Friday, March 2, 2012

The Impact of Fair-Value Accounting on Financial Statement Analysis


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