FAIR VALUE AND HISTORIC COST ACCOUNTING OF BIOLOGICAL ASSETS

VALOR RAZONABLE VERSUS COSTE HISTÓRICO DE ACTIVOS BIOLÓGICOS

Josep Mª. Argilés

University of Barcelona (Department of Accounting)

Josep Garcia Blandón

IQS, (Faculty of Economics)

Teresa Monllau

Universitat Pompeu Fabra (Department of Economics and Business)

Address for correspondence:

Josep Mª. Argilés. Department of Accounting. Facultat d’Econòmiques. 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 Educación y Ciencia for granting this research (SEJ2005-04037/ECON).

FAIR VALUE AND HISTORIC COST ACCOUNTING OF BIOLOGICAL ASSETS

VALOR RAZONABLE VERSUS COSTE HISTÓRICO DE ACTIVOS BIOLÓGICOS

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 transición que la contabilidad está experimentando desde el coste histórico hacia el valor razonable. A pesar de que en no hay acuerdo unánime respecto a las ventajas e inconvenientes de la implementación del valor razonable, en contabilidad agrícola prevalece la opinión en contra de la utilización del valor razonable para los activos biológicos. En este estudio se aporta evidencia empírica de que las empresas que aplican el valor razonable en la valoración de los activos biológicos presentan diferencias significativas, respecto a las que valoran al coste histórico, 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 manipulación contable. No se encuentra que el criterio de valoración de los activos biológicos influencie significativamente la dispersión de los resultados.

Palabras clave: contabilidad agrícola, valor razonable, coste histórico, activos

biológicos.

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

employer’s 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

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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.

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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 Général Agricole (PGCA)

model, entails the recognition of unrealized gains and increases profit volatility.

However, Argilés 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. Argilés

and Slof (2001) stated that IAS 41 conceptual’s framework has already been in fact

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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.

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In order to avoid the incidence of influential cases, we also performed Pearson chi-

square 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:

)1(210 iiii sthistoriccodvcashflowstprofitstdv εβββ +⋅+⋅+=

)2(210 ijiijij sthistoriccocashflowprofit εβββ +⋅+⋅+=

)3(210 ijiijij sthistoriccosalesprofit εβββ +⋅+⋅+=

where is the standard deviation of annual profits of farm i, is

the standard deviation of annual cash flow generated by farm i, is a

dummy variable, which value is 1 when the farm applies historic cost valuation to

biological assets and 0 otherwise, is the annual variation of profit of farm i in

year j with respect to previous year, is the annual variation of cash flow

generated by farm i in year j with respect to previous year and is the annual

variation of sales of farm i in year j with respect to previous year.

iprofitstdv idvcashflowst

isthistoricco

ijprofit

ijcashflow

ijsales

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

5

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

Asociación Española 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.

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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 Liu’s

(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 Weng’s (2007) hypothesis of less efficient decisions under fair valuation, nor

Black and Liu’s (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

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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.

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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).

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Table 1. Mean and median comparisons between samples of farms using fair value and historic cost Number of observations Mean Median Fair value Historic cost Fair value Historic cost Fair value Historic cost

Profits (in €) 128 1092 319563.3 370621.7 68288.0 61345.0 Assets (in €) 128 1095 7401826.0 11000000.0 6116298.0 2951522.0 *** Revenues (in €) 128 1094 6866245.0 11800000.0 3437802.0 4259313.0 * Std. dev. of profits 11 101 132724.8 262950.5 84387.1 69361.4 Std. dev. of assets 11 101 484998.5 1043571.0 401498.3 260525.0 Std. dev. of revenues 11 101 454484.3 993581.2 211038.4 354348.1 Coefficient of variation of profits 11 99 18,92257.0 -2.206374 1.912104 0.8591279 Coefficient of variation of assets 11 99 0.2574009 0.2842284 0.2584495 0.259699 Coefficient of variation of revenues 11 99 0.2595552 0.3065067 0.2374224 0.246293 Return on assets (in percent) 128 1092 0.0334731 0.0269575 0.0186692 0.0236735 Std. dev. of return on assets 11 101 0.016708 0.0213837 0.141564 0.014827 Std. dev. of profits to std. dev. of cash flow 11 99 0.8954057 0.9338611 0.9434019 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

Table 2. Estimations relating profits to cash flow and sales (t-statistics in parenthesis) (A) (B) (C) Eq. (1) Eq. (2) Eq. (3) Variable profitstdv │profit │ │profit │ Constant -6984.62 16865.23 158214.5 (-1.05) (0.61) (1.17) historiccost 2965.405 -11239.84 332716.9 (0.41) (-0.39) (0.53) Control variables: cashflowstdv 0.9702714 *** (32.14) │cashflow │ 0.9562842 *** (201.05) │sales │ 0.0852866 *** (8.86) Fitness of the model: R-square 0.9835 *** R-square (overall) 0.9801 0.2263 Wald (chi-sq.2) 40446.31 *** 79.08 *** Significance levels: * p<0.1, ** p<0.05 and *** p<0.01

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