Does Fair Value Accounting for Non-Financial Assets

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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: The choice between fair value and historical cost accounting is the subject of longstanding controversy among accounting academics and regulators. Nevertheless, the market based evidence on this subject is very 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 low 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.

Keywords: Fair value, IFRS, non-financial assets, illiquid assets. JEL Classification: M4, M41

This version: 4 November 2012


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 two anonymous referees, Ray Ball, Philip Berger, Jannis Bischof, Alexander Bleck, Christof Beuselinck, Johan van Helleman, S.P. Kothari, Laurence van Lent, Christian Leuz, Paul Madsen, Karl Muller, Edward Riedl, Douglas Skinner, Richard Sloan, Abbie Smith, Stephen A. Zeff, Ross Watts, Li Zhang, 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.

1. Introduction
The choice between fair value and historical cost accounting is one of the most widely debated issues in the accounting literature. While the debate dates back to the 1930s (Paton 1932, pp. 739-747, Fabricant 1936), it is still unsettled (e.g., Schipper 2005, Ball and Shivakumar 2006, Watts 2006, Hail, Leuz and Wysocki 2010, Laux and Leuz 2009). One impediment to moving the debate forward is the lack of evidence on the choice between the two accounting practices, when the choice is determined by market forces rather than regulators (Kothari et al. 2010). We exploit a quasi-experiment embedded in the recent mandatory adoption of the International Financial Reporting Standards (IFRS) to study the “market solution” for the choice between historical cost and fair value accounting methods. Our approach follows Leftwich (1983), who documents that private markets often differ from regulators in their accounting method choice.

Our setting has a number of advantages. First, unlike most other accounting standards, IFRS provides a free choice between fair value and historical cost accounting for non-financial assets. The second and more important advantage of the current setting is that IFRS requires ex ante commitment to one of the two accounting policies.1 It is, ex ante, in management’s interest to limit the scope for future opportunistic actions, e.g., earnings management (Jensen and Meckling 1976, Watts 1977, Watts and Zimmerman 1986, Ball 1989). Therefore, firms’

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A number of prior studies have examined settings where firms...
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