FAIR VALUE AND HISTORIC COST ACCOUNTING OF BIOLOGICAL ASSETS VALOR RAZONABLE VERSUS COSTE HISTRICO DE ACTIVOS BIOLGICOS

Josep M. Argils University of Barcelona (Department of Accounting)

Josep Garcia Blandn IQS, (Faculty of Economics)

Teresa Monllau Universitat Pompeu Fabra (Department of Economics and Business)

Address for correspondence: Josep M. Argils. Department of Accounting. Facultat dEconmiques. Universitat de Barcelona. Av. Diagonal, 690. 08034 Barcelona. Spain. Phone: 00 34 93 4021956 00 34 93 4021957 Fax. 00 34 93 4029099 e-mail: josep.argiles@ub.edu

Acknowledgements: The authors would like to thank the firm CABSA for providing the data that made this paper possible, and the Spanish Ministerio de Educacin y Ciencia for granting this research (SEJ2005-04037/ECON).

FAIR VALUE AND HISTORIC COST ACCOUNTING OF BIOLOGICAL ASSETS VALOR RAZONABLE VERSUS COSTE HISTRICO DE ACTIVOS BIOLGICOS

ABSTRACT This paper starts out to analyse the recent debate about the convenience of the move of accounting from historical cost toward the fair-value principle. In spite that there is no unanimous opinion on the advantages and drawbacks of its implementation with respect to historic cost, in the existing previous literature. on agricultural accounting prevails a claim against the requirement of IAS 41 of fair valuation for biological assets. This research provided empirical evidence that the use of fair value principle for biological assets provides significant different valuations of assets and revenues with respect to historic cost, but does neither disclose significant differences in profits, nor increase volatility, nor bring about different profitability and accounting manipulation. Provided that historic cost is a complex valuation method for biological assets, it seems that fair value is an interesting tool for the predominant small holdings in the agricultural sector in the European Union. Keywords: agricultural accounting, fair value, historic cost, biological assets.

RESUMEN Este trabajo comienza analizando el debate existente sobre la conveniencia de la transicin que la contabilidad est experimentando desde el coste histrico hacia el valor razonable. A pesar de que en no hay acuerdo unnime respecto a las ventajas e inconvenientes de la implementacin del valor razonable, en contabilidad agrcola prevalece la opinin en contra de la utilizacin del valor razonable para los activos biolgicos. En este estudio se aporta evidencia emprica de que las empresas que aplican el valor razonable en la valoracin de los activos biolgicos presentan diferencias significativas, respecto a las que valoran al coste histrico, en sus activos e ingresos, pero no ofrecen valores significativamente diferentes en beneficios, ni presentan mayor volatilidad en ninguna de estas magnitudes. Tampoco muestran cifras significativamente diferentes de rentabilidad ni siquiera de manipulacin contable. No se encuentra que el criterio de valoracin de los activos biolgicos influencie significativamente la dispersin de los resultados. Palabras clave: contabilidad agrcola, valor razonable, coste histrico, activos biolgicos.

1. Introduction

An important public debate in recent years has been the reform of the accounting standards toward fair value accounting. Most worldwide important accounting groups and institutions, such as The International Accounting Standards Board (IASB), the U.S.A. Financial Accounting Standards Board (FASB), and the Accounting Regulatory Committee (ARC) and the European Financial Reporting Advisory Group (EFRAG) in the European Union (EU) have encouraged the convergence of international accounting toward standard based on market prices, opposite to traditional accounting measurement based on historical cost. The FASB early issued several standards requiring recognition or disclosure of fair values estimates for assets and liabilities, mainly for financial instruments. For example, Statements of Financial Accounting Standards (SFAS) number 87 in 1985 on employers accounting for pensions, number 105 in 1990 on disclosure of information about financial instruments, number 107 in 1991 on disclosures about fair value of financial instruments, etc. The International Accounting Standards Committee (IASC) issued International Accounting Standard (IAS) requiring measurement at fair value and value changes to be recognised in profit or loss. The most important were the IAS 32 on disclosure and presentation of financial instruments, issued in 1995 and revised in 1998 by IAS 39, and the IAS 41 on Agriculture, issued in 2000. The EU adopted the whole existing IAS by the Commission Regulation (EC)1725/2003, with the exception of IAS 32 and 39, that were adopted in 2004 by Commission Regulations (EC)2086/2004 and (EC)2237/2004. Fair value is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction (e.g., IAS 39, IAS 41, SFAS 107). In 2006 SFAS 157 redefined fair value as the price that would be received to sell the asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date1. In spite of this persistent trend toward fair value, the reform has aroused controversial stances, usually debating around financial instruments, in the practitioner ground (e.g., Day, 2000; Economist, 2007; Joint Working Group of Banking Associations on Financial Instruments, 1999). A rapport of the European Central Bank (2004) summarizes the potential drawbacks and advantages of a fair value accounting

framework from the point of view of financial institutions. There is also an unsolved debate in the academic ground. Academics debate is usually referred to financial instruments and framed within the agency theory, supposing information asymmetry between market participants and the existence of perfect versus imperfect market conditions. Barth and Landsman (1995) concluded that in perfect and complete markets a fair value accounting-based balance sheet reflects all value-relevant information. However, in more realistic market settings management discretion applied to fair valuation can detract from balance sheet and income statement relevance. Watts (2003) argues that fair valuation is subject to more manipulation and, accordingly, is a poorer measure of worth and performance. Rayman (2007) concludes that fair value accounting is liable to produce absurdities and misleading information, if it is based on expectations that turn out to be false. In the same vein, Liang and Wen (2007) are critical with the beneficial effects of moving to fair valuation because it inherits more managerial manipulation and induce less efficient investment decisions than cost valuations. Plantin and Sapra (forthcoming) conclude that, when there are imperfections in the market, there is the danger of the emergence of an additional source of volatility as a consequence of fair valuation, and thus a rapid shift to full mark-to-market regime may be detrimental to financial intermediation and therefore to economic growth. On the contrary, Bleck and Liu (2007) found that historic cost accounting makes easier to hinder bad investment projects, prevents from liquidating them, therefore accumulating volatility to hit the market at a later date and produce crash prices, increasing overall volatility and reducing efficiency (i.e. reducing profitability) with respect to market valuation. Gigler et al. (2006) concluded that even in the case of mixed attribute report (i.e., some items are valued at market while others are carried at historical cost), fair value performs better: it provides stronger signals of financial distress. All these previous mentioned studies are analytical and mainly use mathematical models. However, to our knowledge, there are few empirical studies contrasting hypotheses on these issues. Hann et al. (2007) found empirical evidence of fair-value pension accounting not improving the informativeness of the financial statements and even impairing it. Slightly related to these issues, Beaver et al. (2005) found a small decline in the ability of financial ratios to predict bankruptcy from 1962 to 2002, and an incremental explanatory power of market-related variables over this period. They explain the deterioration of predictive ability of financial ratios in terms of an insufficient improvement of FASB standards. 2

The IAS 41 brought the debate into the agricultural accounting domain. Most authors were critical with the requirement of fair valuation for biological assets and value changes to be recognised in profit and loss statement. Penttinen et al. (2004) claimed that fair valuation would cause unrealistic fluctuations in net profit of forest enterprises. Herbohn and Herbohn (2006) and Dowling and Godfrey (2001) stressed on the increased volatility, manipulation and subjectivity of reported earnings under this standard. Both studies were performed in the context of the Australian of Accounting Standards Board 1037 (requiring similarly to IAS 41) and provided empirical evidence of Australian entities preference for cost valuation or delaying the adoption of fair valuation. Specifically, Herbohn and Herbohn (2006) calculated coefficients of variation of profits, and gains and losses from timber assets as a percent of net profits, of eight public companies and five state and territory government departments with material holdings of timber assets for four years. The authors argued that figures provided an insight into the volatility caused by the fair value measurement. Elad (2004) complained that the IAS 41 is a major departure from historic cost accounting, could signal the demise of the French Plan Comptable Gnral Agricole (PGCA) model, entails the recognition of unrealized gains and increases profit volatility. However, Argils and Slof (2001) welcomed fair value measurement for biological assets because it avoids the complexity of calculating their costs, given the predominance of small family farms in Western countries, and specifically in the European Union (EU), with no resources and skills to perform accounting procedures and valuations. The nature of farming makes an historical-based valuation of biological assets inherently difficult because they are affected by procreation, growth, death, as well as typical problems, usually exceeded in agriculture, of joint-cost situations. This complexity is a specially acute problem for small family households. Kroll (1987) and Lewis and Jones (1980) concluded that historical costs are not very informative to users, and allocations to assets are arbitrary in most cases. The American Institute of Certified Public Accountants (1996) and the Canadian Institute of Chartered Accountants (1986) recommended the historic cost, considering also the possibility of realizable value as an alternative. The French PGCA adhered also to the historic cost principle. However, Kroll (1987) regretted that the complexity in asset valuation and accounts was an important barrier to its use in practice. Elad (2004) points out that simplicity is not a merit of fair value where does not exist an active market for a biological asset. Argils and Slof (2001) stated that IAS 41 conceptuals framework has already been in fact 3

widely and successfully implemented in the EU through the Farm Accountancy Data Network (FADN), which has been fulfilling the role of a quasi-standard-setting body in the absence of previous pronouncements on agricultural standards from other authorities (Poppe and Beers, 1996). Therefore, an assessment of the convenience of fair valuation for agriculture should balance its advantages and drawbacks. Simplicity is the main advantage of fair valuation of biological assets with respect to historic cost. But there is no unanimous pronouncement in previous literature with respect to whether volatility in income and profits, relevance, manipulation and profitability are improved or worsened with fair value. The present paper contributes providing empirical evidence about it in agriculture. The remainder of this paper is organized as follows. Section 2 explains the research design used in this study. We provide results in the third section and present conclusions in the fourth section.

2. Research design

2.1. Empirical design

The purpose of the study is to empirically test the effects of the valuation method used for biological assets, in revenues, profits, volatility and accounting manipulation. We performed mean comparison tests between samples of farms that used fair value and historic cost for biological assets valuation. The tests were performed for revenues, profits and assets. We tested the contradictory hypotheses of increase-decrease in volatility with fair valuation through mean and median comparisons for standard deviation of revenues, profits, assets and return on assets. In order to control for relative variations we also compared coefficient of variations. In order to test whether it is fair valuation or historic cost that entails less efficient investment decisions, we performed mean comparisons for return on assets between both samples. We tested the hypothesis that fair value increases manipulation through the traditional ratio of standard deviation of profit to standard deviation of cash flow. 4

In order to avoid the incidence of influential cases, we also performed Pearson chisquare tests of median association for all previous mentioned variables. We reinforced tests on the influence of the valuation method with regression models. We considered profits as a dependent variable of the valuation method employed and controlling for the cash flow generated by the farm, that is supposed to be a reliable data and independent on accruals and accounting manipulation. On the other hand, we considered profits depending on the valuation method, but controlling for sales performed by the farm. We thus defined the following regression models to reinforce tests on volatility: profitstdv i = 0 + 1 cashflowstdvi + 2 historiccost i + i

(1)

profit ij = 0 + 1 cashflowij + 2 historicco st i + ij

( 2)

profit ij = 0 + 1 sales ij + 2 historicco st i + ij

(3)

where profitstdvi is the standard deviation of annual profits of farm i, cashflowst dvi is the standard deviation of annual cash flow generated by farm i, historiccosti is a dummy variable, which value is 1 when the farm applies historic cost valuation to biological assets and 0 otherwise, profit ij is the annual variation of profit of farm i in year j with respect to previous year, cashflowij is the annual variation of cash flow generated by farm i in year j with respect to previous year and sales ij is the annual variation of sales of farm i in year j with respect to previous year. We performed an ordinary least squares regression for equation (1) and panel data with random effects regressions for equations (2) and (3), thus correcting for autocorrelation disturbances. As we did not find data of whole years for all farms, and the panel data was unbalanced, we performed panel data regressions with random effects.

2.2. Sample

The Spanish firm CABSA provided us with notes to financial statements of 117 listed Spanish farms. CABSA is a firm that provides analysis and financial data of about 300,000 Spanish firms. We classified the sample in two groups: those disclosing fair valuation for biological assets in their notes and those disclosing historical cost valuation. We then selected financial data from those farms available in SABI and CABSA. SABI is a data base of financial statements of about 1,000,000 Spanish and 150,000 Portuguese firms. It covers a larger number of firms than CABSA, but they do not provide notes to financial statements. Through these data bases we collected twelve years-data for these firms. Our review yielded 11 farms valuing biological assets at fair value and 101 at historical cost and 5 were discarded because they did not provide information about their valuation method, or it was not clear the applied method, and/or there was no available financial data for them. CABSA and SABI databases collect information of financial statements of companies obliged to file in the Spanish Registro Mercantil. Most farms have no legal obligation to disclose financial information because of their small size and legal form, and usually do not write up accounting. Only the small proportion of farms that by their legal form are trading companies must file financial statements in the mentioned Registro Mercantil. However, there is no other public file for financial statements from Spanish farms. The small proportion of farms from our sample using fair value can be explained in terms of the Spanish obligation to use the historic cost, stated in the accounting standards number 3 and 13 of the Spanish Plan General Contable. Market value is only allowed when cost price is higher. The 8th rapport of accounting principles of the Asociacin Espaola de Contabilidad (AECA) recognising the possibility to use market prices in agricultural and mining companies under certain conditions, is a mere recommendation of a professional association. Some of the few firms using fair value allege difficulties in calculating historic cost and/or the recommendation of AECA.

3. Results

Table 1 display results about the incidence of the valuation method applied to biological assets in profits, assets, revenues, volatility and profitability. As the distribution of our samples did not fit normality, we applied the Mann-Whitney test. 6

Tests performed did not find significant differences in mean values of profits, assets and revenues between samples. However, we found significant differences in median values of assets with p<0.01 and revenues with p<0.1, that is consistent with the application of different valuation methods. Results suggest that the use of fair value for biological assets significantly changed the value of farm assets and revenues, with respect to historical cost valuation, but did not significantly affect the amount of profits. The absence of significant differences in standard deviation of profits, assets and liabilities does neither provide empirical evidence, for the agricultural sector, to the commonly accepted hypothesis (e.g. Plantin and Sapra, forthcoming; Dowling, 2001; Pentinen et al., 2004) of greater volatility with fair valuation, nor to Bleck and Lius (2007) hypothesis of greater volatility with historic cost. No significant differences in coefficients of variation of these variables confirm this result. The fact that mean and median values of return on asset are not significantly different between groups neither confirm, in the specific circumstances of agricultural sector, Liang and Wengs (2007) hypothesis of less efficient decisions under fair valuation, nor Black and Lius (2007) argument that under historic cost bad investment projects would be pooled with good projects and prevented from liquidation. In a similar way, no significant differences in standard deviation of return on assets confirms the absence of greater volatility under fair value and suggests that there is no significant transfers of gains and loses between periods. No significant differences in standard deviation of profits to standard deviation of cash flows between groups suggests that fair value did not provide greater discretionarily to manipulate earnings, as is usually assumed (e.g. Watts, 2003; Liang and Wen, 2007). Regressions performed for equations (1), (2) and (3) are displayed in table 2. Column (A) displays estimations when the independent variable is standard deviation of profits, Values of variance inflation factors, condition indexes and variance proportion of variables suggest that collinearity and multicollinearity do not likely disturb regression estimations. The model presents a significant goodness-of-fit and explains about 98% of the total variability. The insignificant sign for the coefficient of the dummy variable suggests no influence of the valuation method in profit volatility. The control variable presents the expected significant positive sign. The Durbin-Watson statistics for regression estimations of equations (2) and (3) determine the typical autocorrelation pattern for independent variables in panel data. Given that we have unbalanced panel data, we performed panel data regressions with 7

random effects. Results displayed in columns (B) and (C) of table 2 reinforce the absence of influence of fair valuation in volatility of profits. Both models present a significant goodness-of-fit and the expected significant positive sign for the control variables. In none of the columns the dummy variable for valuation method presents a significant sign. Therefore, estimations from table 2 reinforce our finding that fair valuation of biological assets is not associated with higher volatility.

4. Conclusions

These paper reviews recent literature on the debate about the convenience of the move of accounting from historical cost toward the fair-value principle. There is a lack of agreement about the advantages and drawbacks. No unanimous pronouncement can be ascertained in previous literature with respect to whether volatility in income and profits, relevance, manipulation and profitability are improved or worsened with the use of fair value principle. However, in the existing literature on agricultural accounting prevails a claim against the requirement of IAS 41 of fair valuation for biological assets. Most authors complain that it is a major departure from the convenient valuation method applied in agriculture and will entail serious drawbacks for the agricultural sector. Tests performed with the data sample used in this study provided empirical evidence that fair value of biological assets does neither disclose significant differences in profits, nor increase volatility, nor bring about lower profitability and accounting manipulation. However, significant differences were found in median values of assets and revenues. None of the alleged drawbacks for the agricultural sector were empirically confirmed by this research. On the other hand, fair valuation avoids the unaffordable complexities of cost calculation for biological assets for the predominant small holdings in the agricultural sector. Therefore, fair value for biological assets seems to be a useful simple valuation method that will help to get a more widespread use of accounting in the agricultural sector.

Notes: 1. The IASB started a project on fair value measurement and issued a discussion paper (IASB, 2006) aiming at a providing a single source of guidance on fair valuation, adopting the same definition as in SFAS 157, but stating that it will neither introduce nor require any new fair value measurements (IASB, 2008).

References American Institute of Certified Public Accountants (1996) Audits of Agricultural Producers and Agricultural Cooperatives. New York: AICPA. Argils, J.M. and Slof, J. (2001) New opportunities for farm accounting. European Accounting Review, 10(2), p.361-383. Barth, M.E. and Landsman, W.R. (1995) Fundamental issues related to using fair value accounting for financial reporting. Accounting Horizons, 9(4), p. 97-107. Beaver, W.H., MchNichols, M. and Rhie, J.-W. (2005) Have financial statements become less informative? Evidence from the ability of financial ratios to predict bankruptcy. Review of Accounting Studies, 10, p. 93-122. Bleck, A. and Liu, X. (2007) Market transparency and the accounting regime. Journal of Accounting Research, 45(2), p. 229-256. Canadian Institute of Chartered Accountants (1986) Comptabilit et Information Financire des Producteurs Agricoles. Toronto: CICA. Day, J.M. (2000) Speech by SEC staff: fair value accounting-lets work together and get it done. http://www.sec.gov/news/speech/spch436.htm Dowling, C. and Godfrey, J. (2001) AASB 1037 sows the seeds of change: a survey of SGARA measurement methods. Australian Accounting Review, 11(1), p. 45-51. Economist (2007) A book-keeping error. Economist, 384(8544), p. 69. Elad, Ch. (2004) Fair value accounting in the agricultural sector: some implications fro the international accounting harmonization. European Accounting Review, 13(4), p. 621-641. European Central Bank (2004) Fair value accounting and financial stability. Occasional Paper Series, 13.

Gigler, F. Kanodia, Ch. And Venugopalan, R. (2007) Assessing the information content of market-to-market accounting with mixed attributes: the case of cash flow hedges. Journal of Accounting Research, 45(2), p. 257-276. Hann, R.N., Heflin, F. and Subramanayam, K.R. (2007) Fair-value pension accounting. Journal of Accounting and Economics, 44, p. 328-358. Herbohn, K. and Herbohn, J. (2006) International Accounting Standard (IAS) 41: what are the implications for reporting forest asstes?. Small-scale Forest Economics, Management and Policy, 5(2), p. 175-189. IASB (2006) Fair value measurements. Part 2: SFAS 157 fair value measurement. Discussion paper. http://www.iasb.org/NR/rdonlyres/5D20E453-26D3-4E0AAB08-FC391917FD89/0/DDFairValue2.pdf IASB (2008) Fair value measurement, where are we in the project?. http://www.iasb.org/Current+Projects/IASB+Projects/Fair+Value+Measurement /Fair+Value+Measurement.htm. Joint Working Group of Banking Associations on Financial Instruments (1999) Accounting for financial instruments for banks.

http://www.aba.com/aba/pdf/GR_tax_va4.PDF Kroll, J.C. (1987) Le nouveau plan comptable: les occasions perdues, conomie Rurale, 180: 20-25. Lewis, A.E. and Jones, W.D. (1980) Current cost accounting and farming businesses, Journal of Agricultural Economics, 31: 45-53. Liang, P.J. and Wen, X. (2007) Accounting measurement basis, market mispricing, and firm investment efficiency. Journal of Accounting Research, 45(1), p. 155197. Penttinen, M., Latukka, A. Merilinen, H., Salminen, O. and Uotila, E. (2004) IAS fair value and forest evaluation on farm forestry. Proceedings of Human dimension of family, farm and community forestry international symposium. March 29April 1. Poppe, K.J. and Beers, G. (1996) On innovation management in Farm Accountancy Data Networks, Agricultural Economics Research Institute LEI, 535: 1-37. Plantin, G. and Sapra, H. (forthcoming) Marking-to-market: panacea or Pandoras box?. Journal of Accounting Research.

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Rayman, R.A. (2007) Fair value accounting and the present value fallacy: the need fro an alternative conceptual framework. British Accounting Review, 39, p. 211225. Watts, R.L. (2003) Conservatism in accounting. Part I: explanations and implications, Accounting Horizons, 17(3), p. 207-221.

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Table 1. Mean and median comparisons between samples of farms using fair value and historic cost
Number of observations Fair value Historic cost Profits (in ) Assets (in ) Revenues (in ) Std. dev. of profits Std. dev. of assets Std. dev. of revenues Coefficient of variation of profits Coefficient of variation of assets Coefficient of variation of revenues Return on assets (in percent) Std. dev. of return on assets Std. dev. of profits to std. dev. of cash flow 128 128 128 11 11 11 11 11 11 128 11 11 1092 1095 1094 101 101 101 99 99 99 1092 101 99 Mean Historic cost Median Fair value Historic cost

Fair value

319563.3 7401826.0
6866245.0 132724.8 484998.5 454484.3 18,92257.0 0.2574009 0.2595552 0.0334731 0.016708 0.8954057

370621.7 11000000.0 11800000.0

262950.5 1043571.0 993581.2 -2.206374 0.2842284 0.3065067 0.0269575 0.0213837 0.9338611

68288.0
6116298.0 3437802.0 84387.1 401498.3 211038.4 1.912104 0.2584495 0.2374224 0.0186692 0.141564 0.9434019

61345.0
2951522.0 *** 4259313.0 * 69361.4 260525.0 354348.1 0.8591279 0.259699 0.246293 0.0236735 0.014827 0.9815769

Notes: Mann-Witney test for means Pearson chi-square tests of association for medians, and tests corrected for continuity. Significance levels: * p<0.1, ** p<0.05 and *** p<0.01

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Table 2. Estimations relating profits to cash flow and sales (t-statistics in parenthesis)

Variable Constant historiccost Control variables: cashflowstdv

(A) Eq. (1) profitstdv -6984.62 (-1.05) 2965.405 (0.41) 0.9702714 (32.14) ***

(B) Eq. (2) profit 16865.23 (0.61) -11239.84 (-0.39)

(C) Eq. (3) profit 158214.5 (1.17) 332716.9 (0.53)

cashflow sales Fitness of the model: R-square R-square (overall) Wald (chi-sq. )
2

0.9562842 (201.05)

*** 0.0852866 (8.86) ***

0.9835

*** 0.9801 40446.31 *** 0.2263 79.08 ***

Significance levels: * p<0.1, ** p<0.05 and *** p<0.01

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