Choosing Cost or Fair Value on Adoption of IFRS

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24th Sep 2020 Business Assignment Reference this

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Introduction 

This case discusses an investment property company based in France, Silic, faced with the option of preparing its investment properties either using the fair value model or historical cost model, upon adopting the International financial Reporting Standards (IFRS) as the basis for preparing their financial statements starting from January 1, 2005. Silic was an historic player on the French commercial property market whose strategy was operating and developing business parks as well as providing social amenities in these parks. Before this date, Silic as well as all publicly listed companies in France used their domestic French Accounting standards that obligated them to report their investment properties using the historical cost model. However, in June 2002, the Council of Ministers of the European Union permitted a regulation that obligated all companies listed on the European stock exchange to prepare their financial statements using IFRS starting from January 2005. IFRS introduced International Accounting standard 40 (IAS 40 Investment properties) that requires Silic to report its investment properties using fair value or cost model. This change would have a significant effect on their accounting practices (Demaria and Dufour, 2008) as it prompted an argument about the strengths and weaknesses of both accounting models. This essay will illustrate the accounting entries for two companies (that uses different accounting models) and how each model affects Silic’s income statement and balance sheet, the challenges that result from the impact of adopting the fair value model on previous years key performances, assess the best model to adopt for SILIC, which of the model provides more reliable and relevant information, financial challenges that results from using different accounting models.

Accounting Entries for France Realty and International Realty

The following are the accounting entries for France Realty and International Realty using different accounting models:

Accounting Entry 1

Note that: NI= Net Income, IP= Investment Property and FV= Fair Value.

Financial Analysis Challenges

Using different accounting models from the illustration above can lead to various financial analysis challenges. These challenges could be cultural, sectoral and strategic. First, the fair value model is not reliable and can be subject to manipulation by the management. It also brings about undue volatility in the financial statements and it does not represent current market prices. A lot of factors can cause fair value to increase the volatility of the financial statement which may be, the inherent volatility that is driven by change in the un in underlying economic conditions and is reflective of the changes in the value itself (KPMG, 2012). Prices can be inaccurate due to liquidity challenges, irrationality of investors and market inefficiencies. There is also a challenge of lack of consistency in the preparation of the financial statements. Historical cost does not take into consideration inflation, it uses outdated information that makes it irrelevant to the investors and other users of financial information. It would be difficult for financial analysts to understand the change from historical cost model to fair value model because it will create a change that leads to a disturbance in the figures and because of the cultural habit of using the historical cost model, financial analysis might be difficult. The association of French financial analysts have stated that the use of fair value accounting can confuse the interpretation of the operational results of a company. As discussed earlier, volatility erodes wears down the relevancy and reliability of information for investors, to be specific, the volatility may negatively influence the ability of the investors to confirm or correct expectations and form an understanding of previous and current events. This means that, implementing the fair value model may reduce the investor's ability to assess the economic risk of the company operations.

Trade-Off between Relevance and Reliability

Relevant Information; Fair Value Model

Relevance is an accounting principle that indicates the capacity of influencing the end users of the financial statements in their decision-making process. End users can be either internal or external stakeholders. Fair value model is more relevant than historical cost method because it provides up to date information consistent with market, thereby increasing transparency and encouraging   prompt corrective actions. Information is relevant when it has the power to make a difference in a decision, when it has feedback value and when it is timely such that it is available to decision makers before it loses the power to influence their decisions (Shamkutz, 2010). Investors find fair value model more relevant because it represents the current market value of asset and liability, it provides feedback value and it is timely. In today’s rapidly changing business environment, to be relevant, the financial statements should reflect the underlying economic reality of the companies rather than the summary of past transactions. Fair value model satisfies this condition while the historical cost model does not. Fair value model improves transparency, comparability, and the timeliness of accounting information. Historical cost model on the other hand, does not provide information that is relevant for the users of financial information such as the investors because the information it provides is out of date and does not consider the effect of increase in investment property value, which is relevant information to assess the value of investment property.

Reliable Information; Historical Cost Model

Reliability principle revolves around the idea that accounting records and statements are to be based on the most reliable data available so that they will be accurate and only then has usefulness. The historical cost model is more reliable than the fair value model because it is based on actual cost which was paid at the acquisition of the investment property and the recorded amounts are reliable, verifiable and free from management bias because it is harder to manipulate. Reliable data are accurate, unbiased, and therefore verifiable (Horngren, et al. 2002). Fair value on the other hand, is not as reliable due to the difficulty and subjectivity of future cash flows estimation. Fair value estimates based on inactive markets can prove to be unreliable and are subject to managerial manipulation due to subjective assessment involved in its estimation. The fair value model values the investment property based on estimates and similar investment property values which may be different from the actual value of the investment property. As such, the values will not be reliable due to the dependency on the market information. Fair value model lacks consistency, create volatility of earnings and high cost of training and development (Ramanna, 2013). Watts (2003) argues that fair valuation is subject to more manipulation and, accordingly, is a poorer measure of worth and performance than historical cost.

Effect of Fair Value Model on Balance Sheet and Income Statement

The fair value model records investment properties on the balance sheet at their current market value or fair value (the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date). The fair value should reflect the actual market state as at the balance sheet date. Depreciation, as well as any revaluation reserve is not recorded. All gains and losses that arises from changes in fair value of the investment property are recorded in the income statement. Under the fair value model, the income statement is like a residual of the balance sheet measurement. The only relevant and realistic method of recording transactions in the balance sheet and open disclosure of the transactions is by using the Fair value model (Arya & Reinstein, 2010). This is made evident in under the historical cost model, a whole range of assets and liabilities were not included in the balance sheet. This is due to the fact that they have little or no cost even though they could gain or lose value subsequently as circumstances change due to exchange rate, commodity price, interest rate and other factors. Under the fair value model, income statement portrays the economic income of the company because it shows the changes in the company’s value overtime. This is due to the fact that the fair value model provides more relevant and understandable information which is of great importance to the users of the information such as the shareholders and other stakeholders about the incomes, assets and liabilities of the firm in the financial statements more than the historical cost (Ashford, 2011). Thus, generally it can be argued that fair value model in the balance sheet provides effective value and that the income statement conveys information about management performance and exposure risk. Implementing the fair value model also restrict the company's ability to potentially manipulate its reported net income. For instance, at times the management may intentionally arrange certain asset sales, in order to use the gains or losses to increase or decrease net income as reported at its desired time (Skoda & Bilka, 2012). However, Fair value model has been faced with challenges such as increasing the volatility of the information in the financial statements which may wear away the relevance and reliability of information for investors (David, 2010).

Effect of Historical Cost Model on Balance Sheet and Income Statement

The historical cost model records investment properties on the balance sheet at cost less the accumulated depreciation and other impairment loss. Depreciation is charged in the income statement in the period in which the benefit occurs. Fair values must be disclosed in the footnotes. Any impairments require a reduction in the cost of investment property to its fair value, with the reduction reflected as an impairment charge on the income statement. In addition, under certain conditions, impairment charges can be reversed under international accounting standards in fundamental economic conditions and reflects changes in the value itself (KPMG, 2012). The balance sheets prepared under historical cost accounting, suffers from the impact of inflation. For example, since fixed assets in the balance sheets are valued at their historic cost, the assets are understated, they are stated at an amount that is much lower than their current amount. It should be noted that, the higher the rate of rising prices, the greater the understatements will be. The depreciation of these assets that are undervalued will also be undervalued and this would lead to the overstatement of the net income of the company (Wood and Sangster, 2008). Since the net income of a company based on historical cost model has been overstated, these incomes are going be taxed like that, which leads to companies having a shortage of hard currency and insufficient finance available for future operations. In conclusion, there are shortages and exaggerations in historical cost-based balance sheet and income statements (Alexander and Nobes, 2007).

Impact of adopting the Fair-value model on previous years’ Key Performance Metrics

Adopting the fair value model implies that gains and losses arising from change in the fair value of an investment property must be included in the net profit or loss of the period in which it arises. Revaluation gains and losses would form part of the operating results and should, therefore, be disclosed in arriving at operating profit. Adopting the fair value model will have an impact on previous years key performance metrics such as EBITDA and operating profit. For the operating profit, the impact of adopting fair value is that the depreciation will still use the straight-line method over 10 years using the fair value model. Also, Silic has made a gain that has increased their operating profit as shown in the diagram below, the operating profit has increased from 2003 to 2004 by 1.4%, this increase is due to an increase in the EBITDA. The impact of adopting the fair value model on EBITDA is that it has led to an increase in the EBITDA arising from an increase in the turnover of Silic as well as increased income and expenses.

Conclusion and Discussion

In conclusion, the introduction of the fair value model upon the adoption of IFRS by Silic has left the investment company with the option of choosing between fair value model and historical cost model. This, however, infers both advantages and disadvantages. On one hand, fair value model is more relevant than historical cost model because it represents the current market value of asset and liability, provides feedback value and it is timely unlike historical cost model that provides out of date information. On the other hand, Fair value model is unreliable because of how difficult and subjective estimations of future cash flows is to managerial manipulation unlike the historical cost model which is reliable because it is based on actual figures paid while acquiring the investment properties. After proper analysis of the advantages and disadvantages of both models, it is safe to say that fair value model is the best model to report the investment property of Silic. Therefore, as the CEO of Silic, I would adopt the fair value model that gives more relevant information in the financial statements due to many reasons. First, the fair value model gives a more accurate balance sheet and income statement by giving an accurate asset and liability valuation on a continuing basis to users of the company's reported financial information. Thus, the investors can obtain more relevant and accurate information under the fair value model.  Using this model, gains or losses from any price change for an asset or liability are reported in the period in which they occur. This limits the company’s management to possibly manipulate its net income Also, I would adopt the fair value model because it provides information that is up to date and consistent with the current market values, thus increasing transparency and encouraging actions. Due to the rapidly changing business environment that we have today, the financial statements should not reflect values of past transactions, rather it should reflect current values that shows the economic reality of companies. Fair value improves transparency, timeliness of accounting information and comparability (Schipper 2005). However, the fair value model is open to improvements and should be improved. The preparer and users of the model should make themselves more familiar with the accounting models and implement them rather carefully and effectively and employ them more often.

References

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