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DOCUMENTS DE TREBALL DE LA FACULTAT D ECONOMIA I EMPRESA Col lecció d Economia E09/215 Fair value versus historic cost Valuation for Biological assets: Implications for the quality of financial information

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DOCUMENTS DE TREBALL DE LA FACULTAT D ECONOMIA I EMPRESA Col lecció d Economia E09/215 Fair value versus historic cost Valuation for Biological assets: Implications for the quality of financial information Josep Mª. Argilés (UB) Josep Garcia Bladón (IQS) Teresa Monllau (UPF) Adreça correspondència: Josep Mª. Argilés. Department of Accounting. Facultat d Econòmiques. Universitat de Barcelona. Av. Diagonal, Barcelona. Spain. Phone: Fax Acknowledgements: The authors would like to thank the firm CABSA for providing the data that made this paper possible, and the Spanish Ministerio de Educación y Ciencia for granting this research (SEJ /ECON). Abstract: This research finds neither significant differences in earnings and revenues for farms using fair value (FV) for biological assets with respect to those valuing at historic cost (HC), nor an increase in their volatility. It does not bring about differences in profitability, accounting manipulation and farm cash flows predictability either. On the contrary, most tests reveal higher predictive power of future earnings under FV. The study also provides evidence on flawed HC accounting practices in the agricultural sector and concludes that FV seems an interesting tool for the predominant small holdings in the agricultural sector in the European Union. JEL: M41 Keywords: Agricultural accounting, fair value, historic cost, biological assets, earnings prediction, cash flow prediction, accounting relevance. Resumen: Este trabajo realiza un estudio empírico sobre los efectos, que se señalan en las discusiones teóricas, de la utilización del valor razonable (VR) frente al coste histórico (CH), utilizando dos muestras de explotaciones agrícolas, una de las cuales valora sus activos biológicos a CH y la otra a VR. No se encontraron diferencias significativas en los beneficios e ingresos entre ambas muestras, ni siquiera en sus volatilidades. Tampoco se encontraron diferencias significativas en rentabilidad, manipulación contable, ni en el poder de ambos criterios de valoración para predecir los flujos de tesorería. Por el contrario, la mayor parte de los tests realizados revelan un mayor poder de los beneficios calculados bajo el VR para la predicción de los beneficios futuros, respecto de cuando son calculados bajo el CH. El estudio proporciona también evidencia empírica de prácticas contables defectuosas de CH en el sector agrícola, concluyendo que el VR puede representar un criterio de valoración interesante para un sector, como el agrícola, caracterizado por el predominio de pequeñas explotaciones familiares. Palabras clave: Contabilidad agrícola, valor razonable, coste histórico, activos biológicos, predicción de beneficios, predicción de flujos de tesorería, relevancia contable. 1. INTRODUCTION The reform of the accounting standards towards fair value accounting has raised an intense debate in recent years. Major accounting groups and institutions worldwide, such as The International Accounting Standards Board (IASB), the U.S.A. Financial Accounting Standards Board (FASB), and the Accounting Regulatory Committee and the European Financial Reporting Advisory Group in the European Union (EU) have encouraged the convergence of international accounting towards standards based on market prices, opposite to traditional accounting measurement based on historic cost. The FASB early issued several standards requiring recognition or disclosure of fair values estimates for assets and liabilities, mainly for financial instruments. For example, Statements of Financial Accounting Standards number 87 in 1985 on employer s accounting for pensions, number 105 in 1990 on disclosure of information about financial instruments, number 107 in 1991 on disclosures about financial instruments, etc. The International Accounting Standards Committee issued International Accounting Standard (IAS) requiring measurement at FV and value changes to be recognised in profit or loss. The most important were the IAS 32 on disclosure and presentation of financial instruments, issued in 1995 and revised in 1998 by IAS 39, and the IAS 41 on Agriculture, issued in The EU adopted the whole existing IAS by the Commission Regulation (EC)1725/2003, with the exception of IAS 32 and 39, that were adopted in 2004 by Commission Regulations (EC)2086/2004 and (EC)2237/2004. Fair value is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction (e.g. IAS 39, IAS 41, SFAS 107). In 2006 the SFAS 157 redefined FV as the price that would be received to sell the asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date 1. In spite of this persistent trend towards FV, the reform has raised controversial stances, usually debating around financial instruments, in the practitioner ground (e.g., Day, 2000; Economist, 2007). Together with enthusiastic supporters for fair valuation (e.g. Chartered Financial Analyst Institute, 2007), there are also sceptics (e.g. Joint Working Group of Banking Associations on Financial Instruments, 1999). A rapport of the 1 The IASB started a project on fair value measurement and issued a discussion paper (IASB, 2006a) aiming at a providing a single source of guidance on fair valuation, adopting the same definition as in SFAS 157, but stating that it will neither introduce nor require any new fair value measurements (IASB, 2008). 3 European Central Bank (2004) summarizes the potential drawbacks and advantages of a FV accounting framework from the point of view of financial institutions. There is also an unsolved debate in the academic ground. Academic debate is usually concerned with financial instruments and framed within the agency theory, assuming information asymmetry between market participants and the existence of perfect versus imperfect market conditions. Barth and Landsman (1995) conclude that in perfect and complete markets an FV accounting-based balance sheet reflects all value-relevant information. However, in more realistic market settings management discretion applied to fair valuation can detract from balance sheet and income statement relevance. Watts (2003) argues that fair valuation is subject to more manipulation and, accordingly, is a poorer measure of worth and performance than HC. He argues that any attempt to ban accounting conservatism is sure to fail and that accounting can not compete with the market in valuing the firm (Watts, 2006). Ball (2006) complains that fair valuation does not necessarily make investors better off, and that its usefulness has not been demonstrated. Rayman (2007) concludes that FV accounting is liable to produce absurdities and misleading information, if it is based on expectations that turn out to be false. Ronen (2008) complains that FV suffers from a lack of reliability and can be subject to manipulation. In the same vein, Liang and Wen (2007) are critical with the beneficial effects of moving to FV because it inherits more managerial manipulation and induce less efficient investment decisions than cost valuations. Plantin and Sapra (2008) conclude that, when there are imperfections in the market, there is the danger of the emergence of an additional source of volatility as a consequence of fair valuation, and thus a rapid shift to full mark-to-market regime may be detrimental to financial intermediation and therefore to economic growth. On the contrary, Bleck and Liu (2007) find that HC accounting makes it easier to hinder bad investment projects, preventing their liquidation therefore accumulating volatility to hit the market at a later date and producing crash prices, increasing overall volatility and reducing efficiency (i.e. reducing profitability). Gigler et al. (2006) conclude that even in the case of mixed attribute report (i.e., some items are valued at market while others are carried at HC), FV performs better: it provides stronger signals of financial distress. Finally, Choy (2006) shows that for FV to be relevant, necessary and sufficient conditions must be fulfilled. Almost all existing empirical studies on FV test its relevance when applied to financial instruments, analyzing associations between accounting numbers and share prices. They 4 provide conflicting findings; while Nelson (1996) does not find FV relevance, Barth (1994), Barth et al. (1996) and Bernard et al. (1995) do. Ahmed and Takeda (1995), Carrol et al. (2003), Eccher et al. (1996) and Barth and Clinch (1998) do find relevance, but under certain conditions. A recent study of Hann et al. (2007) finds FV pension accounting not improving the informativeness of the financial statements and even impairing it. Laswad and Baskerville (2007) do not find association between cash flow and unrealized earnings from revaluation of assets to FV, under pension schemes required in New Zealand. Ahmed et al (2006) find that recognition of derivative financial instruments at FV is relevant, while disclosure is not. Danbolt and Rees (2008) find that FV is consistently more value relevant than HC, although this value relevance can be conveyed via asset values and need not be incorporated into income computations. They also find evidence consistent with earnings manipulation under FV. Choy (2006) complains that the predictive power of FV has never been tested, in spite of the fact that both the Statement of Financial Accounting Concepts (SFAC) 2 and the current project of the IASB (2006b) emphasize the need of predictive value of financial information. More predictable earnings and cash flows may help managers to anticipate financial problems, adjust inventories, negotiate funding, adjust resources, exercise judgement in financial reporting, increase or reduce production, etc. Improved accuracy may also lessen agency problems, because managers are considered to be more accountable. Empirical research has found that firms with lower forecast errors have lower implied costs of capital (Gebhardt et al., 2001) 2 and valuations in the stock market (Lang et al., 2003). To our knowledge, only Chen et al. (2006) test the predictive power of FV, finding that it reduces the ability to predict future cash flows. However, they study this relation indirectly, comparing the association between accounting numbers and future cash flows over time, assuming that accounting has been evolving to fair value. Kim and Kross (2005) find an increasing relationship between earning and one-year-ahead operating cash flows over time, but they attribute it to the increasing conservatism in accounting rather than to the influence of fair valuation. Slightly related to these issues, Beaver et al. (2005) find a small decline in the ability of financial ratios to predict bankruptcy from 1962 to 2002, and an incremental explanatory power of market-related variables over this period. They explain the 2 However, their results are not conclusive to the extent that multivariate results, partially contradicting this finding, are not satisfactorily explained. 5 deterioration of predictive ability of financial ratios in terms of an insufficient improvement of FASB standards. The IAS 41 brings the debate into the agricultural accounting domain. Most authors are critical with the requirement of fair valuation for biological assets and value changes to be recognised in profit and loss statement. Penttinen et al. (2004) claim that fair valuation would cause unrealistic fluctuations in net profit of forest enterprises. Herbohn and Herbohn (2006) and Dowling and Godfrey (2001) stress on the increased volatility, manipulation and subjectivity of reported earnings under this standard. Both studies are performed in the context of the Australian of Accounting Standards Board 1037 (similar to IAS 41) and provide empirical evidence of Australian entities preference for cost valuation or delaying the adoption of FV. Specifically, Herbohn and Herbohn (2006) calculate coefficients of variation of profits, and of gains and losses from timber assets, of eight public companies and five state and territory government departments. The authors argue that figures provide an insight into the volatility caused by the fair value measurement 3. Elad (2004) complains that the IAS 41 is a major departure from historic cost accounting; this could signal the demise of the French Plan Comptable Général Agricole (PGCA) model, entail the recognition of unrealized gains and increase profit volatility. However, Argilés and Slof (2001) welcome fair value measurement for biological assets because it avoids the complexity of calculating their costs, given the predominance of small family farms in Western countries, and specifically in the European Union (EU), with no resources and skills to perform accounting procedures and valuations. The nature of farming makes historical-based valuation of biological assets inherently difficult because they are affected by procreation, growth, death, as well as joint-cost situations. Allocation of indirect costs is another source of complexity for cost calculation in farms. This is an especially acute problem for small family households. The American Institute of Certified Public Accountants (1996) and the Canadian Institute of Chartered Accountants (1986) recommend historic cost, considering also the possibility of realizable value as an alternative. The 1986 French PGCA adheres also to the historic cost principle. However, Kroll (1987) regrets that the complexity in asset valuation and accounts is an important barrier to its use in the French PGCA. Elad (2004) points out that where there 3 Barth et al. (1995) find that fair value based earnings and capital are more volatile than historical cost earnings and capital with a sample of banks. However, they do not find this incremental volatility to be associated with bank share prices. 6 is not an active market for a biological asset, simplicity is not a merit of fair value. Argilés and Slof (2001) state that IAS 41 conceptual framework has already been widely and successfully implemented in the EU through the Farm Accountancy Data Network (FADN). The latter has been fulfilling the role of a quasi-standard-setting body in the absence of previous pronouncements on agricultural standards from other authorities (Poppe and Beers, 1996). Therefore, an assessment of the convenience of FV for agriculture should balance its advantages and drawbacks. Simplicity is the main advantage of using FV for biological assets with respect to HC. But there is no unanimous pronouncement in previous literature with respect to whether volatility in income and profits, relevance, income smoothing and profitability are improved or worsened with FV. The present study contributes to this debate providing empirical evidence in valuation of biological assets in agriculture. No previous study has empirically contrasted the predictive power of FV versus HC valuation with respect to income and cash flow comparing two samples of firms each one using one valuation criteria. Comparing data from two samples of farms, one using HC and the other FV for biological assets, we find no significant differences in profitability, income smoothing, volatility in income and revenues, as well as in future cash flow predictive power. Most tests performed reflect lower earnings predictive power for farms using HC with respect to those using FV. In-depth interviews maintained with agricultural accountants help to explain these results, as generalized flawed accounting practices are found. Given the real setting in which agricultural accounting is produced, accurate and reliable cost calculations can not be expected. The remainder of the paper is organized as follows. Section 2 explains the research design used in this study. Results are provided in the third section and discussed in the fourth. Finally, section five presents the conclusions. 2. RESEARCH DESIGN 2.1. EMPIRICAL DESIGN The first purpose of the study is to empirically test the effects of the valuation method used for biological assets in revenues, earnings, volatility and accounting manipulation. 7 We perform mean comparison tests between samples of farms that use fair value and historic cost for biological assets valuation. The tests have been performed for revenues, earnings and assets. We test the contradictory existing hypotheses of increase-decrease in volatility with fair valuation through comparisons for standard deviation of revenues, earnings, assets and return on assets. In order to control for relative variations we also compare coefficients of variations. In order to test whether it is fair valuation or historic cost that entails less efficient investment decisions, we compare return on assets between both samples of farms. In order to test the hypothesis that fair value increases accounting manipulation, we use the income smoothing index (ISI) suggested by Eckel (1981) and employed by Iñiguez and Poveda (2004) to test the market valuation of income smoothing: ISI i CV = CV E i CFO i (1) where CV E is the coefficient of variation of the first difference in annual net earnings i (E) of farm i, while CV CFO is the coefficient of variation of the first difference in i annual cash flow from operations (CFO) of farm i, thus comparing variation in accounting income with income that is free from accounting discretion. We use a well established calculation method for CFO (e.g. Kim and Kross, 2005; Dechow, 1994; Dechow et al., 1998; Chen et al., 2006) 4. Only farms with at least three observations are considered for calculating standard deviations and coefficient of variations, and at least four consecutive observations for calculating first differences of earnings and cash flows. Tests on the influence of the valuation method on earnings volatility are reinforced with regression models. We consider earnings volatility as a dependent variable of the valuation method employed, controlling for the volatility of farm CFO, that is supposed to be reliable data and independent on accruals and accounting manipulation. On the other hand, we consider earnings volatility depending on the valuation method, but 4 According to these authors, and to the available data in the financial statements of the Spanish SABI data base, we perform the most feasible calculation for cash flow from operations: CFO = operating income + depreciation change in inventory change in debtors change in prepayments and accrued income + change in current liabilities (excluding bank loans) + change in provisions. 8 controlling for volatility of farm revenues. We thus define the following regression models: STD Ei = β 0 + β1 STDCFO + β FV i 2 i + ε i (2) Eij = β 0 + β1 CFOij + β 2 FVi + ε ij (3) STD E i = β 0 + β1 STDREVENUE + β 2 FVi + ε ij (4) i Eij = β 0 + β1 REVENUEij + β 2 FVi + ε ij (5) where STD E is the standard deviation of E of farm i, i STD CFO is the standard deviation i of CFO generated by farm i, FV is a dummy variable, whose value is 1 when the farm applies FV to biological assets and 0 otherwise; Eij is the first difference (annual variation) of E of farm i in year j with respect to the previous year; CFOij is the first difference (annual variation) of CFO generated by farm i in year j with respect to the previous year; STD REVENUE is the standard deviation of annual revenue of farm i, and i REVENUE ij is the first difference (annual variation) of revenue of farm i in year j with respect to the previous year. We perform ordinary least squares (OLS) regressions for equation (2) to (5). The second purpose of the paper is to compare the predictive power of income under HC and FV for biological assets. It is tested through differences in errors provided by the following parsimonious prediction models: E ij = β 0 + β1 E ij 1 + εij (6) CFO ij = β 0 + β1 E ij 1 + ε ij (7) CFO ij = β 0 + β1 E
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