You are on page 1of 15

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

2
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,

3
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

4
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

5
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

6
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

7
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

8
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.

9
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

Year Total Gain/Losses Average Close Price
Company Name -Equity Value-
AL-EQBAL 2003 1,998,222.00 3.71
INVESTMENT 2004 2,858,000.00 5.12
COMPANY LTD
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 & 2003 2,778,847.00 8.65
CIGARETTE 2004 7,824,433.00 7.42
INDUSTRIES
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

10
THE PUBLIC MINING 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
ARAB ALUMINIUM 2003 157,761.00 2.18
INDUSTRY /ARAL 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
NATIONAL STEEL 2003 136,475.00 1.76
INDUSTRY 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

JORDAN 2003 0 2.31
PHOSPHATE MINES 2004 0 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
THE JORDAN 2003 0 6.73
CEMENT FACTORIES 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
THE ARAB POTASH 2003 109,000.00 4.33
2004 173,000.00 13.11
2005 260,000.00 12.95
2006 147,000.00 13.72
2007 361,000.00 46.74
2008 284,000.00 36.6
JORDAN ROCK 2003 -91,120.00 1.86
WOOL INDUSTRIES 2004 -130,064.00 1.99
2005 -268,906.00 3.05
2006 -162,412.00 1.72
2007 3,965.00 0.87
2008 -53,867.00 1.01

11
INTERNATIONAL 2003 0 0.94
SILICA INDUSTRIAL 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 MIX 2003 0 1.42
CONCRTE AND 2004 0 3.02
CONSTRUCTION 2005 1,047,728.00 3.49
SUPPLIES
2006 278,441.00 4.58
2007 340,711.00 4.76
2008 -2,739,664.00 2.52
ARABIAN STEEL 2003 398,543.00 2.4
PIPES 2004 735,355.00 4.63
MANUFACTURING 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
GENERAL 2003 248,772.00 2.87
INVESTMENT 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 ARAB 2003 6,249,120.00 2.05
INTERNATIONAL 2004 6,110,646.00 1.8
FOOD FACTORIES 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 JORDAN 2003 10,878,241.00 7.52
WORSTED 2004 30,161,678.00 14.64
MILLS 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

12
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

TOTAL EQUITY
YEAR 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

13
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

14
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.\

15