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

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 recognition of 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 in their 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 and expansionism. 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, all financial 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 financial statements, 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 that controls 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-tomarket 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 20032008. 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 20032008 Year

Total Gain/Losses

Average Close Price -Equity Value-

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

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

Company Name AL-EQBAL INVESTMENT COMPANY LTD

UNION TOBACCO & CIGARETTE INDUSTRIES

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THE PUBLIC MINING

ARAB ALUMINIUM INDUSTRY /ARAL

NATIONAL STEEL INDUSTRY

JORDAN PHOSPHATE MINES

THE JORDAN CEMENT FACTORIES

THE ARAB POTASH

JORDAN ROCK WOOL INDUSTRIES

2003

298,653.00

6

2004

362,863.00

6.25

2005

303,097.00

9.13

2006

-144,269.00

9.83

2007

-76,100.00

8.04

2008

196,542.00

6.54

2003

157,761.00

2.18

2004

0

1.78

2005

412,990.00

2.25

2006

236,207.00

2.27

2007

264,094.00

1.63

2008

0

1.65

2003

136,475.00

1.76

2004

48,222.00

2.28

2005

-7,460.00

1.4

2006

-365,433.00

1.23

2007

26,543.00

1.41

2008

-119,019.00

0.82

2003 2004

0 0

2.31 4.42

2005

597,169.00

4.17

2006

57,509.00

3.7

2007

127,313.00

20.24

2008

10,058.00

17.97

2003

0

6.73

2004

0

13.2

2005

0

13.62

2006

42,026.00

13.2

2007

20,438.00

11.05

2008

12,339.00

6.64

2003

109,000.00

4.33

2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008

173,000.00 260,000.00 147,000.00 361,000.00 284,000.00 -91,120.00 -130,064.00 -268,906.00 -162,412.00 3,965.00 -53,867.00

13.11 12.95 13.72 46.74 36.6 1.86 1.99 3.05 1.72 0.87 1.01

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INTERNATIONAL SILICA INDUSTRIAL

READY MIX CONCRTE AND CONSTRUCTION SUPPLIES

ARABIAN STEEL PIPES MANUFACTURING

GENERAL INVESTMENT

THE ARAB INTERNATIONAL FOOD FACTORIES

JORDAN TANNING

THE JORDAN WORSTED MILLS

2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008

0 -755 -10,319.00 -91,451.00 -41,080.00 -65,929.00 0 0 1,047,728.00 278,441.00 340,711.00 -2,739,664.00 398,543.00 735,355.00 1,136,595.00 166,066.00 320,123.00 826,194.00 248,772.00 248,389.00 9,581,218.00 5,482,447.00 8,476,990.00 6,249,120.00 6,110,646.00 19,469,906.00 11,845,170.00 21,015,338.00 20,242,478.00 27,492.00 51,919.00 61,710.00 -2,032.00 20,598.00 -12,970.00 10,878,241.00 30,161,678.00 59,715,034.00 35,390,780.00 49,567,312.00 27,034,359.00

Table-2 Data analysis output 12

0.94 1.43 1.22 1.28 3.06 4.89 1.42 3.02 3.49 4.58 4.76 2.52 2.4 4.63 3.04 1.82 2.05 2.26 2.87 4.27 5.98 6.06 6.06 2.05 1.8 2.44 2.22 6.11 5.03 3.57 6.37 2.37 2.03 1.83 4.86 7.52 14.64 12.93 8.03 7.96 5.08

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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Aboody, D, M E Barth and R Kasznik (1999): “Revaluations of fixed assets and future firm performance”, Journal of Accounting and Economics 26, pp 149–78.

Barth, M (1994): “Fair value accounting: evidence from investment securities and the market valuation of banks”, The Accounting Review, January, pp 1–25. Barth, M, W Beaver and W Landsman (1996): “Value-relevance of banks’ fair value disclosures under SFAS no 107”, The Accounting Review, October, pp 513–37. Barth, M, W Landsman and R Rendleman (1998): “Option pricing-based bond value estimates and a fundamental components approach to account for corporate debt”, The Accounting Review, January, pp 73–102. Bernard, V L, R C Merton and K G Palepu (1995): “Mark-to-market accounting for banks and thrifts: lessons from the Danish experience”, Journal of Accounting Research 33, pp 1–32.

Eccher, E, K Ramesh and S Thiagarajan (1996): “Fair value disclosures by bank holding companies”, Journal of Accounting and Economics, 22, pp 79–117. Financial Accounting Standards Board. 2004. Statement of Financial Accounting Standards No. 123 (revised), Share-Based Payment. Norwalk, CT: FASB.. Financial Accounting Standards Board. 2006a. Statement of Financial Accounting Standards No. 157, Fair Value Measurements. Norwalk, CT: FASB. Greg N, G and Mohamed, G (2006): “International Accounting; Standards, Regulations, and Financial Reporting”, Elsevier Ltd, pp 43-44 International Accounting Standards Board, 2002. Final Preface to International Financial Reporting Standards. International Accounting Standards Board, May. International Accounting Standards Board, 2003a. International Accounting Standard 32: Financial Instruments: Disclosure and Presentation, London, UK. International Accounting Standards Board, 2003b. International Accounting Standard 39: Financial Instruments: Recognition and Measurement, London, UK. International Accounting Standards Board, 2004. International Financial Reporting Standard 2, Accounting for Share-based Payment, London, UK. Peasnell, K V and Y N Lin (2000): “Fixed asset revaluation and equity depletion in the UK”, Journal of Business Finance and Accounting 27, pp 359–94. Venkatachalam, M (1996): “Value-relevance of banks’ derivatives disclosures”, Journal of Accounting and Economics 22, pp 327–55.\

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