Does
fair-value accounting really matter when it comes to financial
statement analysis? I guess that most people would answer this
question intuitively in the affirmative. So does also an analytical
study that Rodriguez-Perez, Slof, Sola, Torrent, and Vilardell have
recently published in the ABACUS Journal of Accounting, Finance, and
Business Studies.
The authors
have analyzed data from 85 Spanish insurance companies which, due to
specific Spanish regulation, publish both historical cost based and
fair-value based valuations for different types of assets.
In their
analysis, the authors draw two major sets of conclusions:
Difference
in cost-based vs. fair-value based accounting
The numbers
assigned in the the financial statements to financial assets and
tangible fixed assets change significantly when switching from
historical cost-accounting to fair-value accounting. In addition, the
magnitude of such change varies a lot among
companies and asset types.
This means
that it is impossible for financial analysts to correctly convert
historical cost data into fair-value data without having the required
knowledge of asset- and company-specific information.
Relevance
of such difference
In most
cases, the above described changes do not have a significant
influence on the DEA (Data Envelopment Analysis) scores, meaning that
the overall ranking of most companies with regard to their efficiency
and profitability and as compared to peers in their industry remains
identical.
However, the
ranking does change for a minority of companies which leads the
authors to conclude that financial analysis does change according to
which of the valuation methods is used.
Therefore,
the findings of the above cited study nurture the criticism towards
IFRS which provides for an option between historical cost based and
fair-value based accounting in a sense that only a unique valuation
method could lead to fully comparable
financial analysis of firms in an industry.
But
what exactly does IFRS provide for as regards cost based vs.
fair-value accounting?
The main
regulation of fair-value accounting can be found in the International
Accounting Standard 16 “Property, Plant and Equipment”.
As shown in
the above schema, fair-value accounting can apply when initially
accounting for PP&E as well as when accounting for PP&E
during its lifetime.
In the first
case, accountants can be asked to determine the fair value of PP&E
indirectly through valuing a non-monetary asset that the firm
transfers in exchange for the acquired PP&E.
In the
second case, the firm can choose among the cost model and the
revaluation model.
The cost
model applies the formula:
Cost of PP&E
item
=
Initial Cost
– Accumulated Depreciation – Accumulated Impairment Losses
In case of
the revaluation model, the formula is as follows:
Revalued
Amount of PP&E item
=
Fair Value at
the date of Revaluation
–
Subsequent Accumulated Depreciation – Subsequent Accumulated
Impairment Losses
It should be
noted that revaluations must be done
on a regular basis to ensure that the carrying amount matches the
fair value at the end of the reporting period. In addition, if
a firm practices fair-value accounting it must do so for all PP&E
items of the same asset class.
Now, there
is only one last but crucial question left: What is fair value?
According to
IFRS, fair value is „the amount by which an asset could be
exchanged between knowledgeable, willing parties in an arm's length
transaction“. In practice, this amount is determined through
appraisal. In case no market evidence for such appraisal is
available, the fair value shall be estimated using an income or
depreciated replacement cost approach.
Resources:
- Rodriguez-Perez, Slof, Sola, Torrent, Vilardell – Assessing the Impact of Fair-Value Accounting on Financial Statement Analysis: A Data Envelopment Analysis Approach in ABACUS 2011, p. 61 et seq.
- International Accounting Standard 16 – Property, Plant, and Equipment
