Does fair value accounting for non-financial assets pass the market test?

Abstract

The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is limited. We study the choice of fair value versus historical cost accounting for non-financial assets in a setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is consistent with market forces determining the choice. Fair value accounting is used when reliable fair value estimates are available at a lower cost and when they convey information about operating performance. For example, with very few exceptions, firms’ managers commit to historical cost accounting for plant and equipment. Our findings contribute to the policy debate by documenting the market solution to one of the central questions in the accounting literature. Our findings indicate that, despite its conceptual merits, fair value is unlikely to become the primary valuation method for illiquid non-financial assets on a voluntary basis.

Appendices

Appendix 1: The accounting treatment of long-term non-financial assets under UK GAAP, German GAAP, and IFRS

In this appendix we describe the accounting treatment of long-term non-financial assets—investment property, PPE, and intangible assets—under UK GAAP, German GAAP, and IFRS. For brevity, we use the term historical cost to describe historical cost adjusted for depreciations, amortizations, and impairments.

1.1 Accounting for investment property

Investment property consists of land or buildings 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 (German HGB, para. 253, and SSAP 19). 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 (IAS 40). 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 the operating income and the assets are not subject to depreciation.

1.2 Accounting for property, plant, and equipment (PPE)

The only valuation method for PPE permitted under German GAAP is historical cost less depreciations (German HGB, para. 253). 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 (IAS 16 and FRS 15). 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).

1.3 Accounting for intangible assets

Under German GAAP, historical cost is the only valuation method permitted for intangible assets (German HGB, para. 253). 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 (IAS 38 and FRS 10). 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 in the rare circumstances where the intangible asset has a readily ascertainable market value from an active market. The definition of an active market is rather narrow, and for many intangible assets, such as brands, patents, and trademarks, it is non-existent, due to their uniqueness and the specificity of their application (IAS38.78). Hence for most intangible assets, managers are in practice restricted to historical costs accounting, and the valuation choice for intangibles therefore cannot be considered free to the same extent as it can for investment property and PPE.

Appendix 2: Examples of accounting policies for PPE

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

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 2004 £ million	Group 2003 £ million	Company 2004 £ million	Company 2003 £ 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

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 impairment charges in 2004. This reduces the profit for the year ended 31 December 2004 and the value of property, plant and equipment as at 31 December 2004 by £1.8 million.

• Panel B: Fair value under both UK GAAP and IFRS

• Annual report according to UK GAAP for 2004

• The Wolverhampton & Dudley Breweries PLC

• Freehold and leasehold properties are stated at valuation or at cost. Plant, furnishings, equipment, and other similar items are stated at cost.

• Freehold buildings are depreciated to their residual value on a straight line basis over 50 years.

• Other tangible fixed assets are depreciated to their residual value on a straight line basis at rates calculated to provide for the cost of the assets over their anticipated useful lives. Leasehold properties are depreciated over the lower of the lease period and 50 years and other tangible assets over periods ranging from three to 15 years.

• Own labor directly attributable to capital projects is capitalized.

Valuation of properties: Trading properties are revalued professionally by independent valuers on a five-year rolling basis. When a valuation or expected proceeds are below current carrying value, the asset concerned is reviewed for impairment. Impairment losses are charged directly to the revaluation reserve until the carrying amount reaches historical cost. Deficits below historical cost are charged to the profit and loss account except to the extent that the value in use exceeds the valuation, in which case this is taken to the revaluation reserve. Surpluses on revaluation are recognized in the revaluation reserve, except to the extent that they reverse previously charged impairment losses, in which case they are recorded in the profit and loss account. Any negative valuations are accounted for as onerous leases and included within provisions (see note 20).

• Annual report according to IFRS for 2005

• The Wolverhampton & Dudley Breweries PLC

• Freehold and leasehold properties are stated at valuation or at cost. Plant, furnishings, equipment, and other similar items are stated at cost.

• Depreciation is charged to the income statement on a straight-line basis to provide for the cost of the assets less residual value over their useful lives.

• Freehold and long leasehold buildings are depreciated to residual value over 50 years.

• Short leasehold properties are depreciated over the life of the lease.

• Other plant and equipment is depreciated over periods ranging from 3 to 15 years.

• Land is not depreciated.

Valuation of properties: Properties are revalued by qualified valuers on a regular basis using open market value so that the carrying value of an asset does not differ significantly from its fair value at the balance sheet date. When a valuation is below current carrying value, the asset concerned is reviewed for impairment. Impairment losses are charged to the revaluation reserve to the extent that a previous gain has been recorded, and thereafter to the income statement. Surpluses on revaluation are recognized in the revaluation reserve, except where they reverse previously charged impairment losses, in which case they are recorded in the income statement.

• Panel C: Fair value accounting by German company

• Annual report according to IFRS for 2005

• Hypo Real Estate Group

Property, plant, and equipment is normally shown at cost of purchase or cost of production. As an exception to this rule, land and buildings are shown with their fair value in accordance with IAS 16. The carrying amounts—if the assets are subject to wear and tear—are diminished by depreciation in accordance with the expected service life of the assets. In the case of fittings in rented buildings, the contract duration taking account of extension options is used as the basis of this contract duration is shorter than the economic life.

Appendix 3: Variable definitions

Fair :

One if a company uses fair value for at least one asset class within a specific asset group following the adoption of IFRS and zero otherwise

UK :

One if a company is domiciled in the UK and zero otherwise

UkSic65 :

One if a company has SIC 65 (real estate) among its first five SIC codes and is domiciled in the UK and zero otherwise

Germany :

One if a company is domiciled in Germany and zero otherwise

GermanySic65 :

One if a company has SIC 65 (real estate) among its first five SIC codes and is domiciled in Germany and zero otherwise

Early :

One if a company adopted IFRS before 2005 and zero otherwise

Size :

Log of market value of equity

PPEA :

Property, plant, and equipment less revaluation reserve divided by total assets less revaluation reserve

MktLev :

Total liabilities divided by market value of assets (defined as book value of liabilities plus market value of equity) as of December 2005

MktLevLong :

Long-term debt divided by market value of assets (liabilities plus market value of equity) as of December 2005

MktLevShort :

Short-term liabilities defined as total liabilities less long-term debt divided by market value of assets (liabilities plus market value of equity) as of December 2005

LevBook :

Book leverage defined as total liabilities divided by total assets net of fair value revaluation reserve

LevBookLong :

Long-term debt divided by total assets net of fair value revaluation reserve

LevBookShort :

Ratio of total liabilities minus long-term debt to total assets net of fair value revaluation reserve

Convertible :

Ratio of convertible debt to long-term debt

DebtToOi :

Total liabilities divided by operating income

Coverage :

Operating income divided by interest expense

Current :

Current assets divided by current liabilities

Dividend :

One if company pays dividends and zero otherwise

FairInvPr :

One if a company holds investment property recorded at fair value and zero otherwise

DbtIss1 :

Change in total liabilities that took place from 2005 to 2007 scaled by beginning-of-period market value of assets (liabilities plus market value of equity)

DbtIss2 :

Change in long-term debt that took place from 2005 to 2007 scaled by beginning-of-period market value of assets (liabilities plus market value of equity)

FtrLev1 :

Total liabilities as of 2007 scaled by beginning-of-period market value of assets (liabilities plus market value of equity)

FtrLev2 :

Long-term debt as of 2007 scaled by beginning-of-period market value of assets (liabilities plus market value of equity)

DbtGrow1 :

Logarithmic growth in total liabilities from 2005 to 2007

DbtGrow2 :

Logarithmic growth in long-term debt from 2005 to 2007

Note: Unless otherwise stated, variables are measured as of December 2005 using the Worldscope database.

Appendix 4: Fair value accounting and the book value of assets

Companies that follow historical cost accounting must periodically test their assets for impairment. An asset is considered impaired under the IFRS when its carrying amount is higher than (1) its fair value less costs to sell and (2) the present value of the future cash flows it is expected to generate (IAS36.18). Thus under historical cost accounting, companies in practice value assets close to fair value if the depreciated historical costs exceed the fair value. In contrast, under fair value accounting, companies revalue assets either upward or downward depending on the change in the fair value estimate. This revaluation implies that the book values of assets (equity) are likely to be higher for companies that use fair value accounting. To provide evidence on the differences in balance sheet amounts of fair value versus historical cost companies, we carry out the following analysis.

Table 11 compares the book value of total assets (book value of equity) divided by the market value of total assets (market value of equity) for companies that use fair value with that of companies that use only historical cost. We compute the market value of total assets by the sum of the market value of equity and the book value of liabilities. Panel A of Table 11 presents the evidence for investment property, and Panel B of Table 11 presents the evidence for property, plant, and equipment (PPE). Each company that recognizes PPE at fair value is matched on country, industry, and market capitalization with a company that recognizes all assets at historical cost. For investment property, we include all of the companies that hold investment property because there is no pronounced imbalance between the fair value and historical cost subgroups. We find that, on average, the ratio of book value of total assets to market value of total assets is 16 % higher for companies that recognize investment property at fair value; the ratio of book value of equity to market value of equity is 27 % higher. Among companies that apply fair value to PPE, we find that the ratio of the book value of total assets to the market value of total assets and the ratio of the book value of equity to the market value of equity are, respectively, 31 and 87 % higher than those of matched companies that use only historical cost. The differences in the book values of assets and equity in both the investment property and the PPE samples are all significant at the 1 % level. We also examine how the return on assets (ROA) differs between fair value and historical cost companies. We find a lower ROA in the PPE sample among companies that recognize assets at fair value. In the investment property sample, we also find a lower ROA among companies that use fair value accounting; this difference, however, is statistically insignificant. (It is not surprising that fair value accounting for property decreases ROA because while, on average, fair value accounting increases the book value of assets, upward revaluations do not affect the net income. For investment property this effect is smaller because upward revaluations increase both net income and total assets. See “Appendix 1”.)

Table 11 Fair value accounting and book value of assets

The evidence in Table 11 indicates that the decision to use the fair value method is associated with economically significant differences in companies’ balance sheets, which makes companies that use fair value accounting appear less conservative in terms of their book-to-market ratios. We emphasize that one should not interpret these results as causal because they are conditional on the company’s decision to use fair value.