Value-Relevance of Industrial Companies' Fair Value Disclosures Under IAS39

8/14/2019 Value-Relevance of Industrial Companies' Fair Value Disclosures Under IAS39

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University of Jordan

Faculty of Business

Accounting Department

Value-relevance of industrial companies' fair value

disclosures under IAS39

By Fathi Salem Mohammed Abdullah

2009



Abstract

In financial reporting, U.S, and international accounting standard setters have issued

several disclosure and measurement and recognition standards for financial

instruments and all indications are that both standard setters will mandate recognitionof all financial instruments at fair value. The purpose of this paper is therefore to set

out why we consider that the current IASB approach to accounting for financial

instruments based on their interpretation of ‘fair value’ is, conceptually,

fundamentally flawed, and therefore unworkable in practice.

The result of this study indicate there is an insignificant relationship between the total

unrealized gains and losses and the level of security prices, therefore the results

indicate that the IAS 39 Financial Instruments: Disclosure and Presentation, and its

unrealized gain and losses are unvalued-relevant in explaining the market value of

common equity for the sample industrial companies.

Keywords: Fair value, Financial instruments, Industrial, Financial Performance

Measurement

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1. Introduction

Accounting standards setters in many jurisdictions around the world, including the

United States, the United Kingdom, Australia, and the European Union, have issued

standards requiring recognition of balance sheet amounts at fair value, and changes intheir fair values in income. For example, in the United States, the Financial

Accounting Standards Board requires recognition of some investment securities and

derivatives at fair value, Greg N, G and Mohamed, G (2006). In addition, as their

accounting rules have evolved, many other balance sheet amounts have been made

subject to partial application of fair value rules that depend on various ad hoc

circumstances, including impairment (e.g., goodwill and loans) and whether a

derivative is used to hedge changes in fair value (e.g., inventories, loans, and fixed

lease payments), Greg N, G and Mohamed, G (2006). The Financial Accounting

Standards Board and the International Accounting Standards Board (hereafter FASB

and IASB) are jointly working on projects examining the feasibility of mandating

recognition of essentially all financial assets and liabilities at fair value in the

financial statements.

The Jordanian financial sector has changed dramatically over the last few years,

introducing more rivalry for and from banks, achieving high rates of growth andexpansionism. Whereas, the number of industrial companies operating in Jordan

reached by the end of year 2008 (87) companies. Of which 86 of them are traded in

Amman Exchange stock.

The purpose of this paper is therefore to set out why we consider that the current

IASB approach to accounting for financial instruments based on their interpretation of

‘fair value’ is, conceptually, fundamentally flawed, and therefore unworkable in

practice.

The main objective of this paper is to find the relation between fair value-book value

differences (unrealized gains and losses) for financial instruments and security prices.

And the main question is, is there a link between unrealized gain and losses and the

equity values? This study is organized as follow, explains the background of fair

value accounting in standard setting, and this contains definition of fair value,

applications to standard setting, and are fair values useful to investors. After that, we

state about the methodology of this paper, results, conclusion, and references,

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2. Background of Fair Value Accounting in Standard Setting

In its Framework (April 2005, F.24), the International Accounting Standards

Board (IASB) fully recognizes and acknowledges that:

‘Financial statements cannot provide all the information that users may need to make economic decisions. For one thing, financial statements show the

financial effects of past events and transactions, whereas the decisions that

most users of financial statements have to make relate to the future.’

(Emphasis added)

Also, the following explanation of relevance is given in the Framework (F.26–28):

‘Information in financial statements is relevant when it influences the

economic decisions of users. It can do that both by (a) helping them evaluate

past, present, or future events relating to an enterprise and by (b) confirming

or correcting past evaluations they have made.’ (Emphasis added)

The focus on decision-making instead of accountability leads to a concern for

predictive value, as opposed to feedback value, in financial statements. Given that fair

value is deemed by many researchers to be the most relevant measure for financial

reporting, the desire to enhance users’ ability to predict firms’ future cash flows leads

the IASB to conclude that the changes in market values should be reflected in

financial statements.

2.1 Definition of fair value

IASB defines fair value as the amount for which an asset could be exchanged, or a

liability settled, between knowledgeable, willing parties in an arm’s-length

transaction.

The FASB defines “fair value” as the price that would be received to sell an asset or

paid to transfer a liability in an orderly transaction between market participants at the

measurement date” (FASB, 2006a).As the FASB notes, “the objective of a fair value

measurement is to determine the price that would be received to sell the asset or paid

to transfer the liability at the measurement date (an exit price).” Implicit in this

objective is the notion that fair value is well defined so that an asset or liability’s

exchange price fully captures its value. However, in practice, fair value may not be

well defined. This occurs when no active market exists for the asset or liability. In this

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situation, it becomes difficult to disentangle an asset or liability’s fair value from its

value-in-use to the entity.

2.2 Applications to standard setting

The IASB are often accepted or required as generally accepted accounting principles

(GAAP) in many countries. For example, the European Union generally requires

member country firms to issue financial statements prepared in accordance with IASB

GAAP beginning in 2005. IASB GAAP comprises standards issued by its predecessor

body, the International Accounting Standards Committee (IASC), as well as those it

has issued since its inception in 2001.

The IASC issued two key fair value standards, both of which have been

adopted by the IASB, IAS 32: Financial Instruments: Disclosure and

Presentation (IASB, 2003a), IAS 39, Financial Instruments: Recognition and

Measurement (IASB, 2003b). The former standard is primarily a disclosure

standard, and is similar to its US GAAP counterparts, SFAS no's 107 and 119. IAS 39

describes how particular financial assets and liabilities are measured (i.e. amortized

cost or fair value), and how changes in their values are recognized in the financial

statements. The scope of IAS 39 roughly encompasses accounting for investment

securities and derivatives, which are covered under SFAS no's 115 and 133, although

there are some minor differences between IAS and US GAAP.

The IASB has also issued a key fair value standard, International Financial

Reporting Standard 2, Accounting for Share-based Payment (IASB, 2004).

IFRS 2 is very similar to SFAS no 123 (revised) (FASB, 2004) in requiring firms to

recognize the cost of employee stock option grants using grant date fair value. In IAS

39, a mixture of both treatments of unrealized gains can be found. In general, allfinancial instruments are initially recognized at FV as on the date of acquisition or

issuance, corrected for transaction costs (IAS 39.43). For the measurement in

subsequent periods, all financial instruments have to be classified. Financial assets

have to be classified either as (a) held-to-maturity, (b) loans and receivables, (c)

financial assets at fair value through profit or loss, or as (d) assets available for sale

(IAS 39.45). After initial recognition, assets in the first two categories are

subsequently measured at amortized costs, while all other assets are measured at FV.

Financial liabilities are generally measured at amortized cost (using the effective

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interest method). Nevertheless, some liabilities (e.g. derivatives) have to be measured

at FV (IAS 39.47). If available, the best FV estimate here is a quoted market price in

an active market (IAS 39, AG71). If such market prices do not exist, other valuation

techniques have to be applied (‘marking to model’) (IAS 39, AG74). Revaluations

occur on every balance sheet date. The treatment of unrealized gains depends on

whether an asset is classified as available for sale (AVS), or as ‘at fair value through

profit or loss’. Increases in value of the latter category are recognized as profit (IAS

39.55a), while increases in the value of AVS assets are directly recorded in equity

(IAS 39.55b). Revaluations of liabilities measured at FV also affect net income (IAS

39.47a).

Apparently, the most distinctive feature of FVA in different IAS standards is

the treatment of unrealized holding gains. Crediting revaluation surpluses directly into

equity corresponds to the concept of physical capital maintenance.

FV through profit and loss is, in fact, closer to maintaining economic capital.

However, the extensive (and probably increasing) use of FV under IFRS might merely

be attributed to the fact that the IASB (now) follows a balance-sheet oriented (often

labeled as ‘static’) approach to financial accounting, Greg N, G and Mohamed, G

(2006).

Are fair values useful to investors? Evidence from research

When assessing the quality of fair value information, a natural question to ask is

whether fair value information is useful to investors. The concerning is with policy

questions relating to the relevance and reliability of disclosed amounts. Regarding

relevance, the IASB was interested in whether IAS39 disclosures would be

incrementally useful to financial statement users relative to items already in financialstatements, including recognized book values and disclosed amounts.

As Barth, et al (2001) note, policy-based accounting research cannot directly

address these questions, but can provide evidence that helps standard setters assess

relevance and reliability questions. A common way to assess the so-called value

relevance of a recognized or disclosed accounting amount is to assess its incremental

association with share prices or share returns after controlling for other accounting or

market information. Several studies address the value relevance of banks’ disclosed

investment securities fair values before mandating recognition of investment

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securities’ fair values and effects of their changes on the balance sheet and the income

statement.

For a sample of US banks with data from 1971–90, Barth (1994) finds that

investment securities’ fair values are incrementally associated with bank share prices

after controlling for investment securities’ book values. When examined in an annual

returns context, the study finds mixed results for whether unrecognized securities’

gains and losses provide incremental explanatory power relative to other components

of income.

One leading candidate for the ambiguous finding is that securities’ gains and

losses estimates contain too much measurement error relative to the true underlying

changes in their market values. Using essentially the same data base, Barth, et al

(1995) confirm the Barth’s (1994) findings and lend support to the measurement error

explanation by showing that fair value-based measures of net income are more

volatile than historical cost-based measures, but that the incremental volatility is not

reflected in bank share prices.

Of particular interest to bank regulators, Barth, et al (1995) also find that

banks violate regulatory capital requirements more frequently under fair value than

historical cost accounting, and that fair value regulatory capital violations help predict

future historical cost regulatory capital violations, but share prices fail to reflect this

increased regulatory risk. Barth, et al (1996), Eccher, et al (1996) and Nelson (1996)

use similar approaches to assess the incremental value relevance of fair values of

principal categories of banks assets and liabilities disclosed under us standards in

1992 and 1993, i.e., investment securities, loans, deposits, and long-term debt.

Supporting the findings of Barth (1994), all three studies find investment

securities fair values are incrementally informative relative to their book values in

explaining bank share prices. However, using a more powerful research design thatcontrols for the effects of potential omitted variables, Barth, Beaver and Landsman

(1996) also find evidence that loans’ fair values are also incrementally informative

relative to their book values in explaining bank share prices.

Barth, et al (1996) also provides additional evidence that loans’ fair values reflect

information regarding loans’ default and interest rate risk. Moreover, the study’s

findings suggest that investors appear to discount loans’ fair value estimates made by

less financially healthy banks (i.e. those banks with below sample median regulatory

capital), which is consistent with investors being able to see through attempts by

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managers of less healthy banks to make their banks appear more healthy by exercising

discretion when estimating loans fair values.

Finally, Venkatachalam (1996) examines the value relevance of banks’

derivatives disclosures for a sample of banks in 1993 and 1994. Findings from the

study suggest that derivatives’ fair value estimates explain cross-sectional variation in

bank share prices incremental to fair values of the primary on-balance accounts (ie

cash, investments, loans, deposits, and debt).

Because IASs/ IFRSs, Australian and UK GAAP permit upward asset revaluations

but, as with US GAAP, require downward revaluations in the case of asset

impairments, several studies examine the dimensions of value relevance of

revaluations in Australia / UK and US.

Most studies, including Easton, Eddey, and Harris (1993), Barth and Clinch

(1996), Barth and Clinch (1998), and Peasnell and Lin (2000), focus on tangible fixed

asset revaluations. However, Aboody, Barth and Kasznik (1999) examine the

association between asset revaluations for financial, tangible, and intangible assets for

a sample of Australian firms in 1991–95. Focusing on the financial assets, Aboody,

Barth and Kasznik (1999) find that revalued investments for financial firms as well as

non-financial firms are consistently significantly associated with share prices.

One interesting study of Danish banks, Bernard, Merton and Palepu (1995),

focuses on the impact of mark-to-market accounting on regulatory capital as opposed

to the value relevance of fair values for investors. Denmark is an interesting research

setting because Danish bank regulators have used mark-to-market accounting to

measure regulatory capital for a long period of time.

Bernard, Merton and Palepu (1995) find that although there is evidence of

earnings management, there is no reliable evidence that mark-tomarket numbers are

managed to avoid regulatory capital constraints. Moreover, Danish banks’ mark-to-market net equity book values are more reliable estimates of their equity market

values when compared to those of US banks, thereby providing indirect evidence that

fair value accounting could be beneficial to US investors and depositors.

Several studies examine the value, relevance of stock options fair values

disclosures, including Bell, Landsman, Miller, and Yeh (2002), Aboody, Barth and

Kasznik (2004), and Landsman, Peasnell, Pope and Yeh (2005). Findings in Bell,

Landsman, Miller and Yeh (2002) differ somewhat from those in Aboody, Barth and

Kasznik (2004), although both studies provide evidence that employee option expense

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is value relevant to investors. Landsman, Peasnell, Pope and Yeh (2005) provide

theoretical and empirical support for measuring the fair value of employee stock

option grants beyond grant date, with changes in fair value recognised in income

along with amortisation of grant date fair value. Because quoted prices for employee

stock options typically are not available because of non-tradability provisions, the fair

value estimates are based on models that rely on inputs selected by reporting firms.

Aboody, Barth and Kasznik (2005) find evidence that firms select model

inputs so as to manage the pro forma income number disclosed in the employee stock

option footnote.This finding is potentially relevant to accounting standard setters as

well as bank regulators in that it is additional evidence that managers facing

incentives to manage earnings are likely to do so when fair values must be estimated

using entity-supplied estimates of values or model inputs if quoted prices for assets or

liabilities are not readily available. If managers have the incentive to use discretion

when estimating fair values of on and off-balance sheet asset and liability amounts

when such values are not recognized in the financial statements, it is reasonable to

assume the incentive will only increase if fair value accounting is used for recognition

of amounts on the balance sheet and in the income statement.

3. THE METHODOLOGY OF STUDY

3.1 Data sources

The data used in this study comprise representative sample of a group of industrial

companies operating in Jordan which consist of sixteen company listed in Amman

stock exchange, the data represent their operations in Jordan over the period of 2003-

2008. Data sources include financial statements: particularly, the balance sheet, and

income statement. we examined 27 industrial companies and we had been excluded

11 companies as follow; TBCO, NATA, JMAG, JOSE, and JOPI had been excluded

from this study because the researcher does not found all or some annual reports for

these companies for the period from 2003 to 2008. Companies JOST, INTI, and

SLCA do not have stock prices for some periods, so for this reason it's had been

excluded. Some companies do no invest in long or short investment and these

companies are TRAV, WOOD, IENG, and AJFM.

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3.2 Methodology

This study aims to provide evidence about the implementing of accounting fair value

of the financial instruments on the security prices, by finding out the relationship

between fair value-book and value differences (unrealized gains and losses) for financial instruments and security prices.

To fulfill the study objectives the regression between the total unrealized gains

and losses captured from income statement and balance sheet and the average of

closing prices for the security for the first three months of each year in order to

analyze to what extent the price of the stock is affected by valuing financial

instruments at fair value.

4. RESULTS

As shown in table 1, the use of fair value accounting to measure the financial

instruments has an insignificant effect on the industrial companies' stock prices.

The result of testing the model shows an insignificant relationship between the total

unrealized gains and losses and the level of security prices. So it can be concluded

that the price of the stock is not affected by valuing financial instruments at fair value

as shown in table 2.

Table-1-: Jordanian industrial companies' unrealized gains or losses of valuing

industrial companies' financial instruments at fair value during the period of 2003-

2008

Company Name

Year Total Gain/Losses Average Close Price

-Equity Value-

AL-EQBALINVESTMENT

COMPANY LTD

2003 1,998,222.00 3.71

2004 2,858,000.00 5.12

2005 7,491,931.00 4.01

2006 3,208,160.00 2.64

2007 1,482,785.00 2.88

2008 -86,922.00 2.4

UNION TOBACCO &CIGARETTEINDUSTRIES

2003 2,778,847.00 8.65

2004 7,824,433.00 7.42

2005 32,829,221.00 7.91

2006 10,029,858.00 5.87

2007 4,912,247.00 3.67

2008 -2,297,925.00 1.94

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INTERNATIONALSILICA INDUSTRIAL

2003 0 0.94

2004 -755 1.43

2005 -10,319.00 1.22

2006 -91,451.00 1.28

2007 -41,080.00 3.06

2008 -65,929.00 4.89

READY MIXCONCRTE AND

CONSTRUCTIONSUPPLIES

2003 0 1.42

2004 0 3.02

2005 1,047,728.00 3.49

2006 278,441.00 4.58

2007 340,711.00 4.76

2008 -2,739,664.00 2.52

ARABIAN STEELPIPES

MANUFACTURING

2003 398,543.00 2.4

2004 735,355.00 4.63

2005 1,136,595.00 3.04

2006 166,066.00 1.82

2007 320,123.00 2.05

2008 826,194.00 2.26

GENERALINVESTMENT

2003 248,772.00 2.87

2004 248,389.00 4.27

2005 9,581,218.00 5.98

2006 5,482,447.00 6.06

2007 8,476,990.00 6.06

THE ARABINTERNATIONAL

FOOD FACTORIES

2003 6,249,120.00 2.05

2004 6,110,646.00 1.8

2005 19,469,906.00 2.44

2006 11,845,170.00 2.22

2007 21,015,338.00 6.11

2008 20,242,478.00 5.03

JORDAN TANNING 2003 27,492.00 3.57

2004 51,919.00 6.37

2005 61,710.00 2.37

2006 -2,032.00 2.03

2007 20,598.00 1.83

2008 -12,970.00 4.86

THE JORDANWORSTED

MILLS

2003 10,878,241.00 7.52

2004 30,161,678.00 14.64

2005 59,715,034.00 12.93

2006 35,390,780.00 8.03

2007 49,567,312.00 7.96

2008 27,034,359.00 5.08

Table-2 Data analysis output

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Model R Square t-test Sig. F

Total G/L .015 1.184 .239 1.402

As shown in table 3, there is a positive relationship between shares prices and

unrealized gain or losses for years 2003 and 2004, 2005 and 2006, 2006 and 2007,

and 2007 and 2008. The equity price of industrial companies in 2004 was 91.72 and it

decreased to 89.96 in 2005, but total unrealized gain or losses for industrial

companies increased from 48,443,686 in 2004 to 132,619,914 in 2005. So I can

conclude that there is no relationship between shares prices and unrealized gain or

losses.

\Table-3 Total Equity prices and total gains and losses for all companies

YEAR

TOTAL EQUITY

PRICE TOTAL G/L for ALL Companies

2003 58.31 23,190,006.00

2004 91.72 48,443,686.00

2005 89.96 132,619,914.00

2006 80.20 66,118,067.00

2007 128.37 86,822,277.00

2008 100.19 43,229,674.00

5. Conclusions

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This paper reviews the extant capital market literature that examines the usefulness of

fair value accounting information to investors. In doing so, we highlight findings that

are of interest not just to academic researchers, but also to practitioners and standard

setters as they assess how current fair value standards require modification, and issues

future standards need to address. Taken together, the research findings suggest that

disclosed and recognized fair values are uninformative, (unimportant, useless) to

investors, and the level of informativeness is affected the amount of measurement

error and source of the estimates—management or external appraisers.

Comparability of financial position and financial performance may be

impaired by the mixed measurement model and the mix of criteria prescribed and

permitted by IAS 39 for determining how financial assets should be categorized and

measured. The nature of financial instruments and the availability of active markets

and techniques for estimation of fair value provide the strongest case for giving fair

value a ‘fair go’. However, the absence of international agreement and conceptual

guidance on a consistent measurement model and concept of capital maintenance

continue to impede the application of a fair value model.

6. References

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Documents

Value-Relevance of Industrial Companies' Fair Value Disclosures Under IAS39