable estimates are relatively low. Hence, the resistance to fair value does not appear to be due to managers’ disagreement with standard setters on the conceptual merits of fair values in decision making, but rather due to the costs of establishing reliable fair value estimates.
Our paper makes three contributions to the literature. First, it documents that, in a setting where companies must adhere to their choice in the future, fair value accounting for non-financial assets is crowded out by historical cost accounting, arguably with the exception of property. This finding implies that despite the conceptual appeal of fair value, the costs of establishing reliable estimates prevent fair value from becoming the primary valuation method for non-financial assets. In light of the policy debate over whether to expand mandatory fair value accounting for non-financial assets, our evidence on managers’ actual choices cautions that the firm-specific benefits are unlikely to exceed the firm-specific costs. However, mandatory fair value accounting for illiquid non-financial assets may still be socially optimal if fair value
7 accounting is associated with positive externalities. More research is needed to understand potential externalities.
Second, this is the first study to exploit revealed preferences for pre-commitment to fair value accounting. Our results contrast sharply to the prior evidence on ex post revaluations. For example, Brown et al. (1992) report that about two-thirds of Australian companies revalued assets upwards (at least once) over three- and four-year periods. Similarly, studies on intangibles such as brand names (e.g., Barth and Clinch 1998; Muller 1999) report relatively frequent ex post revaluations. We, however, find that few companies pre-commit to the use of fair value for PPE and no sample firms make such a pre-commitment for intangibles. These differences suggest that the requirement to pre-commit affects managers’ choices and also highlights the difference between our setting and the settings studied in prior literature.
Third, our study contributes to the policy-related debate on the consequences of adopting IFRS in the US (e.g., Hail et al. 2009). Under US GAAP, fair value accounting is not allowed for non-financial assets, and this difference between US GAAP and IFRS amounts to an important point of disagreement among the standard setters. It is often argued that a consequence of mandatory IFRS adoption is a significant increase in the use of fair value (see Cairns 2006 for examples). Our evidence generally does not support this conjecture for non-financial assets. One potential scenario is that fair value accounting becomes a popular and widely used vehicle for misrepresentation of financial reports. For example, recent evidence in Ramanna and Watts (2009) suggests that mandatory application of fair value to assess goodwill impairments is consistent with opportunistic representation of financial reports. In our voluntary setting, however, most companies choose to pre-commit against the use of fair value for non-financial assets. This suggests that most managers are unwilling to subject shareholders to the agency
8 costs associated with fair value measurement for non-financial assets. Interestingly, our finding echoes accounting practice in the United States before the Securities and Exchange Commission (SEC) banned upward revaluations in 1940: downward revaluations were much more common than upward revaluations and the latter were almost never performed on intangible assets (Fabricant 1936; Paton 1932). The consistency of accounting practice across time and different institutional settings speaks to the existence of an economic mechanism that governs companies’ choice to use fair value.
Section 2 describes the accounting traditions in the UK and Germany, as well as the valuation methods available to companies under German GAAP, UK-GAAP, and IFRS; Section 3 develops testable hypotheses; Section 4 describes the sample selection procedure and presents our results; and Section 5 concludes.
2. Accounting in the UK and Germany
Despite EU accounting harmonization that began decades prior to IFRS, the UK and Germany arguably had the two most distinct asset valuation traditions in Europe at the time of IFRS adoption. The differences in their accounting traditions are due to institutional differences in legal systems and ownership structures. Germany has traditionally been characterized by the existence of private companies who raise capital from banks and communicate via private information channels (Leuz and Wüstemann 2004). Accounting was mainly used to establish taxable income; hence, accounting regulation was codified and focused mainly on legal entity statements. As revaluations are often in conflict with the objectives of tax authorities, German GAAP only allowed historical cost accounting. Today in Germany, there is no formal link between legal entity reports, which are still used primarily for tax purposes, and consolidated statements. Thus, companies’ financial reporting choices in the consolidated statements,
9 including their valuations of non-financial assets, have no tax consequences. In contrast, UK accounting has historically developed separately from tax accounting and in the private sector rather than in company law. UK ownership is dispersed and even middle-sized companies are commonly listed on the London Stock Exchange. Such ownership structure requires that financial reporting reduce information asymmetry, and in this context revaluations may serve the purpose of conveying information about assets' current values.
Next, we discuss the accounting treatment of long-term non-financial assets—investment property, PPE, and intangible assets—under UK-GAAP, German GAAP, and IFRS.
2.1 Accounting for investment property
IAS 40 defines investment property as land or buildings not currently occupied by the owner that are held to generate rental income or capital appreciation. Under German GAAP, companies must value investment property at historical cost, while under UK-GAAP, companies are required to use fair value. Net income is unaffected by upward revaluations of this asset group under UK-GAAP, as they are credited to the revaluation reserve. IFRS offers companies the choice between recognizing investment property at historical cost or fair value. Thus a significant shift towards fair value is expected among German companies while not for UK firms. Under IFRS, if a company chooses to recognize investment property at historical cost, it must systematically depreciate the acquisition costs and disclose the investment property's fair value in the notes accompanying the financial statements. In contrast, if a company chooses to apply fair value, changes in the investment property's value become part of operating income and the assets are not subject to depreciation. We assume that investors are rational and cannot be misled by whether fair value changes affect net income or directly go to shareholders’ equity. Thus we rule out this consideration as a determinant of the fair value choice.
10
2.2 Accounting for property, plant, and equipment (PPE)
The only valuation method for PPE permitted under German GAAP is historical cost. Under both IFRS and UK-GAAP, PPE is initially recognized at cost but at each subsequent balance sheet date is valued at either historical cost or fair value. In either case, these assets are subject to depreciation. When fair value is applied, positive changes in an asset's value are credited to the revaluation reserve, which constitutes part of shareholders’ equity. Revaluations, therefore, only affect net income through future depreciation charges (unlike for investment property). Finally, under IFRS, the choice of valuation method must be consistent for all assets in the same asset class (IAS16.29).
2.3 Accounting for intangible assets
Under German GAAP, historical cost is the only valuation method permitted for intangible assets. Under both UK-GAAP and IFRS, however, intangible assets are to be carried at either historical cost or fair value less any amortization and impairment charges. Under fair value, the accounting treatment is similar to that of PPE; that said, a company may only apply fair value to an intangible asset if an active market exists for that asset (IAS38.75). The definition of an active market is very narrow, and for many intangible assets, such as brands, patents, and trademarks, it is nonexistent, due to their uniqueness and the specificity of their application (IAS38.78).
2.4 Fair value under IFRS vs. settings in prior literature
The IFRS setting is different from the Australian and UK settings used in prior research in that companies must ex ante state their choice between historical cost and fair value in their accounting policy.4,5 If a company decides to apply fair value under IFRS, it must revalue assets
4 Note that both the UK and Australia adopted accounting standards in 1999 and 2000 that are similar to IAS 16,
11
every time the book value is materially different from the market value (IAS 16 and IAS 40). If
the same company instead decides to use historical cost, it cannot perform upward revaluations in the future. A switch between historical cost and fair value is considered a voluntary change in accounting principles and needs to be justified to auditors, lenders, equity investors, and potentially to regulators. Therefore, the choice between fair value and historical cost in our setting represents an ex ante commitment and hence is unlikely to be driven by instantaneous earnings management considerations. Indeed, the early studies argued that discretionary revaluations are related to contracting motives – consistent with this view leveraged companies in danger of violating covenants are more likely to revalue assets (Whittred and Chan 1992; Brown et al. 1992; Cotter and Zimmer 1995).6
The problem with discretionary revaluations is that managers decide whether to revalue assets ex post after they know the effect of the fair value estimate on the financial statements. For instance, managers may only revalue assets when they need to manipulate reported performance. Alternatively, managers may revalue assets when reliable fair value estimates are available. Our setting isolates this issue as we examine ex ante choices to use fair value with limited ex post discretion to change valuation methods. Thus, examining ex ante choices is more likely to be informative about the economic trade-off between fair value and historical cost than examining
ex post revaluations. Furthermore, the ex ante requirement in IFRS aids firms in committing to
non-opportunistic use of fair value accounting, which may imply that fair value accounting under IFRS is associated with greater benefits than ex post revaluations. Consistent with this view,
5
Analogous to, e.g., inventory valuation methods.
6 Whittred and Chan argue that asset revaluations reduce underinvestment problems that arise from contractual
restrictions, while Cotter and Zimmer argue that upward revaluations increase borrowing capacity. While debt contracting is the main explanation for asset revaluations, Brown et al. also find that bonus contracts, as well as signaling and political cost explanations, play an important role.
12 Muller et al. (2008) find lower bid-ask spreads for fair value companies and Cairns et al. (2008) find that fair value accounting increases international comparability in the IFRS setting.
3. Background and hypotheses
Relevance and reliability are the most basic and important attributes of accounting information. The tradeoff between relevance and reliability is recognized in the conceptual frameworks of both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).7 Thus, when standard setters choose between fair value
and historical cost, the relevance-reliability tradeoff is at play. In recent years, both FASB and IASB have placed more emphasis on relevance, not reliability.8 This change in focus is reflected,
for example, in the conclusion of a discussion of relevance and reliability by L. Todd Johnson, a senior project manager at FASB:
The Board has required greater use of fair value measurements in financial statements because it perceives that information as more relevant to investors and creditors than historical cost information. Such measures better reflect the present financial state of reporting entities and better facilitate assessing their past performance and future prospects. In that regard, the Board does not accept the view that reliability should outweigh relevance for financial statement measures. (Johnson 2005).
FASB's and IASB's shift towards fair value accounting suggests that they believe the efficient solution to asset measurement has shifted closer to the relevance side of the tradeoff (Watts and Zimmerman 1986). The standard setters’ position is justified on the grounds that fair value measurement aids financial statement users' decision making. Fair value is also argued to improve transparency, comparability, the timeliness of accounting information, and relative performance measurement (e.g., Schipper 2005a). In line with benefits of fair value, a large stream of value relevance studies on asset revaluations indeed finds that fair value possesses
7 See IASB's Framework paragraph 45 and FASB's Conceptual Statement 2 paragraph 15.
13 superior relevance. These studies find that upward revaluations are positively associated with equity returns in the month of the revaluation (Sharpe and Walker 1975; Standish and Ung 1982) and that they are associated with longer period stock returns, future cash flows, and the market value of equity (e.g., Easton et al. 1993; Barth and Clinch 1998; Aboody et al. 1999; Danbolt and Rees 2008).
Barth et al. (2001) argue that the value relevance tests are joint tests of relevance and reliability, because a certain degree of reliability is also established by rejecting the null of no association. This conclusion increases confidence in fair value and (combined with the argument that the reliability of fair values is similar to that of other accounting estimates, e.g., allowance for uncollectible accounts) potentially influences the regulators’ views. A caveat that is in order is that the previously documented associations between revaluations and equity values are
largely conditional on a company’s discretionary choice to revalue assets. These choices are
non-random as, for example, managers may revalue assets because they anticipate a market’s response to the reported numbers or know how reliable the revaluations are. Alternatively, as the association is measured over a relatively long window, it could be that managers choose to revalue when the firm does well, hence has higher returns. Thus, the association could capture the underlying change in firm performance and hence does not establish that the markets trust the re-valued numbers. These possibilities potentially limit the generalizability of value relevance tests for companies that do not use fair value and underscore the need to study the choice between fair value and historical cost.
IFRS offers an opportunity to test whether the move toward fair value in accounting standards is supported by the accounting practice choices that managers are making. Managers have incentives to make ex ante valuation choices that reflect the interests of firms’ stakeholders
14 (otherwise stakeholders will price protect or impose costs on management), and hence are cost-justified for a particular company. The observed choices can be used to infer whether managers agree with IASB (and FASB) that the efficient solution to the relevance-reliability trade-off has indeed shifted towards relevance. If the firm-specific benefits of fair value exceed its costs we hypothesize:
H1: IFRS adoption is associated with a shift towards fair value accounting for non-financial
assets.
The effort and resources a company needs to expend in order to obtain reliable fair value estimates are likely important in determining a manager’s choice of valuation practice. We next consider how the costs of obtaining reliable estimates affect the choice between fair value and historical cost. The ability to obtain reliable fair value estimates is closely related to the existence of liquid markets for assets, which provide an independent source of verification (Watts 2006). Property is the only non-financial asset class for which a relatively liquid market with official statistics exists. Therefore, our second hypothesis proposes:
H2: Fair value accounting is more likely for asset classes for which liquid markets exist, i.e., for
property as opposed to plant, equipment, and intangibles.
Similarly, the existence of reliable fair value estimates for purposes other than financial reporting affects the marginal cost of recognizing fair values in financial statements. Companies that access debt markets are commonly required under their credit arrangements to provide valuations of collateral. The fact that lenders are willing to lend against these valuations implies that a company invests in measuring them reliably (e.g., independent valuation and certification).9 Given this, recognizing the fair values of these assets in financial statements is
9 Muller and Riedl (2002) document that fair value estimates produced by independent valuators are viewed by
15 associated with low incremental costs (Holthausen and Watts 2001). Therefore, our third hypothesis is:
H3: Fair value accounting is positively associated with reliance on debt financing.
Earlier studies have documented a positive correlation between ex post revaluations and leverage (Brown et al. 1992; Whittred and Chan 1992; Cotter and Zimmer 1995). However, this positive correlation is often attributed to opportunistic behaviour where managers perform upward revaluation to avoid covenant violations when they move closer to technical default (see discussion in Cotter and Zimmer 1999). If this hypothesis is indeed true, then we do not expect to find a significant association between leverage and the use of fair value since avoiding default on covenants is unlikely to drive managerial choice (i.e., pre-commitments) in our setting. Furthermore, if opportunism was to explain the association between leverage and the use of fair value, we would expect to find the association stronger in case of long-term debt, where accounting-based covenants are more common compared to short-term debt. We test this implication empirically.
4. Results
4.1 Sample selection and descriptive statistics
We manually verify the accounting standards that a given company follows by looking at either the accounting policy section or the auditor’s opinion section of its annual report(s). To identify the asset valuation practice a company follows, we read the accounting policy section of its annual report(s). We begin with all UK and German companies (active and inactive) in Worldscope and further restrict to those complying with IFRS in either 2005 or 2006. For inclusion in the German and UK cross-sectional samples, we further require that a company has an annual report under IFRS in Thomson One Banker. We construct a cross-sectional sample to
16 examine valuation practices after mandatory IFRS adoption and a switch sample (UK only) to examine whether companies use mandatory IFRS adoption to switch their accounting practices. For inclusion in the UK switch sample, we also require that a company has an annual report (prepared according to UK-GAAP) before IFRS adoption.10
Table 1, Panels A and B present the distribution by industry of companies in Worldscope as well as in the German sample, the UK cross-sectional sample, and the UK switch sample. The industry distribution in each sub-sample approximates that of Worldscope.
4.2 Valuation practices
In this section, we provide evidence on hypothesis H1. A company is classified as applying fair value accounting if it recognizes at least one asset class (within an asset group) at fair value.11 Similarly, a company is classified as applying historical cost if it recognizes at least
one asset class (within an asset group) at historical cost. Appendix A presents examples of fair value accounting and historical cost accounting for PPE.12
4.2.1 Valuation practices in the UK
Table 2 documents the valuation practices in the UK cross-sectional sample. We identify no use of fair value accounting for intangible assets; instead, all companies in our sample rely on historical cost for this asset group. For PPE, 5% of companies use fair value accounting while all
10 For companies both in Germany and the UK, we obtain their first annual report under mandatory IFRS, which is
typically for fiscal year 2005. In addition, for companies in the UK, we look for their last UK-GAAP annual report, which is typically for fiscal year 2004. In the rare cases where we cannot find these annual reports, we take the next annual report available in Thomson One Banker (e.g., for fiscal year 2006).
11
Note that this is a conservative way of defining the use of fair value because the fraction of assets recognized at fair value can be relatively small. Yet, even this definition generates pronounced economic differences across the two groups of companies.
12 Panel A of Appendix A provides an example of a company that switched from fair value to historical cost, Panel
B provides an example of a company that used fair value under both UK-GAAP and IFRS, and Panel C provides an example of a German company that uses fair value.
17 companies use historical cost for at least one asset class within this asset group. We observe that fair value use differs across industries, with higher concentration in the financial sector.
Table 3 presents the results from the UK switch sample. For PPE, we find that 6% of companies use fair value under UK-GAAP and 5% use fair value under IFRS. A large number of switches occur for this asset group. Specifically, 44% of companies that use fair value for at least one asset class in PPE under UK-GAAP switch to historical cost (for all asset classes) upon IFRS adoption. In contrast, only 1% of companies using historical cost for all asset classes under UK-GAAP switch to fair value for at least one asset class upon IFRS adoption. The joint evidence in both tables does not support H1 and implies that only a small number of companies find fair value to be cost-justified.
What made a high portion of UK companies switch to historical cost on IFRS adoption? IFRS and UK-GAAP are very similar when it comes to the valuation of PPE (see Section 2.2). Thus, the switches observed upon IFRS adoption are voluntary in the sense that IFRS did not force these companies to switch to historical cost. If historical cost maximizes net benefits, why did these firms not switch to historical cost under UK GAAP?13 One explanation is that
switching accounting principles is uncommon in practice because it is costly.14 The costs of
switching accounting principles include renegotiating contracts that require consistency in GAAP, convincing auditors that the new practice better reflects the underlying economics of the company, and communicating the change to financial statement users. Most of these costs are
13 We contacted those non-financial companies that switched to historical cost and received several replies
indicating that IFRS was a convenient opportunity for them to make the switch.
14
Consistency in accounting policies across time is highly regarded by the accounting profession. Comparability is a qualitative characteristic expressed in IASB’s Framework (paragraph 39): ―. . . the measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout an entity and over time for that entity.‖ In U.S. literature, consistency is expressed in several places, including the Accounting Research Study No. 1 of the American Institute of Certified Public Accountants (postulate C-3). See Ball (1972) for an extensive discussion of the accounting profession’s reliance on consistency.
18 fixed (i.e., they are independent of the number of changes) so the incremental cost of voluntary changes is substantially lower when combined with a mandatory change such as IFRS adoption. Even if these companies did want to switch to historical cost before IFRS adoption, the associated costs could have made switching unattractive. However, the observation that a switch is more likely from fair value to historical cost than from historical cost to fair value implies that firms’ revealed preferences do not echo with the standard setters' enthusiasm over fair value accounting, in contrast to hypothesis H1.
After IFRS adoption, fair value is more common for investment property, for which UK companies had to use fair value under local GAAP, than it is for PPE. Nevertheless, 23% of companies reveal preferences for historical cost by switching from fair value to historical cost once they are no longer constrained to the use of fair value by accounting regulation. Significant industry variation is present: whereas only 2% of financial companies switch to historical cost, 45% of non-financial companies switch.
4.2.2 Valuation practices in Germany
Table 4 documents the valuation practices in the German sample. We find no use of fair value accounting for intangible assets in Germany, similar to the UK. For PPE, 1% of companies switch to fair value for at least one asset class upon IFRS adoption (note that under German GAAP fair value was not allowed). Only one company applies fair value to all asset classes in PPE, while all other companies use historical cost for at least one asset class. These findings approximate those we observed in the UK and indicate that most managers reveal preferences for historical cost.
For investment property, we find that 23% of German companies reveal preferences for fair value by switching from historical cost to fair value once they are no longer constrained to
19 historical cost by accounting regulation. However, we also observe substantial industry variation. Among financial companies, 49% switch to fair value, while only 6% of non-financial companies switch.
In summary, we find that a small number of companies use fair value accounting for at least one asset class under PPE after IFRS adoption. The absence of fair value accounting for intangibles and its limited use for PPE in both the UK and Germany suggests that only a small subset of companies perceive net firm-specific benefits of fair value accounting. Counter to hypothesis H1, there is no general shift towards fair value accounting for non-financial assets. The exception is investment property among German financial institutions where approximately one half of them shift to fair value. The evidence that shifts towards fair value occur for investment property rather than PPE and intangibles is consistent with H2. Next, we provide further evidence on H2 by exploiting the differences in asset liquidity within the PPE group.
4.2.3 Assets recognized at fair value
In this section, we examine which asset classes in PPE are recognized at fair value. Table 5 presents the distribution of fair value use across the three asset classes within the asset group. Sixty-nine companies in the sample use fair value accounting either before mandatory IFRS adoption, after mandatory IFRS adoption, or both. Of these companies, 93% use fair value accounting for property. Only 3% use fair value for plant, and only 4% use fair value for several asset classes in PPE. The distributions of fair value use in the UK and Germany are similar. Hence, the application of fair value accounting is, in practice, not only limited in terms of the number of companies using it, but also in terms of the assets to which it is applied, namely property. While this evidence is at odds with hypothesis H1, it supports H2 as property is the only non-financial asset class for which a relatively liquid market is often present.
20
4.3 Analysis of the decision to use fair value
In this section, we examine the revealed preferences for valuation practices following IFRS adoption in a cross-section of firms using logistic regression analysis. Our analysis draws on two different subsamples and controls for common company-specific characteristics. First, we analyse the sample of all companies that hold investment property. Second, we restrict our analysis to the sample of companies that use fair value for PPE matched with a historical cost control group. The summary statistics for variables used in this analysis are reported in Table 6. All variables are defined in Appendix B. Because the number of observations and the set of explanatory variables vary across the two subsamples, we report two separate sets of summary statistics in Panels A and B.
4.3.1 Investment property
While IFRS provides UK companies with the first opportunity to switch to historical cost for investment property, in Germany the opposite is the case. Thus, IFRS gives both German and UK company managers an option to move to the asset valuation method not previously available under local GAAP in these countries. Such a setting is particularly convenient to study revealed preferences because significant switching from historical cost to fair value in Germany and, in contrast, from fair value to historical cost in the UK is difficult to attribute to factors other than the presence of considerable firm-specific benefits associated with the alternative accounting treatment. We begin by exploring whether firm-specific cost and firms-specific benefits of fair value accounting differ across industries. Note that in this regard the real estate industry is unique, as its main assets (investment property) exhibit relatively liquid markets. Consequently, under H2, we predict that German real estate firms are more likely to switch to fair value than
21 German firms in other industries, while UK real estate firms are less likely to switch to historical cost than UK firms in other industries.
Our sample comprises the 275 companies (124 UK companies; 151 German companies) that hold investment property. Depending on the specification, additional data requirements limit the sample further. We begin with a basic regression that examines whether accounting methods vary based on country of domicile and industry type
1 2 * 65 3 4 * 65
IFRS
Fair UK UK Sic Germany Germany Sic , (1)
where UK (Germany) is an indicator variable that takes the value of one for UK (German) companies and zero otherwise, and Sic65 is an indicator that takes the value of one when a company has SIC code 65 (real estate) among its first five SIC codes and zero otherwise. Equation 1 examines how consistency of valuation practices varies, conditional on whether real estate is among a company's primary business activities. As discussed in Section 2, the UK and Germany have very different institutional features. If institutions, as opposed to accounting standards per se, determine the accounting practice, then we expect to find the country variables to be significant. Specifically, the coefficients β1 and β3 capture the consistency of reporting
methods in the UK and Germany in general, while β2 and β4 measure increments in consistency
when real estate is among a company's primary business activities.
Table 7 Column 1 presents the regression estimates of Equation 1. The pseudo R-squared suggests that Equation 1 explains a substantial portion (i.e., 34%) of the variance in the decision to use fair value. The estimates indicate that companies domiciled in Germany are significantly more likely to use historical cost after IFRS adoption (β3). This effect, however, is significantly
smaller for companies whose primary industries include real estate (β3 + β4). Companies
22 small. This effect, however, is much stronger (and more significant) for companies in the real estate business (β1 + β2). The evidence is in line with H2. The switches from historical cost to fair value among German real-estate-companies and from fair value to historical cost among UK non-real-estate-companies, when companies are no longer constrained by accounting regulation, is strong evidence that the real estate industry has net firm-specific benefits of fair value accounting for investment property. This finding is consistent with the capital market benefits of fair value accounting for real estate firms documented in Muller et al. (2008). Real estate businesses' greater propensity to switch to fair value (or continue its use) is consistent with fair value being a superior measure of economic performance in the real estate industry. However, the evidence also indicates that the valuation practices remain somewhat persistent across IFRS adoption (historical cost in Germany and fair value in the UK). This finding is policy-relevant because it implies that the application of GAAP need not be uniform under one set of standards, and is specific to institutional setting, in line with arguments in Ball (2006).
In Table 7, Columns 2 through 6, we augment Equation 1 with log of market capitalization and an IFRS early adoption dummy (Muller et al. 2008) and test whether fair value is positively associated with reliance on debt as predicted by hypothesis H3.
The key finding in Column 2 is that companies that rely more heavily on debt financing are more likely to use fair value accounting for investment property. This is consistent with the incremental costs of obtaining reliable fair value for financial reporting purposes being low when they are already produced for financing purposes (Holthausen and Watts 2001). An alternative explanation is that companies may choose fair value accounting because it allows them to avoid covenant breaches (Cotter and Zimmer 1999).
23 To shed more light on this issue, in Model 3 we decompose leverage into its long- and short-term components, as well as proxy for reliance on convertible debt. We find that short-term leverage is more important than long-term debt in explaining fair value use. The coefficient on convertible debt is also significantly positive. As accounting-based covenants are less important and less common from short-term and convertible-debt perspectives, the results are inconsistent with the conclusion that companies use fair value opportunistically to avoid covenant violations. Rather this finding suggests that firms accessing debt markets frequently are more likely to use fair value. This is intuitive as these companies need to produce reliable estimates for financing purposes more frequently and therefore have a low incremental cost of committing to fair value.
Models 4 through 6 of Table 7 replace leverage with other ―leverage‖ proxies frequently used in contracts.15 We find that the ratio of total debt to operating income is positively related to
the use of fair value, while the coverage of interest and the current ratios are negatively related to fair value use. These results are consistent with hypothesis H3 and confirm the effect of leverage by showing that companies that rely more on debt are more likely to use fair value.
To provide further evidence on H3, we examine whether fair value companies access debt markets more frequently than historical cost companies following IFRS adoption in 2005. If indeed the availability of reliable fair value estimates relates to debt financing activities, fair value choices should predict more frequent debt market access. Based on Worldscope data for 2006 and 2007, we construct several proxies for access to debt and equity financing. Specifically, we proxy for future debt financing with the following variables: DebtIss1 (DebtIss2) indicates whether by 2007 total debt (long-term debt) had increased by more than 10% of the current market value of assets; FtrLev1 (FtrLev2) proxies for the level of future total
15 We exclude leverage because these variables are highly correlated with leverage and therefore capture aspects of
24 debt (long-term debt) in 2007 while controlling for the level of current debt in the regression; and
DbtGrow1 (DbtGrow2) indicates growth in total debt (long-term debt). To ensure that our debt
financing variables are not capturing financing activity in general we measured equity market access as a benchmark. Proxies for equity issuance over 2006 and 2007 are as follows: EqIss1 indicates whether combined net proceeds of equity issuance less proceeds from stock options exceed 10% of market value of current assets; and EqIss2 is the ratio of net proceeds to current market value of assets. We regress these proxies on both the fair value indicator variable and controls for company characteristics that include country, size, leverage, and an SIC code 65 indicator.
We present our findings in Table 8. Columns (1) through (6) present regressions with the six proxies for debt issuance used as the dependent variables, while columns (7) and (8) are based on the two equity issuance variables. All proxies for debt issuance are statistically significant and indicate a relation between fair value use and future debt financing. Proxies for equity financing are insignificant at the conventional levels. While we have no strong prior for why equity market access should relate to fair value use, the relation between fair value use and future debt issuance supports the explanation that the costs of recognizing reliable fair value estimates are lower when firms regularly enter debt markets, as predicted by H3.
4.3.2 Property, plant, and equipment (PPE)
We conduct a similar analysis of a company's decision, post-IFRS, to apply fair value to PPE. A few distinctions, however, bear mentioning. First, we hand-collect the fair value revaluation reserve data from companies’ annual reports. This enables us to compute book values of equity, PPE, and total assets as if companies used historical cost. Thus we can include book-to-market and book leverage as additional explanatory variables. In addition, we include the ratio
25 of PPE to total assets to examine weather PPE-heavy companies are more likely to use fair value. Second, the percentage of fair value companies in the population is low for this asset group; therefore, to improve our ability to draw inferences, we match each fair value company to a historical cost company.16 We perform this match according to country of domicile, two-digit
industry code, and the log of market value of equity and use the closest match. This procedure, which requires non-missing market value of equity, yields 90 observations. Data availability restrictions further reduce the sample to 87 (86 in Table 8 column 7) observations.
Table 9 presents the results from our logistic regression analysis. Because we match according to country, industry, and size, we omit these as explanatory variables. In line with the evidence for investment property and hypothesis H3, we find a positive and significant association between market leverage (book leverage) and the use of fair value accounting. Further analysis in column (3) reveals that, once again, short-term debt is at least as important as long-term debt in this association. The portion of convertible debt is now significantly negatively related to the use of fair value, a finding for which we currently have no explanation.
The effect of book-to-market is somewhat stronger in some specifications and indicates that after IFRS adoption, high growth companies are less likely to use fair value. One interpretation of this result is that companies with fewer growth opportunities use fair value accounting as a means of avoiding overinvestment in fixed assets. In particular, common accounting metrics—for example, return on assets or return on investment—are less likely to reflect actual performance under historical cost accounting because the depreciated cost is usually lower than market value, that is, the value in alternative use (see Appendix C). A commitment to fair value accounting dilutes the return on assets, makes it more costly for
16 We do not include all historical cost companies in the logit regressions because this would result in an unbalanced
sample. While our matched sample is sufficient to perform statistical tests, we acknowledge that a larger sample would be preferable for making robust inferences.
26 management to hold unproductive assets, and when fair value estimates are reliable, improves performance measurement. In other words, a commitment to fair value effectively forces managers to incur rent on their investments' current values, regardless of the time of purchase and their historical cost.
We further find a positive coefficient on PPE, but it does not attain statistical significance in most specifications. The positive coefficient on FairInvPr in Table 9 Column 5 suggests that companies that apply fair value to investment property are more likely to also apply fair value to PPE. Controlling for this effect, however, does not alter our findings with respect to leverage or book-to-market.
5. Summary
We investigate the choice between fair value and historical cost accounting for non-financial assets when markets, rather than regulators, determine the outcome. In light of the significant debate over fair value, understanding this choice is useful for regulators as it informs about relative firm-specific costs and benefits of fair value accounting. The IFRS setting is different from the settings in prior studies as it allows companies to choose between historical cost and fair value accounting for non-financial assets, but requires companies to pre-commit to their choice over time. We examined the accounting policies for intangible assets, investment property, and PPE of 1,539 companies. With very few exceptions, we find that fair value is used exclusively for property. We find that 3% of companies use fair value for owner-occupied property, compared with 47% for investment property. The lack of companies that use fair value for all other non-financial assets is inconsistent with fair value accounting yielding net firm-specific benefits for those assets. The use of fair value for property alone is likely explained by lower costs to reliably measure fair values in the presence of relatively liquid property markets.
27 The main cross-sectional determinant of fair value for both investment property and PPE is reliance on debt financing. When fair value estimates are constructed for financing purposes, they are likely to be relatively reliable, and the incremental costs of also recognizing them in financial reports are low.
Overall, our evidence suggests that most managers do not perceive the net benefits of fair value accounting to exceed those of historical cost accounting for non-financial assets. However, the cross-sectional variation in the choice reveal that fair value is chosen over historical costs when the cost of establishing reliable fair value estimates are low. This suggests that managers’ resistance to fair value use is likely to be driven by the costs of establishing reliable fair value estimates rather than a disagreement with standard setters on the conceptual merits of fair value accounting. These results have policy implications, as they suggest that fair value accounting for non-financial assets is costly for most firms. Thus, mandatory fair value accounting for illiquid non-financial assets may only be socially optimal if fair value accounting is associated with positive externalities that exceed the net costs imposed on those firms forced to use fair value accounting. Our setting does not allow us to explore externalities associated with fair value accounting. More research is needed to understand these issues.
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30
Appendix A: Examples of accounting practice
This appendix presents examples of fair value and historical cost accounting from the accounting policy section of annual reports of companies in our samples. Panel A presents an example of a switch from fair value under UK-GAAP to historical cost under IFRS. Panel B presents an example of fair value accounting under both UK-GAAP and IFRS. Panel C presents an example of a German company that uses fair value accounting under IFRS.
Panel A: Switch from fair value to historical cost
Annual report according to UK-GAAP for 2004
AMEC plc annual report and accounts 2004 (page 67) 12 Tangible assets (continued)
All significant freehold and long leasehold properties were externally valued as at 31 December 2004 by CB Richard Ellis Limited in accordance with the Appraisal and Valuation Manual of the Royal Institute of Chartered Surveyors.
For the United Kingdom, the basis of revaluation was the existing use value for properties occupied by group companies and the market value for those properties without group occupancy. For properties outside the United Kingdom, appropriate country valuation standards were adopted that generally reflect market value.
No provision has been made for the tax liability that may arise in the event that certain properties are disposed of at their revalued amounts.
The amount of land and buildings included at valuation, determined according to the historical cost convention, was as follows:
Group Group Company Company 2004 2003 2004 2003 £ million £ million £ million £ million
Cost 39.2 46.4 9.3 8.6
Depreciation (10.61) (13.9) (2.5) (1.7) Net book value 26.6 32.5 6.8 6.9
Annual report according to IFRS for 2005
AMEC plc annual report and accounts 2005 (page 102) IAS 16 Property, plant and equipment
Under UK-GAAP, AMEC’s policy was to revalue freehold and long leasehold property on a regular basis. Under IAS 16, AMEC has opted to carry property, plant, and equipment at cost less accumulated depreciation and impairment losses. As permitted by IFRS 1, AMEC has frozen the UK-GAAP land and buildings revaluations as at 1 January 2004 by ascribing the carrying value as deemed cost. The impact of this change in policy is as follows:
the revaluation reserve is reclassified into retained earnings as at the date of transition;
the results of the external revaluation as at 31 December 2004 are reversed, reducing the value of property, plant and equipment as at 31 December 2004 by £9.6 million; and
as part of the 2004 external revaluation, certain properties were revalued downwards. Under UK-GAAP, these deficits were charged against previous revaluations held in the revaluation reserve. Under IFRS, these downward revaluations have been taken as indicators that the value of the relevant properties is impaired and as such, they have been charged to the income statement as
