Fair Value or Cost Model? Drivers of Choice for IAS 40 in the Real Estate Industry

Abstract

The IFRS mandatory adoption in European countries is an excellent context from which to assess the validity of accounting choice theory, which postulates that information asymmetry, contractual efficiency (agency costs) and managerial opportunism reasons could drive the choice. With this aim, we test the impact of these factors to explain the adoption of fair value for investment properties (IAS 40) in the real estate industry, taking into account the ‘revaluation’ option offered by IFRS1 and using historical cost without revaluations as a baseline category for comparison purposes. We select a sample of European real estate companies from Finland, France, Germany, Greece, Italy, Spain and Sweden, all first-time adopters of the IFRS. Using a multinomial logistic model, we show that information asymmetry, contractual efficiency and managerial opportunism could account for the fair value choice. Particularly, the most significant findings are that size as a proxy of political costs reduces the likelihood of using fair value while market-to-book ratio is negatively associated with the fair value choice. On the other hand, leverage, another typical proxy of contracting costs, seems not to influence the choice. This evidence confirms the current validity of traditional accounting choice theory even if it reveals, in such a context, the irrelevance of the usual relations between accounting choice and leverage.

Acknowledgements

The authors gratefully acknowledge the help of the two anonymous referees of the European Accounting Review, as well as Katherine Schipper, Marco Trombetta and Beatriz García Osma. The paper has benefited from comments and suggestions by seminar participants at the EAR research conference on Measurement Issues in Financial Reporting (Segovia, 2009), and at the Wards Seminars, Department of Accounting and Finance, Glasgow University (February, 2008). The authors would also like to thank Professor Jo Danbolt for the precious comments on the earlier version of the paper. The previous draft of this paper was entitled: ‘Why Do Real Estate Companies Adopt Fair Value? A Cross-Country Analysis on Investment Properties’. All views and errors are our own.

Notes

This second alternative is possible only at the IFRS transition date and implies a revaluation only in equity, without any impact on profit and loss.

Some scholars cast doubts on the fair value information content. Watts (2006) states that fair value estimated by managers could never reach the information level of the whole financial market, due to the enormous number of market operators and consequent information contributing to determine the prices. In this perspective, financial accounting can only produce ‘hard verifiable numbers’ (based on the cost model), giving market operators the basis for their personal interpretation.

Through analytical models (Reis and Stocken, 2007; Plantin et al., 2008) and empirical evidence (Khurana and Kim, 2003), a stronger value relevance of the fair value model is supported vs. the cost model when fair values are obtained from liquid markets.

While there are few studies demonstrating that recognition has the same effect as disclosure (see Gopalakrishnan, 1994; Davis-Friday et al., 1999, for pension accounting under US GAAP), much more evidence is found where recognition has a stronger impact on financial markets (Aboody, 1996; Espahbodi et al., 2002; Beattie et al., 2003; Ahmed et al., 2006; Viger et al., 2008).