PDF Ebook Who uses fair value accounting for non-financial assets after IFRS adoption?
We examine whether and why companies prefer fair value to historical cost when they can choose between the two valuation methods. With the exception of investment property owned by real estate companies, historical cost by far dominates fair value in practice. Indeed, fair value accounting is not used for plant, equipment, and intangible assets. We find that companies using fair value accounting rely more on debt financing than companies that use historical cost. This evidence is consistent with companies using fair value to signal asset liquidation values to their creditors, and is not consistent with equity investors demanding fair value accounting for non-financial assets. Our evidence broadly speaks to the importance of accounting for contracting.
Academics and practitioners alike are actively debating the movement toward fair value accounting, both in the United States and around the world. The Securities and Exchange Commission (SEC) recently proposed a roadmap that could require mandatory adoption of International Financial Reporting Standards (IFRS) in the United States by 2014. If adopted, IFRS will allow a much wider application of fair value accounting to non-financial assets in the United States. The documented correlation between market value of equity and fair value estimates, however, offers little information regarding the reliability of such estimates. Indeed, the judgment required to establish fair value estimates, absent liquid markets, undermines their use (Watts 2006). In this paper, we examine whether and why in practice companies use fair value accounting for three major asset groups: (i) property, plant, and equipment; (ii) investment property; and (iii) intangible assets. Specifically, we exploit changes in accounting practices around the adoption of IFRS in the UK and Germany. We focus on the UK and Germany for two reasons: they have the largest financial markets in the European Union (EU) and, historically, they are at the opposite ends of the spectrum in terms of applying fair value accounting. Moreover, under IFRS, companies in the UK and Germany are permitted to choose between fair value and historical cost accounting for each of the three asset groups we examine.
Throughout this paper, we adopt a positive accounting theory view of accounting practice (Watts and Zimmerman 1986). This view maintains that accounting choices are shaped by incentives to improve the costly contracting process between a company and its claimholders. Agency-related conflicts induce suboptimal behavior on the side of management and thus impose substantial costs on companies in the form of price protection on the side of market participants (Jensen and Meckling 1976). The price protection, in turn, encourages companies to select accounting methods that pre-commit against value-destroying actions by management and therefore reduce agency costs. In our setting, for example, choosing historical cost over fair value can be viewed as a commitment against upward asset revaluations, which can be desirable from a contracting perspective, particularly when no objective way exists to measure fair value. Such pre-commitment can be a powerful way for creditors to curb shareholders’ incentives to overstate assets and thereby expropriate wealth from other claimholders.
Since January 1, 2005, all listed companies domiciled in the UK and Germany have been required to prepare their consolidated statements according to IFRS. The new standards provide companies in either country with the same set of valuation alternatives. Yet the companies domiciled in Germany and the UK are departing from very different local GAAP regimes. Under German GAAP, for example, upward revaluations are not allowed for any of the asset groups examined in this study. On the contrary, under UK-GAAP, companies are required to recognize investment property at fair value and are allowed to choose between fair value and historical cost for property, plant, and equipment and intangible assets. Under IFRS, companies domiciled in either country can choose to continue with the same valuation method as under local GAAP or they can switch to the other method.
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PDF Ebook Who uses fair value accounting for non-financial assets after IFRS adoption?
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