International Journal of Law and Management

The effect of accounting methods on financial reporting quality

Andrain Hadiyanto, Evita Puspitasari, Erlane K Ghani,
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Andrain Hadiyanto, Evita Puspitasari, Erlane K Ghani, "The effect of accounting methods on financial reporting quality",
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 The effect of accounting methods on financial reporting quality
Abstract

Purpose - This study examines the relationship between accounting measurement method of
biological asset and financial reporting quality. Specifically, this study examines whether using
fair value method or the historical cost method on biological asset provides different financial
reporting quality.
Design/ Methodology/ Approach - This study uses data from 38 agricultural companies that are
members of the Roundtable on Sustainable Palm Oil. The annual reports of 38 companies from
the Palm Oil Growers over a 4 year period starting from 2011 to 2014 are analysed.
Findings - This study shows that companies using historical cost measurement produce less
reliable and less relevance information compared to the companies that are using fair value
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measurement.
Research Implications - The results in this study imply that the use of fair value measurement
improves the quality of financial information.
Practical Implication - This study supports IASB’s justification of developing IAS 41 as the
principle based standard that better represent the financial information related to biological asset
and subsequently lead to good accountability and harmonisation practices.
Original/ Value – This study provides evidence on the best measurement to be used in
agriculture activities using a larger sample size of few countries. In addition, this study
contributes to the existing literature on the effect of accounting methods on financial reporting
quality.

Keywords: Agriculture, Biological asset, Fair value, Historical cost, Accountability,

Harmonisation
Paper type: Research Paper

1. Introduction
Each country has different accounting system which is adjusted with the needs of the
country. To enhance financial statement comparability and quality globally, the International
Accounting Standard Board (IASB) developed and issued the International Financial Reporting
Standard (IFRS) with the objective of reducing distinctive reporting regulation between
countries, reducing the cost of multinational company financial reporting and reducing the cost
of financial statement analysis (IASB, 2000). IFRS is a codification of accounting standards,
interpretations, and framework in the preparation and presentation of the financial statements
that provides high quality financial statement based on principle-based standards rather than rule-
based standards. This would provide companies with more flexibility in choosing the accounting
policy and estimates that best fit their companies. However, the use of the principle-based
standards may increase risks such as error in management estimates and business distortions
(Elad, 2004; Muhammad and Ghani, 2014), particularly when involving transactions which may
not have market value such as bearer biological asset in the agriculture industry.
The agriculture industry plays an important role in the economic development of many
countries that offers a range of commodities consisting of biological asset and agriculture
produce (Lloyd and Malcolm, 1997). Prior to IFRS, many agriculture companies report their
biological assets using various methods. For example: Malaysian agriculture companies measure
 their biological assets in accordance to the Malaysian Accounting Standard (MAS) 8 in which
this standard allows companies to either use the amortization method as a benchmark treatment
for pre-cropping costs or the capital maintenance method as an allowed alternative treatment
(Muhammad and Ghani, 2014). The use of various methods and practices have somewhat led to
the deterrence of harmonization in the accounting presentation and disclosure (Sadeghi et al.,
2015). In addition, due to the special characteristics on growth and regeneration process of the
biological asset require the asset to be valued independently rather than as a whole (Thurrun
Bakir, 2010) that caused the historical cost measurement to be somewhat difficult to implement
(Herborn and Herborn, 2006; Goncalves and Lopez, 2015).
Following these issues, the IASB developed IAS 41 Agriculture under the IFRS
framework which specifically addresses the relevance of the fair value measurement of
biological asset and agriculture produce (Azevedo, 2007). IAS 41 Agriculture defines biological
asset as living plants and animals. The standard categorises biological asset into consumable
biological asset which is accounted within the scope of IAS Agriculture and bearer biological
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asset which is accounted under the scope of IAS 16 Property, Plant and Equipment (IASB,
2000). Under IAS 41 Agriculture, the consumable biological asset such as trees in a timber
plantation is measured at its fair value less costs to sell which can be determined by the existence
of market value (Muhammad and Ghani, 2014). One however, could pose a question. Apart from
increasing harmonisation, does accounting biological asset at fair value impacts the financial
reporting quality?
This study aims to examine the relationship between accounting measurement method of
biological asset and financial reporting quality. Specifically, this study examines whether using
fair value method or the historical cost method on biological asset provides different financial
reporting quality. The results in this study imply that the use of fair value measurement improves
the quality of financial information. This study provides evidence on the best measurement to be
used in agriculture activities using a larger sample size of few countries. The remainder of this
paper is structured as follows. The next section, Section 2 provides the literature review. This is
followed by Section 3 that outlines the research design. Section 4 provides the research model of
this study. The results of the data analyses and discussions are shown in Section 5. The last
section concludes this study.

2. Literature Review
Prior to IAS 41, the plantation companies often reported their biological assets in the
financial statements based on cost. For example: In Malaysia, prior to 2012, the companies are
required to measure the biological asset in accordance with the Malaysian Accounting Standard
(MAS) 8 – Accounting for Pre-cropping costs. Under MAS 8, the standard allows two methods
namely, the amortisation method and the capital maintenance method of which the earlier serves
as the benchmark method. Under the amortisation method, the pre-cropping costs includes
expenditures relating to new planting or replanting of crops prior to their maturity, land
preparation, roads, drains, plants, planting, fertilisation, irrigation and labour. Such costs are then
capitalised and subsequently amortised on a systematic basis over useful life. Studies have
argued that cost accounting the biological asset provides better financial reporting as it avoids
data distortion and hence, quality financial reporting.
On the other hand, IAS 41 relates to agriculture which aims to establish standards of
accounting for agricultural activities. It involves the management of the biological asset and
agricultural produce. According to IAS 41, an entity must recognise a biological asset or
 agriculture produce only when the entity controls the asset as a result of past events, it is
probable that future economic benefits will flow to the entity, and the fair value or cost of the
asset can be measured reliably. Under IAS 41, biological asset is defined as a living animal or
plant whilst agriculture produce is defined as harvested product of the entity’s biological asset.
IAS 41 requires the entities to measure their biological assets in the statement of financial
position using the fair value measurement. Fair value is defined as the price received when
selling an asset or paid to transfer a liability in an orderly transaction between the market
participants at the measurement date.
There are three hierarchies in the fair value determination namely, Level 1, Level 2 and
Level 3. Level 1 refers to inputs with quoted prices in active markets for identical assets or
liability that the entity can access at the measurement date. Level 2 refers to inputs that are not
inputs with quoted market prices within level 1 that are observable for the asset or liability, either
directly or indirectly. On the other hand, level 3 refers to unobservable inputs for the asset or
liability. In level 3, the companies develop unobservable inputs using the best information
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available in the circumstances, which might include their own data, taking into account all
information about market participant assumptions that is reasonably available (IFRS 13).
According to IAS 41, an entity must recognise a biological asset or agriculture produce
only when the entity can controls the asset as a result of past events, it is probable that future
economic benefits will flow to the entity, and the fair value or cost of the asset can be measured
reliably. Further, IAS 41 requires the entity to measure the biological asset at initial recognition
and at subsequent reporting dates at fair value less estimated costs to sell, unless fair value
cannot be reliably measured. On the other hand, agricultural produce is measured at fair value
less estimated costs to sell at the point of harvest. There is no measurement reliability exception
for agriculture produce since it is a marketable commodity. The gain or loss as the result of the
fair value measurement, for both biological assets and agricultural product will be included in the
profit or loss for the period in which it arises.
A group of studies supported the use of fair value measurement such as Laux and Leuz
(2009) and Argiles et al. (2011). These studies suggested that using fair value would provide
better presentation of the usefulness and transparency of information because of the timely
reflection of current market value (Lauz and Leuz, 2009; Muhammad and Ghani, 2014). These
studies argued that the use of fair value measurement would assist the entities in mitigating the
complexity in determining the cost relating to the agriculture specifically on biological asset. In
addition, it provides accurate on an ongoing basis to the users of financial reports as the
biological asset or agriculture produce would be recorded at its market price and therefore,
reflect what it would be receive if the biological asset or agriculture produce is sold. This is in
contrast when using the historical cost measurement that does not provide the current market
price of the biological asset and agriculture produce which may pose a burden of overpricing or
under-pricing the biological asset and agriculture produce upon decision to sell.
The use of fair value however, has its advantage. One eminent disadvantage is that the
entities have the flexibility in determining the fair value of their biological assets that may
increase the possibility of the earnings management practice (Cahyonowati and Ratmono, 2012).
Rayman (2007) argued that fair value measurement in accounting is responsible in producing
misled information if the measurement is estimated differently with the reality. Further, Argiles
et all (2012) explained that fair value measurement could be manipulative. The same argument
has been declared by Herborn and Herborn (2006) and Plantin and Sapra (2008). Similarly,
Belkoui (2004) argued that managers prefer to have more flexible financial reporting standard in
 order to (a) shift the income from the profitable periods to the unprofitable periods; (b) impress
the shareholders; and (c) protect the managers’ position from the entity take over. Further, more
flexibilities that the managers have would provide more opportunities for the managers to adapt
and reflect the real economic situations. Hence, the managers can choose their preferred methods
and estimates to manage the income for the benefits of the managers and other stakeholders
(Watts and Zimmerman, 1990).
To this date, there are not many studies that have examined the link between fair value
accounting and agriculture. One of the early studies that have examined this issue is by Aryanto
(2010). He conducted his study using an Indonesian setting to examine the theoretical aspects of
IAS 41 and found many rejected the standard due to earning volatility and misleading tax-related
decision. Thurrun Bakir (2010) examined the method used by Malaysian plantation entities in
valuing their biological assets and found not many of these entities have adopted fair value
measurement. His study found that the main reason contributing for the lack of adopting fair
value measurement is the difficulty in identifying attributes of biological asset and considering
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that the valuation process of biological asset that does not have market value as costly and
burdensome. Staltmane (2010) examined the factors that affect the valuation of biological asset
using a Latvian and found that using discounted cash flow method in determining the fair value
of the biological asset does not represent accurate fair value of the biological asset.
Another group of studies have examined the link between fair value model of the
biological asset and financial reporting quality. For example: Barasa (2015) examined the
different accounting methods on financial reporting quality by analysing the differences of
biological assets’ total value, revenue total value and profit total value. They also analysed the
trend of income smoothing index of fair value model as opposed to historical cost model.
However, his study focuses on a case study of an agricultural company. Apart from Barasa’s
study, there is yet a study that has examined the link between fair value model and financial
reporting quality. Examining this issue and comparing with historical cost measurement using a
larger sample size of a few countries would provide evidence on the best measurement to be used
in agriculture activities.

3. Research Model
Figure 1 presents the research model used in this study. This study anticipates that there
would be differentiation of financial information quality between the entities that are using the
historical cost measurement and the fair value measurement. The financial information used in
this study are gross profit, net earnings, biological assets, agricultural products, profitability, and
earnings management which is based on the Income Smoothing Index.

<FIGURE 1 IS ABOUT HERE>

Beside the financial information, this study also anticipates that there would be
differentiation between the volatility of the gross profit, net earnings, biological assets,
agriculture products, and the profitability, between the entities that are using the cost
measurement and fair value measurement. This study anticipates that the financial information
reported would be smaller for entities that use the cost measurement compared to those entities
that are using the fair value measurement since the later provide more flexibility to the entities.
 This study then predicts the ability of the net earnings between the companies that are
using the cost method and fair value method. This study anticipates to find the predicting ability
of the net earnings for the entities that use the historical cost measurement are better than those
entities that use the fair value measurement. This study develops three models based on MAPE
to determine whether the predictions are true. In this study, MAPE is a measure of prediction
accuracy of a forecasting the effect of using fair value model and cost model on the biological
assets.

The models are:

Eij = β0 + β1.Eij-1 + εij

CFOij = β0 + β1.Eij-1 + εij
CFOij = β0 + β1.Eij-1 + β2.CFOij-1 + εij
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Eij = Net earnings for companies i for the year j

Eij-1 = Net earnings for companies i for the year j-1
CFOij = Operating Cash Flow for companies i for the year j
CFOij-1 = Operating Cash Flow for companies i for the year j-1
MAPE = Mean Absolute Percentage Error
Aij = Net earnings or Operating Cash Flow for companies i for the year j
Faij = Prediction of Net earnings or Operating Cash Flow for companies i for
the year j

4. RESEARCH DESIGN
4.1 Sample
This study uses the Roundtable on Sustainable Palm Oil (RSPO) agriculture companies
as the sample. RSPO is a non-profit organisation established in 2004 with the objective to
promote the growth and use of sustainable oil pal products through credible global standards and
engagement of stakeholders. The member of RSPO consists of the stakeholders coming from 7
palm oil industry sectors namely, Oil Palm Growers, Processors or Traders, Consumer Goods
Manufacturers, Retailers, Bank and Investors, Environmental and Conservatism NGOs and
Social and Development NGOs.
4.2 Data Collection
This study then relies on the annual reports of 38 companies from the Palm Oil Growers
over a 4 year period starting from 2011 to 2014. Most of these entities use historical cost
measurement to measure the biological assets. The data was then keyed-in and analysed using
SPSS. Before the data analysis, this study converted the financial information currency into US
Dollar in order to allow comparability on the financial information among the entities.
To analyse the data, this study relied on two analyses namely, the Mann-Whitney test and
linear regression. The Mann-Whitney test was used to investigate the information quality
differentiation between the companies that have used fair value measurement and those that have
used historical cost method. Linear regression was used to investigate the level of the net
earnings information predictive value.
 5. RESULTS
5.1 Financial Information Components
Table 1 presents the results of analysing the financial information components for the
entities using the Mann Whitney test. Financial information in this study includes gross profit,
net earnings, biological assets, agriculture products, profitability and earnings management. For
gross profit, the result shows that the entities that are using historical cost measurement have a
lower mean score of US352.928 million compared to the entities that are using fair value
measurement that have a mean score of US521.836 million. For net earnings, the result shows
that the entities that are using historical cost measurement have a lower mean score of
US145.626 million compared to the entities that are using fair value measurement that have a
mean score of US153.433 million. In terms of earnings management, the result shows that the
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entities that are using historical cost measurement have a lower mean score of US1,220 million
compared to the entities that are using fair value measurement that have a mean score of
US1,755 million. Only for profitability, the result shows that the entities that are using historical
cost measurement have a higher mean score of US0.076 million compared to the entities that are
using fair value measurement that have a mean score of US0.047 million.

<TABLE 1 IS ABOUT HERE>

The results shown in Table 1 indicates that the overall mean score for all financial information
except for profitability are lower for entities that are using the historical cost measurement for
the biological asset, compared to entities that are using the fair value measurement. Such
findings show that by using the fair value measurement, the companies will report the gross
profit, net earnings, biological asset, agricultural products, and earnings management higher.
Particularly for earnings management, the income smoothing index are higher for the companies
that use the fair value measurement. It represents that the use of the fair value measurement
increases the possibility to elevate the net earnings due to the flexibilities of the fair value
measurement determination. However, the results are not statistically significant. These results
support the empirical findings of Argileset al. (2011). The net earnings reported by the entities
that use the historical cost measurement in measuring the biological assets is lower compared to
the entities that use the fair value measurement. This study suggests that such findings exist due
to the unrealized gain (loss) from the changing of the biological assets fair value recognised by
the entities that use the fair value measurement. This study supports the findings by Argiles et al.
(2011) and Maruli (2010).
The results in table 1 also show that the entities that are using historical cost
measurement for biological asset and agriculture products have a lower mean score of
US490.624 and US211.352 million compared to the entities that are using fair value
measurement that have a mean score of US1029.343 million and US741.396 million
respectively. The results indicate that these two components are found to be higher for the
entities that are using the fair value measurement compared to those entities that are using the
historical cost measurement. This could happen because the fair value of the biological assets
and agricultural products tend to increase every year.
Table 1 also shows that the earnings management (income smoothing index) is higher for
those entities that use the fair value measurement. Such result supports the findings in Argiles et
 al. (2011), Maruli (2010) and Goncalves and Lopes (2015). This study indicates that the main
weakness of the fair value measurement is the non-availability of active market for some of the
biological assets. Since there is no active market, the entities have flexibilites in chosing certain
model in the fair value application.

5.2 Financial Information Components Volatility

Table 2 presents the results of analysing the financial information components volatility
standard deviation for the entities using the Mann Whitney test. Financial information in this
study includes gross profit, net earnings, biological assets, agriculture products, profitability and
earnings management. For gross profit, the result shows that the entities that are using historical
cost measurement have a lower mean score of US68.044 million compared to the entities that are
using fair value measurement that have a mean score of US83.563 million. For net earnings, the
result shows that the entities that are using historical cost measurement have a lower mean score
of US48.353 million compared to the entities that are using fair value measurement that have a
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mean score of US79.591 million. Only for profitability, the result shows that the entities that are
using historical cost measurement have a higher mean score of US0,041 million compared to the
entities that are using fair value measurement that have a mean score of US0,030 million.

<TABLE 2 IS ABOUT HERE>

Table 3 presents the results of analysing the financial information components volatility
variance for the entities using the Mann Whitney test. Financial information in this study
includes gross profit, net earnings, biological assets, agriculture products, profitability and
earnings management. For gross profit, the result shows that the entities that are using historical
cost measurement have a higher mean score of US0,294 million compared to the entities that are
using fair value measurement that have a mean score of US0,270 million. For net earnings, the
result shows that the entities that are using historical cost measurement have a lower mean score
of US0,574 million compared to the entities that are using fair value measurement that have a
mean score of US0,654 million. Similarly, for profitability, the result shows that the entities that
are using historical cost measurement have a lower mean score of US0,671 million compared to
the entities that are using fair value measurement that have a mean score of US0,695 million.

<TABLE 3 IS ABOUT HERE>

The results shown in Table 2 and Table 3 indicate that the volatility mean scores of the
gross profit, net earnings, and agricultural product are smaller for those entities that use the
historical cost measurement compared to the entities that use fair value measurement. Hence, for
the volatility mean score of the biological assets and profitability is higher for those entities that
use the historical cost measurement compared to those entities that use the fair value
measurement. The results support the findings of Argiles et al. (2011). The results confirm that
the agriculutural product value (inventory) using the fair value measurement is more fluctuative
compared to the historical cost measurement, in accordance to the fluctuation of the price of the
palm oil. Of consequence, it affects the gross profit of the entities.
From Table 3, it shows that the volatilily mean score of biological assets and agricultural
products is higher for the entities that use fair value measurement. This result supports the
findings in Herbohn and Herbohn (2006) that implied the conditions (the increasing of the
 volatility, manipulation, and the subjectitity) are the effect of the use the fair value measurement
according to IAS 41. However, the result is not statistically significant.

5.3 Fair Value versus Historical Cost Measurement

Table 4 displays the result of the regression analysis fort the companies that use historical
cost measurement for their biological asset The table shows the predictive value of the financial
information quality in terms of relevance when using historical cost measurement.

<TABLE 4 IS ABOUT HERE>

Table 5 on the other hand, displays the result of the regression analysis for companies
that used the fair value measurement for their biological asset. The table shows the predictive
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value of the financial information quality in terms of relevance when using historical cost
measurement.

<TABLE 5 IS ABOUT HERE>

Table 6 displays the result on examining the predictive value of relevance information
quality by comparing the predicting ability of information using the MAPE (mean average
percentage error). Based on the MAPE calculation, this study shows that companies using the
historical cost measurement for biological asset have higher MAPE compared to those
companies that are using the fair value measurement. The results imply that the predicting ability
of the historical cost measurement is smaller compared to the fair value measurement. The
results shown in study are consistent with Ball (2006) that found fair value measurement would
produce more relevance information. Similar findings are also found in Argiles et al. (2012) that
found fair value measurement as more reliable in the decision making process for an agriculture
company. However, such results are not consistent with the results shown in Argiles et al.
(2011), particularly for the operating cash flow predicting value. However, the results are not
statistically significant.

<TABLE 6 IS ABOUT HERE>

6. CONCLUSION
The objective of this study is to provide empirical findings on the fair value and historical
cost measurement in valuing biological assets and the implications towards financial information
quality. Using RSPO companies as research sample and conducting several tests, this study
concludes that the financial information volatility in terms of gross profit, net earnings,
biological assets, agricultural products and the earnings management is smaller for companies
that are using the historical cost measurement compared to those companies that are using the
fair value measurement. However, apart from profitability, this study shows no significant
evidence despite the difference on impact between the two measurements.
This study also concludes that the infomation predicting ability of the companies that use
the historical cost measurement is smaller than those companies that are using the fair value
measurement. This evidence implies that the fair value of the biological asset produce more
 relevant information in helping the investor perception in the decision making process. However,
the ability to predict information is not significantly between the two measurements.
This study is not without limitations. First, the sample of this study is the annual reports
of 38 agriculture companies over a 5 year period. In addition, some of the data in the annual
reports of the companies may be distorted due to retrospective adjustment. Future studies may
use a larger sample and consider the distortion of data since some of the companies make the
retrospective adjustment, but making restatement for only one previous year.
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 FIGURES AND TABLES

Figure 1: Fair value versus historical cost measurement on financial reporting quality
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 Table 1: Financial Information Components
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Table 2: Financial Information Components Volatility: Standard Deviation

Table 3: Financial Information Components Volatility: Variance

 Table 4: Historical Cost Measurement

Model 1: Eij = 0,955.Eij-1

Model 2: CFOij = 0,885.Eij-1
Model 3: CFOij = 0,721.Eij-1 + 0,184.CFOij-1
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Table 5: Fair Value Measurement

Model 1: Eij = 0,776.Eij-1

Model 2: CFOij = 0,369.Eij-1
Model 3: CFOij = 0,279.Eij-1 + 0,234.CFOij-1

Table 6: M A P E