Does Fair Value Accounting For Non-Financial Assets Pass The Market Test PDF

Rev Account Stud (2013) 18:734775
DOI 10.1007/s11142-013-9232-0
Does fair value accounting for non-financial assets pass

the market test?
Hans B. Christensen Valeri V. Nikolaev
Published online: 29 May 2013

Springer Science+Business Media New York 2013
Abstract The choice between fair value and historical cost accounting is the
subject of long-standing controversy among accounting academics and regulators.
Nevertheless, the market-based evidence on this subject is limited. We study the
choice of fair value versus historical cost accounting for non-financial assets in a
setting where market forces rather than regulators determine the outcome. In gen-
eral, we find a very limited use of fair value accounting. However, the observed
variation is consistent with market forces determining the choice. Fair value
accounting is used when reliable fair value estimates are available at a lower cost
and when they convey information about operating performance. For example, with
very few exceptions, firms managers commit to historical cost accounting for plant
and equipment. Our findings contribute to the policy debate by documenting the
market solution to one of the central questions in the accounting literature. Our
findings indicate that, despite its conceptual merits, fair value is unlikely to become
the primary valuation method for illiquid non-financial assets on a voluntary basis.
Keywords Fair value IFRS Non-financial assets Illiquid assets
JEL Classification M4 M41
This paper previously circulated under the title: Who uses fair-value accounting for non-financial assets
after IFRS adoption?
H. B. Christensen (&) V. V. Nikolaev

Booth School of Business, The University of Chicago, 5807 South Woodlawn Avenue, Chicago,
IL 60637, USA
e-mail: hchrist2@Chicagobooth.edu
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Fair value accounting 735
1 Introduction
The choice between fair value and historical cost accounting is one of the most
widely debated issues in the accounting literature. While the debate dates back to
the 1930s (Paton 1932; pp. 739747; Fabricant 1936), it is still unsettled (e.g.,
Schipper 2005; Ball and Shivakumar 2006; Watts 2006; Laux and Leuz 2009; Hail
et al. 2010). One impediment to moving the debate forward is the lack of evidence
on the choice between the two accounting practices, when the choice is determined
by market forces rather than regulators (Kothari et al. 2010). We exploit a quasi-
experiment embedded in the recent mandatory adoption of the International
Financial Reporting Standards (IFRS) to study the market solution for the choice
between historical cost and fair value accounting methods. Our approach follows
Leftwich (1983), who documents that private markets often differ from regulators in
their accounting method choice.
Our setting has a number of advantages. First, unlike most other accounting
standards, IFRS provides a free choice between fair value and historical cost
accounting for non-financial assets. The second and more important advantage of
the current setting is that IFRS requires ex ante commitment to one of the two
accounting policies.1 It is, ex ante, in managements interest to limit the scope for
future opportunistic actions, e.g., earnings management (Jensen and Meckling 1976;
Watts 1977; Watts 1986; Ball 1989). Therefore firms managers have stronger
incentives to respond to market demands and commit to the accounting treatment
that maximizes the value of the firm, i.e., is more efficient.2
We study valuation practices for arguably the most controversial (non-financial)
asset groups: property, plant and equipment (PPE), investment property, and
intangibles. Out of the twenty-nine European countries that mandated IFRS from
2005, we select the United Kingdom (UK) and Germany because they have the
largest financial markets in Europe and are historically at opposite ends of the
spectrum in terms of using fair value accounting under the local GAAP.
Specifically, for non-financial assets, German GAAP allows only historical cost
accounting, whereas UK GAAP either allows (for PPE) or mandates (for investment
property) fair value accounting. As a result, IFRS expands the available valuation
practices in both the UK and Germany. Indeed, under IFRS, both fair value and
historical cost are allowed for PPE and investment property and, if an active market
exists, for intangibles.3 The free choice under IFRS allows managers representing
outside stakeholders to reveal preferences with respect to valuation practices.
1
A number of prior studies have examined settings where firms were not required to commit to either
fair value or historical costs but could ex post revalue non-financial assets. Evidence from the US prior to
1940 is provided in Fabricant (1936) and ARB (1940). Evidence from Australia is provided in Whittred
and Chan (1992), Brown et al. (1992), Easton et al. (1993), Cotter and Zimmer (1995), and Barth and
Clinch (1996, 1998). Evidence from the UK is provided in Amir et al. (1993), Barth and Clinch (1996),
Aboody et al. (1999), Muller (1999), and Danbolt and Rees (2008).
2
Note that distinguishing between opportunism and value maximizing explanations is central to
understanding accounting choices but rarely achieved in practice (Fields et al. 2001).
3
An active market rarely exists for intangibles and hence the managerial choice of valuation policies for
intangibles cannot be consider as free as for PPE and investment property.
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736 H. B. Christensen, V. V. Nikolaev
To better understand whether preferences revealed by the managers reflect

market demand and supply forces, we analyze the observed choices from an
economic cost-benefit perspective. On the demand (benefit) side, fair value
accounting seems superior to historical cost on most qualitative characteristics
described in the Financial Accounting Standard Boards (FASB) conceptual
framework (e.g., Herrmann et al. 2006). The only exception is, arguably, the
reliability criterion on which historical cost is likely to score higher. Indeed,
consistent with the merits of fair value outweighing the cost of potentially lower
reliability, some commentators have explicitly or implicitly criticized the Securities
and Exchange Commissions (SEC) de facto ban on upward revaluations of non-
financial assets in effect since 1940 (see Graham and Dodd 1951; Weston 1953;
Paton and Dixon 1958; Herrmann et al. 2006). Therefore our prediction is that the
IFRS adoption is associated with a significant shift towards fair value accounting for
non-financial assets among firms that were constrained to historical cost accounting
under local GAAP.
We test a number of cross-sectional predictions focusing on the cost-benefit
tradeoffs between the two valuation practices. First, we expect that local economic
institutions influence the market solution in a predictable manner. Second, as
reliability is the principal dimension on which historical cost arguably dominates
fair value, the costs of constructing reliable fair value estimates are expected to be a
key cross-sectional determinant of the choice between the two accounting practices.
We predict that fair value accounting is more likely chosen for property than other
non-financial assets because property markets are generally more liquid. Our third
prediction is that managers are more likely to adopt fair value when it facilitates
performance measurement: (1) value changes in investment property are informa-
tive of operating performance when capital gains are part of the business model, and
thus we expect the use of fair value among real estate firms that hold investment
property; (2) fair value adversely affects key performance measures (e.g., ROA) if
the management chooses to hold unproductive assets (assets with high value in
alternative use) and thus can benefit in governing firms lacking investment
opportunities. Finally, we expect that reliance on debt-financing influences the
choice of fair value: on the one hand debtholders can demand a greater degree of
verifiability, but, on the other hand, they also require estimates of the value of the
collateral. We elaborate on these predictions in Sect. 3.
To test the above predictions, we manually collect data on valuation practices used
in Germany and the UK around the IFRS adoption. Our sample comprises the
Worldscope universe of companies domiciled in the UK and Germany for which we
can obtain an annual reportin total 1,539 companies. We identify the valuation
practices by reading the accounting policy sections of the companies annual reports.
Our findings are as follows: (1) for PPE, we find that only 3 % of the sample
firms use fair value accounting for at least one asset class following the IFRS
adoption. With very few exceptions, these companies use fair value accounting for
the property asset class only; members of the plant and equipment asset classes are
valued at historical cost in almost all cases. An even more striking observation
emerges for companies that used fair value under local GAAP: 44 % of these firms
switch to historical cost accounting upon the IFRS adoption. In contrast, among
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companies that previously recognized all PPE asset classes at historical cost under
the local GAAP, only 1 % switches to fair value for at least one asset group; (2) for
investment property (i.e., property held for the purpose of earning rental income or
for capital appreciation), we find that companies are equally likely to use historical
cost and fair value accounting; (3) for intangible assets, we find that all firms in the
sample pre-commit to historical cost, consistent with the stricter requirements under
IFRS for valuing intangibles at fair value. Overall, our results do not support the
prediction that firms managers find the shift towards fair value accounting to be a
beneficial commitment.
However, further tests do indicate that the choice to use fair value varies
meaningfully with its economic costs and benefits. Consistent with our first
prediction, we find that institutional differences are important determinants of the
choice to use fair value. Consistent with the second prediction, managers use fair
value when the costs of obtaining reliable estimates are relatively low, i.e., for more
liquid (or re-deployable) assets such as property and investment property.
Consistent with our third prediction, fair value is more common when it is
expected to facilitate performance measurement. Specifically, we find that for firms
holding investment property, the fair value choice is positively associated with real
estate being a primary activity. We also find some evidence that companies with
lower investment opportunities use fair value. Finally, the reliance on debt financing
is positively associated with the use of fair value for both investment property and
PPE. This finding is robust and holds both when measuring the reliance on debt by
leverage and the frequency of accessing debt markets. In sum, while our evidence
suggests that market supply (cost) and demand (benefit) factors influence the choice
of fair value versus historical cost accounting, historical cost is by far the dominant
accounting practice when market forces determine the outcome of the choice.
Our paper contributes to the policy debate over fair value accounting by
documenting a market solution for the choice between historical cost and fair value
for non-financial assets. Understanding the market solution provides input into
regulators decision-making. While markets are, generally, more efficient at
coordinating economic choices than regulators, potential market failures should
be considered. First, the choice should be exercised under the principles of free
exchange and in the absence of externalities (e.g., coercion on part of auditors or
industry organizations). Second, if free markets fail to discipline management to
promote the interests of outside investors, e.g., due to governance failure or the
presence of information asymmetry, managers may choose accounting practices
opportunistically (in their private interest). However, for over 95 % of managers to
choose historical cost opportunistically, the governance (market) failure should take
a rather extreme form. Two additional features of our setting render opportunism
unlikely: (1) the IFRS requirement to pre-commit to either fair value or historical
cost and (2) the absence of information asymmetry between the principal (investors)
and the agent (management) with respect to the agents actions (choice of
accounting practice). For these reasons, management is likely to ultimately bear the
cost of opportunism and to be subject to market discipline in our setting.
Nevertheless, we cannot rule out opportunism as an explanation for observed
managerial choices. Furthermore, the efficient market solution may take some time
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to evolve.4 When making policy decisions, regulators need to consider potential

market frictions and their effect on the reporting choices.
We also contribute to the debate over fair value by complementing the studies
that document benefits of fair value accounting for non-financial assets such as
increased value relevance and information content (Sharpe and Walker 1975;
Standish and Ung 1982; Easton et al. 1993; Barth and Clinch 1996, 1998; Aboody
et al. 1999; Danbolt and Rees 2008), reduced information asymmetry (Muller et al.
2011), and increased comparability (Cairns et al. 2011). Our findings suggest that
the choice to use fair value is not random and occurs when benefits outweigh the
costs. Yet our evidence suggests that the vast majority of managers find the net
benefits from fair value accounting to be rather limited. Indeed, our evidence is
consistent with opportunistic revaluations of non-financial assets documented in
settings where fair value accounting is mandatory (e.g., Ramanna and Watts 2012)
and the acclaimed opportunism in revaluations in the 1920s, which initially
motivated the SEC to ban upward revaluations in 1940 (Zeff 1995, 2007).5
Section 2 describes the accounting traditions in the UK and Germany, as well as
the valuation methods available to companies under German GAAP, UK GAAP,
and IFRS; Sect. 3 develops testable hypotheses; Sect. 4 describes the sample
selection procedure and presents our results; and Sect. 5 summarizes the findings
and discusses the implications.
2 Distinctions of the IFRS-based setting and the institutional details
2.1 Fair value under IFRS versus settings in prior literature
The current setting that exploits the IFRS adoption has a valuable distinction from
the Australian, UK, and US settings used in prior research. The choice between
historical cost and fair value must be stated in the accounting policy section of the
annual report following the IFRS adoption and must be applied consistently going
forward (analogous to revenue recognition or inventory valuation methods).6 A
company that chooses to use fair value must revalue assets every time the book
value materially differs from the market value (IAS 16 and IAS 40). A company that
chooses historical cost cannot perform upward revaluations in the future. A switch
between historical cost and fair value is considered a voluntary change in
accounting principles and needs to be justified to auditors, lenders, equity investors,
and potentially to regulators. Therefore the choice between fair value and historical
cost in our setting effectively represents an ex ante commitment and as such is
unlikely to be driven by earnings management considerations. Indeed, the early
studies argued that discretionary revaluations are related to contracting motives
4
Due to the costs of data collection, we only have evidence from the first year of IFRS adoption.
5
Agents have incentives to pre-commit against ex post opportunism if a pre-commitment mechanism
existsotherwise the agent will bear the costs (Jensen and Meckling 1976). Under IFRS, historical cost is
a pre-commitment mechanism against future revaluations.
6
Note that both the UK and Australia adopted accounting standards in 1999 and 2000 that are similar to
IAS 16. However, the prior literature relies on data before this change.
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consistent with the finding that leveraged companies in danger of violating

covenants are more likely to revalue assets (Brown et al. 1992; Whittred and Chan
1992; Cotter and Zimmer 1995).7
The problem with discretionary revaluations is that managers decide whether to
revalue assets after they know the effect of the fair value estimate on the financial
statements. For instance, managers may only revalue assets when they need to
manipulate reported performance. Alternatively, managers may revalue assets when
reliable fair value estimates are available. Our setting isolates this issue as we
examine ex ante choices to use fair value with limited ex post discretion to change
the valuation method. Ex ante, the pre-commitment to contracting (accounting)
practices that minimize agency costs is optimal from the standpoint of managers
(Jensen and Meckling 1976; Watts 1986). Thus pre-commitments to fair value are
more likely to be informative about firm-specific net benefits, rather than managerial
opportunism, as compared to ex post revaluations.
2.2 Accounting in the UK and Germany
Despite the EUs accounting harmonization efforts that began decades prior to the
mandatory IFRS adoption, the UK and Germany arguably have two of the most
distinct traditions for asset valuation. The differences in their accounting traditions
are due to institutional differences in economic, governance, and legal systems.
Germany was traditionally characterized by the existence of private companies that
raised capital from banks and communicated via private information channels (Leuz
and Wustemann 2004). Accounting was mainly used for profit distribution and tax
purposes; hence accounting regulation was codified and focused mainly on legal
entity statements. As revaluations are often in conflict with the objectives of tax
authorities and are not available for distribution until realized, German GAAP only
allowed historical cost accounting. Today in Germany, there is no formal link
between legal entity reports and consolidated financial statements. Thus financial
reporting choices in the consolidated statements, including the valuation methods
for non-financial assets, have no tax consequences.
In contrast, the UKs accounting practices have historically developed separately
from tax accounting and in the private sector rather than in company law. UK
ownership is dispersed, and even middle-sized companies are commonly listed on
the London Stock Exchange. Such an ownership structure requires that financial
reporting reduces information asymmetry, and in this context revaluations can serve
the purpose of conveying information about the assets current values.
Table 1 summarizes the permitted accounting treatments for non-financial
assetsinvestment property, PPE, and intangible assetsunder UK GAAP,
German GAAP, and IFRS. In brief, German GAAP prescribes historical costs for
all three asset groups, whereas UK GAAP allows a choice between fair value and
historical costs for PPE and intangibles but requires fair value for investment
7
Whittred and Chan argue that asset revaluations reduce underinvestment problems that arise from
contractual restrictions, while Cotter and Zimmer argue that upward revaluations increase borrowing
capacity. While debt contracting is the main explanation for asset revaluations, Brown et al. also find that
bonus contracts, as well as signaling and political cost explanations, play important roles.
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Table 1 The accounting treatment of long-term non-financial assets under German GAAP, UK GAAP,
and IFRS
Asset type German GAAP UK GAAP IFRS
Balance Income Balance Income Balance Income

sheet statement sheet statement sheet statement
Property, plant HC Depreciations/ HC or Both HC and HC or FV Both HC and

and impairments/ FV FV: FV:
equipment realized Depreciations/ Depreciations/
(PPE) gains and impairments/ impairments/
losses realized gains realized gains
and losses and losses
Investment HC Depreciations/ FV Depreciations/ HC (with If HC:
property impairments/ impairments/ disclosure Depreciations/
(land and realized realized gains of FV in impairments/
buildings gains and or losses footnotes) realized gains
held for losses or FV and losses
rental If FV: Gain and
income or losses in
capital operating
appreciation) income
regardless of
realized or
unrealized
Intangible HC Amortizations/ HC or Both HC and HC or FV (if Both HC and
assets impairments/ FV (if FV: active FV:
realized active Amortizations/ market Amortizations/
gains and market impairments/ exists) impairments/
losses exists) realized gains realized gains
or losses or losses
FV is defined as fair value accounting, and HC is defined as historical cost accounting adjusted for depreciations,
amortizations, and impairments
property. In contrast, IFRS allows a choice between fair value and historical costs
for all three asset groups, although an active market is a requirement for using fair
value for intangibles. See Appendix 1 for a detailed explanation of the accounting
treatments under each accounting regime.
3 Empirical predictions
The choice between fair value and historical cost accounting of accounting standard
setters such as the FASB and the International Accounting Standards Board (IASB)
is guided by their conceptual frameworks that emphasize and promote the decision-
usefulness of accounting information. The decision-usefulness perspective faces a
central trade-off between the relevance and the reliability of accounting informa-
tion.8 In recent years, both FASB and IASB have emphasized relevance as more
important than reliability and it has manifested itself in a shift towards fair value
8
See IASBs Framework paragraph 45 and FASBs Conceptual Statement 2 paragraph 15. Phase A of
the IASB-FASB Joint Project was completed in September 2010 and resulted in a statement that
superseded the documents cited in the previous sentence. However, despite changes in definitions the
123
accounting.9 This change in focus is reflected, for example, in the conclusion of a

discussion of relevance and reliability by L. Todd Johnson, a senior project manager
at FASB:
The Board has required greater use of fair value measurements in financial
statements because it perceives that information as more relevant to investors
and creditors than historical cost information. Such measures better reflect the
present financial state of reporting entities and better facilitate assessing their
past performance and future prospects. In that regard, the Board does not
accept the view that reliability should outweigh relevance for financial
statement measures (Johnson 2005).
Fair value measurement is justified on the grounds of being more relevant for
the decisions by users of financial statements. For example, revaluations to fair
value allow managers to convey their private information on asset values
(Aboody et al. 1999). Fair value is also argued to improve transparency,
comparability, and the timeliness of accounting information (Schipper 2005). In
line with the benefits of fair value accounting, many studies on asset revaluations
find that fair value possesses superior relevance. These studies find that upward
revaluations have a positive association with equity returns in the month of the
revaluation (Sharpe and Walker 1975; Standish and Ung 1982) and that they
have association with long-window stock returns, future cash flows, and the
market value of equity (e.g., Amir et al. 1993; Easton et al. 1993; Barth and
Clinch 1996, 1998; Aboody et al. 1999; Danbolt and Rees 2008). In contrast,
historical cost is likely to conceptually dominate fair value on the reliability
dimension (Herrmann et al. 2006).10
An important question that remains unanswered, however, is whether, in a free
market for accounting principles, managers choose fair value over historical cost.
Managers, who represent outside stakeholders, have economic incentives to respond
to market demands and to select a set of accounting principles that reflect the
interests of the firms stakeholders. Thus the observed choices represent the market
solution to fair value vs. historical cost accounting. IFRS offers an opportunity to
examine whether the observed choices by firms management are consistent with
IASBs (and FASBs) shift towards fair value accounting in accounting standards.
In such a case, one should expect that the IFRS adoption is associated with a shift
towards fair value accounting for non-financial assets.
Footnote 8 continued
fundamental trade-off between relevance and reliability remains. For consistency with prior research and
the quote we provide, we use the definitions from the superseded documents cited in this footnote.
9
See for example IASB Discussion Paper July 2006, paragraph BC2.62.
10
Barth et al. (2001) argue that the value relevance tests are joint tests of relevance and reliability,
because a certain degree of reliability is also established by rejecting the null of no association. Although
value relevance tests establish a minimum level of reliability of observed revaluations, the level is
presumably below the reliability of historical cost where the accounting treatment is generally
inexpensive to verify.
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3.1 Cross-sectional predictions
Next, we examine whether managements decision to use fair value is explained by

market supply and demand factors related to the costs and benefits of fair value
accounting. In a free market, fair value is expected to be used when the economic
benefits net of its costs compare favorably to those of historical cost accounting.
First, as discussed earlier, there are important distinctions in economic and legal
institutions across the UK and Germany. While we cannot exploit variation in the
institutional factors because we only have two countries, we do expect that the
market solution will exhibit important differences across the two countries (Ball
2006). In particular, based on the discussion in Sect. 2.2 we expect that the German
economic institutions are less suitable to fair value accounting than the UK
economic institutions.
H1: Fair value is more likely to be used in the UK than Germany following the
IFRS adoption.
Second, the effort and resources a company needs to expend to obtain reliable
fair value estimates are likely to play an important role in determining a managers
choice of valuation practice. The ability to obtain reliable fair value estimates is
closely related to the existence of liquid markets for assets that provide an
independent source of verification (Watts 2006). Because property is typically more
re-deployable than other non-financial assets and has relatively liquid markets
(Shleifer and Vishny 1992), we predict that fair value is more frequently used as a
valuation practice for property relative to other non-financial assets.
H2: Managers are more likely to choose fair value accounting for property than
plant, equipment, and intangible assets.
On the benefit side, we expect fair value accounting to be used when it is more
likely to facilitate performance measurement and hence to be useful in evaluating a
firms management. Whether fair value dominates historical cost in this regard is
likely to depend on how an asset is used. If a firm derives significant profit from
trading the asset, fair value is likely to provide a better measure of periodic income
than historical cost. In contrast, if the company intends to hold the asset and to
generate income from its use, then historical costs is likely to be preferable. For
instance, changes in the value of investment property are likely informative about
the operating performance of firms that primarily invest in real estate, because
realizing capital gains is often part of their business model.
The definition of PPE excludes assets held for the purpose of sale.11 However,
fair value for PPE can still improve performance measurement because it disciplines
investment policies among companies with relatively few investment opportunities.
Such firms can be prone to overinvestment (or the failure to discontinue bad
projects) because the historical cost does not reflect the investments opportunity
costs, e.g., a companys headquarters purchased many years ago may be fully
11
IAS 16 does not apply to assets classified as held for sale. They are accounted for in accordance with
IFRS 5.
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depreciated. In contrast, fair value forces managers to incur rent on their

investments current values, regardless of the time of purchase and their historical
costs. More generally, common accounting metricsfor example, return on assets
or return on investmentare more likely to reflect economic performance under fair
value because the depreciated cost (which is usually lower than market value) does
not account for the value in alternative use (see Appendix 4). In other words, fair
value accounting dilutes the return on assets, makes it more costly for management
to hold unproductive assets, and can improve performance measurement (subject to
reliability concerns). This leads to our third prediction.
H3: Fair value is more likely to be used when recognizing asset-value changes in a
timely manner facilitates performance measurement.
Finally, we explore whether reliance on debt financing influences the use of fair
value accounting. On the one hand, debt holders have a demand for reliable
information as it limits the extent of managerial discretion in accounting
measurement (e.g., Watts 2003). To this end, they are likely to favor contracts
written in terms of historical-cost-based measures. At the same time, most contracts
exclude the revaluation reserve and hence contracting, in the case of PPE, is not
directly influenced by fair value accounting (Citron 1992). On the other hand,
companies that access debt markets are commonly required, under their credit
arrangements, to provide valuations of collateral and thus are likely to face a
demand for fair value accounting. Furthermore, the fact that lenders are willing to
lend against their asset valuations implies that a company can measure them reliably
(e.g., invests in independent valuation and certification).12 In this case, also
recognizing the fair value estimates of these assets in general purpose financial
statements is associated with low incremental costs (Holthausen and Watts 2001).
This yields our fourth hypothesis.
H4: Fair value accounting has an association with reliance on debt financing.
4 Results
4.1 Sample selection
We manually verify the accounting standards that a given company follows in either
the accounting policy section or the auditors opinion section of its annual reports.
To identify the asset valuation practice a company follows, we read the accounting
policy section of its annual reports. We begin with all the UK and German
companies (active and inactive) available in Worldscope and further restrict the
sample to the companies that comply with IFRS in either 2005 or 2006. For
inclusion in the German and UK cross-sectional samples, we further require that a
company has an annual report under IFRS in Thomson One Banker. We construct a
12
Cotter and Richardson (2002) and Muller and Riedl (2002) document that fair value estimates
produced by independent valuators are viewed by capital markets as being more reliable than fair value
estimates produced by managers.
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cross-sectional sample to examine the valuation practices after the mandatory IFRS
adoption and a switch sample (UK only) to examine whether companies use the
IFRS adoption to switch their accounting practices. For inclusion in the UK switch
sample, we also require that a company has an annual report (prepared according to
UK GAAP) before the IFRS adoption.13
Table 2, Panels A and B, present the distribution by industry of the companies in
Worldscope as well as in the German sample, the UK cross-sectional sample, and
the UK switch sample. The industry distribution in each sub-sample approximates
that of Worldscope.
4.2 Valuation practices
In this section, we provide evidence on the prevalence of valuation practices in the

UK and Germany. A company is classified as applying fair value accounting if it
recognizes at least one asset class (within an asset group) at fair value. Similarly, a
company is classified as applying historical cost if it recognizes at least one asset
class (within an asset group) at historical cost. Appendix 2 presents examples of
fair value accounting and historical cost accounting for PPE, whereas Appendix 4
suggests that application of fair value has an economically significant association
with financial ratios.
4.2.1 Valuation practices in the UK
Table 3 documents the valuation practices in the UK cross-sectional sample. We

identify a complete absence in the use of fair value accounting for intangible assets;
instead, all companies in our sample rely on historical cost for this asset group. For
PPE, 5 % of companies use fair value accounting while all companies use historical
cost for at least one asset class within this asset group. We observe that the fair value
use differs across industries, with higher concentration in the financial sector.
Table 4 presents the results from the UK switch sample. For PPE, we find that
6 % of companies use fair value under UK GAAP and 5 % use fair value under
IFRS. A large number of switches occur for this asset group. Specifically, 44 % of
the companies that use fair value for at least one asset class in PPE under UK GAAP
switch to historical cost (for all asset classes) upon the IFRS adoption. In contrast,
only 1 % of companies that use historical cost for all asset classes under UK GAAP
switch to fair value for at least one asset class upon IFRS adoption. The joint
evidence in both tables implies that, almost uniformly, the market solution is given
by historical cost accounting.
An intriguing question is why 44 % of the firms that used fair value under UK
GAAP switched to historical costs upon the IFRS adoption. IFRS and UK GAAP are
very similar when it comes to the valuation of PPE (see Sect. 2.2 and Appendix 1).
13
For companies both in Germany and the UK, we obtain their first annual report under mandatory IFRS,
which is typically for fiscal year 2005. In addition, for companies in the UK, we look for their last UK
GAAP annual report, which is typically for fiscal year 2004. In the rare cases where we cannot find these
annual reports, we take the next annual report available in Thomson One Banker (e.g., for fiscal year
2006).
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Table 2 Sample selection process
Panel A: UK samples
Active companies (March 2008) 2,312

Inactive companies (March 2008) ?5,597
UK listed companies in Worldscope 7,909
Fair value accounting
Companies that Worldscope does not classify as complying with IFRS in 2005 or 2006 (mainly inactive companies) 6,464
IFRS companies 1,445
Companies not domiciled in the UK 270
UK companies subject to mandatory IFRS 1,175
Companies for which we cannot identify an IFRS annual report or companies with more than one security listed on LSE 241
UK cross-sectional sample 934
Companies for which we cannot identify a UK GAAP annual report 231
UK switch sample 703
No. Industry name UK Worldscope UK IFRS UK cross-sectional UK switch
All All Excl. N/A

Obs. % % Obs. % Obs. % Obs. %
Industry distribution in the UK samples

N/A No industry classification 3,139 40
13 Aerospace 19 0 0 11 1 5 1 5 1
16 Apparel 42 1 1 7 1 7 1 6 1
19 Automotive 44 1 1 6 1 6 1 5 1
22 Beverages 50 1 1 11 1 7 1 5 1
25 Chemicals 106 1 2 24 2 20 2 18 3
28 Construction 234 3 5 65 5 54 6 49 7
31 Diversified 48 1 1 8 1 6 1 6 1
745
123
Table 2 continued
746
No. Industry name UK Worldscope UK IFRS UK cross-sectional UK switch
123
All All Excl. N/A
Obs. % % Obs. % Obs. % Obs. %
34 Drugs, cosmetics, and healthcare 178 2 4 52 4 44 5 31 4

37 Electrical 55 1 1 13 1 10 1 6 1
40 Electronics 539 7 11 136 11 109 12 90 13
43 Financial 674 9 14 187 16 140 15 105 16
46 Food 107 1 2 27 2 23 2 21 3
49 Machinery and equipment 141 2 3 22 2 22 2 16 2
52 Metal producers 213 3 4 59 6 49 5 23 3
55 Metal product manufacturers 63 1 1 15 1 12 1 11 2
58 Oil, gas, coal, and related services 251 3 5 64 6 52 6 29 4
61 Paper 44 1 1 9 1 6 1 5 1
64 Printing and publishing 92 1 2 25 2 19 2 16 2
67 Recreation 294 4 6 51 4 41 4 32 5
70 Retail 211 3 4 56 4 51 5 43 6
73 Textile 53 1 1 10 1 8 1 6 1
76 Tobacco 10 0 0 6 0 3 0 3 0
79 Transportation 73 1 2 19 2 17 2 14 2
82 Utilities 232 3 5 62 6 31 3 23 3
85 Other industries 997 13 21 230 18 192 21 135 19
Total 7,909 100 100 1,175 100 934 100 703 100
H. B. Christensen, V. V. Nikolaev
Table 2 continued
Panel B: The German sample
Active companies (March 2008) 1,437

Inactive companies (March 2008) ?10,126
German listed companies in Worldscope 11,563
Companies that Worldscope does not classify as complying with IFRS in 2005 or 2006 (mainly inactive companies) -10,117
IFRS companies 1,446
Companies not domiciled in Germany -635
German companies subject to mandatory IFRS 811
Companies for which we cannot identify an IFRS annual report -206
German sample 605
No. Industry name German Worldscope German IFRS German sample
All All Excl. N/A

Obs. % % Obs. % Obs. %
Industry distribution in the German sample

N/A No industry classification 2,192 19% N/A N/A N/A N/A N/A
13 Aerospace 25 0 0 2 0 1 0
16 Apparel 72 1 1 19 2 11 2
19 Automotive 99 1 1 18 2 10 2
22 Beverages 93 1 1 11 1 9 1
25 Chemicals 207 2 2 34 4 16 3
28 Construction 235 2 3 34 4 22 4
31 Diversified 74 1 1 12 1 8 1
34 Drugs, cosmetics, and healthcare 610 5 7 36 4 25 4
37 Electrical 143 1 2 21 3 13 2
747
123
Table 2 continued
748
No. Industry name German Worldscope German IFRS German sample
123
All All Excl. N/A
Obs. % % Obs. % Obs. %
40 Electronics 1,832 16 20 95 12 78 13
43 Financial 1,430 12 15 131 16 96 16
46 Food 154 1 2 11 1 8 1
49 Machinery and equipment 324 3 3 69 9 54 9
52 Metal producers 251 2 3 1 0 1 0
55 Metal product manufacturers 108 1 1 10 1 6 1
58 Oil, gas, coal, and related services 323 3 3 9 1 5 1
61 Paper 69 1 1 9 1 6 1
64 Printing and publishing 78 1 1 6 1 6 1
67 Recreation 371 3 4 30 4 25 4
70 Retail 350 3 4 23 3 17 3
73 Textile 46 0 0 8 1 5 1
76 Tobacco 16 0 0 0 0 0 0
79 Transportation 148 1 2 10 1 7 1
82 Utilities 497 4 5 25 3 20 3
85 Other industries 1,816 16 19 187 23 156 26
Total 11,563 100 100 811 100 605 100
Table presents the sample selection process and industry distribution. Panel A presents the selection process for the UK samples. The cross-sectional sample consists of
companies for which we can identify an annual report according to IFRS. Our switch sample further requires that an annual report (according to UK GAAP) be available
prior to mandatory IFRS adoption. Panel B presents the selection process for the German sample. To be included in the German sample, companies must have available an
annual report according to IFRS. Percentages are rounded and thus may not exactly sum to 100 %
Table 3 UK companies valuation practices after IFRS adoption

No. Industry name Cross- Property, plant, and Intangible assets
sectional equipment
sample
With Historical Fair With Historical Fair
PPE cost value intan. cost value
No. No. % No. % No. No. % No. %
13 Aerospace 5 5 5 100 0 0 5 5 100 0 0

16 Apparel 7 7 7 100 1 14 7 7 100 0 0
19 Automotive 6 6 6 100 0 0 6 6 100 0 0
22 Beverages 7 7 7 100 1 14 7 7 100 0 0
25 Chemicals 20 20 20 100 1 5 20 20 100 0 0
28 Construction 54 54 54 100 4 7 39 39 100 0 0
31 Diversified 6 6 6 100 0 0 6 6 100 0 0
34 Drugs, cosmetics, 44 44 44 100 0 0 44 44 100 0 0
and healthcare
37 Electrical 10 10 10 100 0 0 10 10 100 0 0
40 Electronics 109 107 107 100 1 1 100 100 100 0 0
43 Financial 140 118 118 100 16 14 68 68 100 0 0
46 Food 23 23 23 100 2 9 23 23 100 0 0
49 Machinery and 22 22 22 100 1 5 22 22 100 0 0
equipment
52 Metal producers 49 44 44 100 1 2 44 44 100 0 0
55 Metal product 12 12 12 100 1 8 12 12 100 0 0
manufacturers
58 Oil, gas, coal, and 52 52 52 100 1 2 50 50 100 0 0
related services
61 Paper 6 6 6 100 0 0 6 6 100 0 0
64 Printing a 19 19 19 100 0 0 16 16 100 0 0
publishing
67 Recreation 41 41 41 100 1 2 36 36 100 0 0
70 Retail 51 50 50 100 3 6 40 40 100 0 0
73 Textile 8 8 8 100 1 13 8 8 100 0 0
76 Tobacco 3 3 3 100 0 0 3 3 100 0 0
79 Transportation 17 17 17 100 1 6 17 17 100 0 0
82 Utilities 31 31 31 100 0 0 31 31 100 0 0
85 Other industries 192 191 191 100 6 3 185 185 100 0 0
Total sample 934 903 903 100 42 5 805 805 100 0 0
Table presents the valuation practices among companies in the UK cross-sectional sample (defined in
Table 2). The industry classification is based on Worldscopes major industry groups. The With PPE
(With intan.) column presents for each industry how many companies have property, plant, and
equipment (intangible assets). The historical cost (fair value) columns present how many companies use
historical cost (fair value) for at least one asset class within property, plant, and equipment and intangible
assets
123
Table 4 UK companies valuation practices before and after IFRS adoption
750
No. Industry name Property, plant, and equipment Investment property
123
Switch With Fair value Switch to Switch to fair Cross- With inv. Keep fair Move to
sample PPE historical cost value sectional prop. value historical
UK IFRS samplec cost
No. % No. % No. %a No. %b No. % No. %
13 Aerospace 5 5 0 0 0 0 0 N/A 0 0 5 2 1 50 1 50
16 Apparel 6 6 1 17 1 17 0 0 0 0 7 0 0 N/A 0 N/A
19 Automotive 5 5 1 20 0 0 1 100 0 0 6 1 1 100 0 0
22 Beverages 5 5 1 20 1 20 0 0 0 0 7 1 0 0 1 100
25 Chemicals 18 18 1 6 1 6 0 0 0 0 20 0 0 N/A 0 N/A
28 Construction 49 49 6 12 4 8 3 50 1 2 54 10 7 70 3 30
31 Diversified 6 6 0 0 0 0 0 N/A 0 0 6 1 1 100 0 0
34 Drugs, cosmetics, 31 31 1 3 0 0 1 100 0 0 44 0 0 N/A 0 N/A
and healthcare
37 Electrical 6 6 0 0 0 0 0 N/A 0 0 10 1 1 100 0 0
40 Electronics 90 89 1 1 1 1 0 0 0 0 109 3 1 33 2 67
43 Financial 105 90 13 14 10 11 6 46 3 4 140 66 65 98 1 2
46 Food 21 21 2 10 1 5 1 50 0 0 23 2 1 50 1 50
49 Machinery and equipment 16 16 0 0 1 6 0 N/A 1 6 22 1 0 0 1 100
52 Metal producers 23 22 0 0 0 0 0 N/A 0 0 49 1 0 0 1 100
55 Metal product manufacturers 11 11 0 0 1 9 0 N/A 1 9 12 0 0 N/A 0 N/A
58 Oil, gas, coal, and related services 29 29 1 3 1 3 0 0 0 0 52 3 3 100 0 0
61 Paper 5 5 0 0 0 0 0 N/A 0 0 6 1 0 0 1 100
64 Printing and publishing 16 16 0 0 0 0 0 N/A 0 0 19 0 0 N/A 0 N/A
67 Recreation 32 32 2 6 1 3 1 50 0 0 41 1 0 0 1 100
Table 4 continued
No. Industry name Property, plant, and equipment Investment property
Switch With Fair value Switch to Switch to fair Cross- With inv. Keep fair Move to
sample PPE historical cost value sectional prop. value historical
UK IFRS samplec cost
No. % No. % No. %a No. %b No. % No. %
70 Retail 43 42 4 10 2 5 2 50 0 0 51 9 1 11 8 89
73 Textile 6 6 1 17 1 17 0 0 0 0 8 2 1 50 1 50
76 Tobacco 3 3 0 0 0 0 0 N/A 0 0 3 0 0 N/A 0 N/A
79 Transportation 14 14 0 0 1 7 0 N/A 1 7 17 2 2 100 0 0
82 Utilities 23 23 1 4 0 0 1 100 0 0 31 3 1 33 2 67
85 Other industries 135 135 8 6 4 3 4 50 0 0 192 14 10 71 4 29
Total sample 703 685 44 6 31 5 20 44 7 1 934 124 96 77 28 23
Table presents valuation practices among companies in the UK switch sample (defined in Table 2). The industry classification is based on Worldscopes major industry
groups. The With PPE (With inv. prop.) column presents for each industry how many companies have property, plant, and equipment (investment property). The
historical cost (fair value) columns present how many companies use historical cost (fair value) for at least one asset class within property, plant, and equipment and
investment property
a
As a percentage of companies that use fair value accounting under UK GAAP
b
As a percentage of companies that use only historical cost under UK GAAP
c
Given that UK GAAP requires that investment property be recognized at fair value, the application of historical cost always constitutes a switch. Therefore, in Table 4,
we use the UK cross-sectional sample for investment property
751
123
Thus the switches observed upon the IFRS adoption are voluntary in the sense that
IFRS did not force a switch to historical cost. If managers find historical cost to be
more beneficial, why did these firms not switch to historical cost under UK
GAAP?14 One explanation is that switching accounting principles is uncommon and
costly due to consistency requirements.15 The costs of switching accounting
principles include renegotiating contracts (which require consistency in GAAP),
convincing auditors that the new practice better reflects the underlying economics of
the company, and communicating and justifying the change to financial statement
users. Most of these costs are fixed (i.e., they are independent of the number of
accounting principle changes), so the incremental cost of voluntary changes is lower
when combined with a mandatory change such as IFRS adoption. Even if these
managers did want to switch to historical cost before IFRS adoption, the associated
costs could have made switching unattractive. However, the observation that a
switch is more likely from fair value to historical cost than from historical cost to
fair value is inconsistent with a shift in the market solution towards fair value.
We do find, however, that, after IFRS adoption, fair value is more common for
investment property, for which UK companies had to use fair value under local
GAAP, than it is for PPE. Nevertheless, managers of 23 % of the companies reveal
preferences for historical cost by switching from fair value to historical cost once
they are no longer constrained to the use of fair value by the accounting regulation.
Significant industry variation is present: whereas only 2 % of the financial
companies switch to historical cost, 45 % of the non-financial companies switch.
4.2.2 Valuation practices in Germany
Table 5 documents the valuation practices in the German sample. As in the UK, we
find no use of fair value accounting for intangible assets in Germany. For PPE, 1 %
of companies switch to fair value for at least one asset class upon IFRS adoption
(note that under German GAAP fair value was not allowed). Only one company
applies fair value to all asset classes in PPE, while all other companies use historical
cost for at least one asset class. These findings document that the market solution
generally reveals preferences for historical cost accounting. Consistent with
prediction H1, fewer German than UK firms commit to fair value accounting.
For investment property, we find that the managers of 23 % of the German
companies reveal preferences for fair value by switching from historical cost to fair
value once they are no longer constrained to historical cost by the accounting
regulation. The German evidence is in contrast to the 77 % of UK companies that
14
We contacted those non-financial companies that switched to historical cost and received several
replies indicating that IFRS was a convenient opportunity for them to make the switch.
15
Consistency in accounting policies across time is highly regarded by the accounting profession.
Comparability is a qualitative characteristic expressed in IASBs Framework (paragraph 39): the
measurement and display of the financial effect of like transactions and other events must be carried out
in a consistent way throughout an entity and over time for that entity. In US literature, consistency is
expressed in several places, including the Accounting Research Study No. 1 of the American Institute of
Certified Public Accountants (postulate C-3). See Ball (1972) for an extensive discussion of the
accounting professions reliance on consistency.
123
Table 5 German companies valuation practices after IFRS adoption
No. Industry name Property, plant and equipment Investment property Intangible assets
Sample With Fair value Historical With inv. Fair value Historical With Fair value Historical
PPE cost prop. cost intan. cost
No. % No. % No. % No. % No. % No. %

13 Aerospace 1 1 0 0 1 100 0 0 N/A 0 N/A 1 0 0 1 100

16 Apparel 11 11 0 0 11 100 0 0 N/A 0 N/A 11 0 0 11 100
19 Automotive 10 10 0 0 10 100 4 0 0 4 100 10 0 0 10 100
22 Beverages 9 9 0 0 9 100 3 1 33 2 67 9 0 0 9 100
25 Chemicals 16 16 0 0 16 100 2 0 0 2 100 16 0 0 16 100
28 Construction 22 22 0 0 22 100 8 1 13 7 88 22 0 0 22 100
31 Diversified 8 8 0 0 8 100 7 0 0 7 100 8 0 0 8 100
34 Drugs, cosmetics, and healthcare 25 25 0 0 25 100 4 0 0 4 100 25 0 0 25 100
37 Electrical 13 13 0 0 13 100 3 0 0 3 100 13 0 0 13 100
40 Electronics 78 78 0 0 78 100 6 1 17 5 83 77 0 0 77 100
43 Financial 96 96 3 3 96 100 57 28 49 29 51 87 0 0 87 100
46 Food 8 8 0 0 8 100 1 0 0 1 100 8 0 0 8 100
49 Machinery and equipment 54 54 1 2 54 100 11 2 18 9 82 54 0 0 54 100
52 Metal producers 1 1 0 0 1 100 0 0 N/A 0 N/A 1 0 0 1 100
55 Metal product manufacturers 6 6 1 17 6 100 1 0 0 1 100 6 0 0 6 100
58 Oil, gas, coal, and related services 5 5 0 0 5 100 1 0 0 1 100 4 0 0 4 100
61 Paper 6 6 0 0 6 100 1 0 0 1 100 6 0 0 6 100
64 Printing and publishing 6 6 0 0 6 100 3 0 0 3 100 6 0 0 6 100
67 Recreation 25 25 0 0 25 100 0 0 N/A 0 N/A 25 0 0 25 100
70 Retail 17 17 1 6 17 100 8 0 0 8 100 17 0 0 17 100
73 Textile 5 5 0 0 5 100 3 0 0 3 100 5 0 0 5 100
753
123
Table 5 continued
754
No. Industry name Property, plant and equipment Investment property Intangible assets
123
Sample With Fair value Historical With inv. Fair value Historical With Fair value Historical
PPE cost prop. cost intan. cost
No. % No. % No. % No. % No. % No. %
76 Tobacco 0 0 0 N/A 0 N/A 0 0 N/A 0 N/A 0 0 N/A 0 N/A

79 Transportation 7 7 0 0 7 100 3 0 0 3 100 7 0 0 7 100
82 Utilities 20 20 0 0 20 100 6 0 0 6 100 20 0 0 20 100
85 Other industries 156 156 1 1 155 99 19 1 5 18 95 154 0 0 154 100
Total sample 605 605 7 1 604 100 151 34 23 117 77 592 0 0 592 100
Table presents the valuation practices among companies in the German sample (defined in Table 2). The industry classification is based on Worldscopes major industry
groups. The With PPE (With inv. prop.) [With intan.] column presents for each industry how many companies have property, plant, and equipment (investment
property) [intangible assets]. The historical cost (fair value) columns present how many companies use historical cost (fair value) for at least one asset class within
property, plant, and equipment, Investment property, and intangible assets
commit to fair value for investment property, which is also in line with H1.
However, we observe substantial industry variation. Among financial companies,
49 % switch to fair value, while only 6 % of the non-financial companies switch.
In summary, we find that a small number of companies use fair value accounting
for at least one asset class under PPE after the IFRS adoption. The absence of fair
value accounting for intangibles and its limited use for PPE in both the UK and
Germany suggests that only a small subset of managers perceive net benefits of fair
value accounting in their setting. In contrast to the expectation, there is virtually no
shift towards fair value accounting for non-financial assets, with the exception of
investment property among German financial institutions. However, the shift
towards fair value for investment property is consistent with benefits of fair value
often outweighing the costs for this asset class. Next, we provide evidence on H2 by
exploiting variation in the valuation practices within the PPE group.
4.2.3 Does the choice to use fair value for PPE vary with asset liquidity?
In this section, we collect evidence on specific asset classes within the PPE asset
group that are recognized at fair value as opposed to historical cost. Table 6 presents
the distribution of the use of fair value across the three asset classes. We find that 69
companies in the sample use fair value accounting either before the mandatory
adoption of IFRS, after the adoption, or both. Of these companies, 93 % use fair
value accounting for property. Only 3 % use fair value for plant, and only 4 % use
fair value for several asset classes in PPE. The distributions of fair value use in the
UK and Germany are rather similar. The evidence suggests that the application of
fair value accounting is, in practice, not only limited in terms of the number of
companies using it but also in terms of the assets to which it is applied: fair value is
Table 6 Asset classes and the application of fair value accounting

United Kingdom Germany Full sample
a
No. % No. % No. %
Companies that use fair value for PPE 62 100 7 100 69 100
Divided according to asset classes
Property 58 94 6 86 64 93
Plant 2 3 0 0 2 3
Equipment 0 0 0 0 0 0
PPE in general 2 3 1 14 3 4
Table presents evidence regarding which asset classes under property, plant, and equipment are recog-
nized at fair value. The No. columns present the number of companies that recognize assets at fair value
within the respective asset classes. The % columns present the values in the No. columns as a percentage
of those companies in the UK, Germany, and the full sample that use fair value for any class of assets
under property, plant, and equipment
a
Includes companies that use fair value under UK GAAP or IFRS, or both
123
largely limited to property. This result supports H2 and suggests that the existence
of liquid markets decreases the costs of committing to fair value accounting.
4.3 Regression analysis of the choice to use fair value
In this section, we examine the determinants of the decision to use fair value
accounting by using regression analysis. We revisit H1 more formally and further
test H3 and H4. Our analysis draws on two different subsamples and controls for
common company-specific characteristics. First, we analyze the sample of
companies that hold investment property as it offers a richer variation in accounting
method choice than PPE. Second, we examine the choice to use fair value for PPE
because, relative to investment property, PPE is applicable to a broader set of firms.
Table 7 reports the summary and correlation statistics for variables used in this
analysis. All variables are defined in Appendix 3.
4.3.1 What are the determinants of the commitment to fair value for investment
property?
IFRS gives managers of both German and UK companies an option to move to the
asset valuation method not previously available under local GAAP in these
countries. (Recall that UK companies face the first opportunity to switch to
historical cost for investment property, whereas in Germany the opposite is the
case.) In such a setting, observing switches from historical cost to fair value in
Germany and from fair value to historical cost in the UK is difficult to reconcile
with factors other than the existence of net benefits associated with the alternative
accounting treatment (e.g., as opposed to opportunism).
Our sample consists of the 275 companies (124 UK companies; 151 German
companies) that hold investment property. Depending on the specification,
additional data requirements limit the sample further. We begin with a basic
regression that examines whether accounting methods vary based on country of
domicile and whether real estate is a primary industry,
Fair b1 UK b2 UK Sic65 b3 Germany b4 Germany Sic65
b5 Leverage Rbk Controlk e 1
where Fair indicates that a company uses fair value for investment property fol-
lowing IFRS adoption; UK (Germany) is an indicator variable that takes the value of
one for UK (German) companies and zero otherwise; Sic65 is an indicator that takes
the value of one when a company has the SIC code 65 (real estate) among its first
five SIC codes and zero otherwise; Leverage is one of the proxies for reliance on
debt financing; and Control denotes other control variables such as log of market
capitalization and an IFRS early adoption dummy (Muller et al. 2011). H1 predicts
that the institutional differences across the UK and Germany, as opposed to only
accounting standards, influence the market solution to the choice of accounting
practice. Thus under H1, we expect to find the country differences reflected by
significant b1 and b3 coefficients. The coefficients b2 and b4 measure country
123
Table 7 Descriptive statistics for logistic regression analysis
Variable Mean SD Q25 Median Q75
Panel A: Summary statistics

Fair value dummyPPE 0.035 0.184 0 0 0
Fair value dummyInv property 0.079 0.269 0 0 0
Inv property dummy 0.182 0.386 0 0 0

Germany 0.418 0.493 0.000 0.000 1.000
Sic65 0.093 0.290 0.000 0.000 0.000
Early 0.228 0.420 0.000 0.000 0.000
Size 11.781 2.150 10.207 11.668 13.251
PPEadj 0.238 0.243 0.034 0.159 0.358
Btm 0.573 0.507 0.289 0.491 0.783
MktLev 0.392 0.246 0.190 0.373 0.563
MktLevShort 0.293 0.210 0.140 0.245 0.416
MktLevLong 0.098 0.129 0.000 0.045 0.152
LevBook 0.561 0.456 0.360 0.561 0.718
LevBookShort 0.423 0.344 0.243 0.394 0.559
LevBookLong 0.137 0.221 0.001 0.071 0.209
DebtToOI 0.320 2.161 -0.485 0.707 1.590
Coverage 2.005 1.746 0.952 1.756 2.859
Current 0.501 0.803 0.073 0.381 0.820
Convertible 0.030 0.193 0.000 0.000 0.000
FairInvPr 0.079 0.269 0.000 0.000 0.000
DbtIss1 0.464 0.499 0.000 0.000 1.000
DbtIss2 0.272 0.445 0.000 0.000 1.000
FtrLev1 0.679 2.082 0.261 0.458 0.725
FtrLev2 0.306 1.380 0.002 0.117 0.313
DbtGrow1 0.336 0.903 -0.059 0.197 0.546
DbtGrow2 0.277 1.634 -0.280 0.126 0.718
757
123
Table 7 continued
758
Variable/Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
123
Panel B: Correlation table
1. Fair PPE 1.00
2. Fair IP 0.06 1.00
3. IP 0.00 0.45 1.00
4. Germany -0.07 -0.13 0.17 1.00
5. Sic65 0.07 0.30 0.28 0.01 1.00
6. Early -0.01 -0.06 0.03 0.61 0.00 1.00
7. Size -0.10 -0.03 0.12 -0.19 0.02 -0.02 1.00
8. PPEadj 0.07 0.02 0.12 -0.08 0.08 -0.13 0.10 1.00
9. Btm 0.08 0.06 0.10 0.19 0.09 0.05 -0.39 0.14 1.00
10. MktLev 0.03 0.04 0.14 0.11 0.07 -0.05 -0.15 0.17 0.43 1.00
11. MktLevShort 0.04 0.05 0.12 0.14 -0.03 0.04 -0.19 -0.08 0.37 0.80 1.00
12. MktLevLong -0.01 0.00 0.08 -0.01 0.15 -0.13 0.02 0.39 0.20 0.54 -0.07 1.00
13. LevBook -0.01 0.01 0.06 -0.09 -0.02 -0.14 0.16 0.07 -0.23 0.68 0.51 0.41 1.00
14. LevBookShort 0.01 0.03 0.05 -0.01 -0.10 -0.01 0.05 -0.20 -0.18 0.46 0.77 -0.31 0.68 1.00
15. LevBookLong -0.03 -0.01 0.02 -0.12 0.09 -0.17 0.16 0.33 -0.09 0.34 -0.24 0.90 0.50 -0.29 1.00
16. DebtToOI -0.08 0.00 0.07 0.04 0.10 -0.06 0.01 0.26 0.19 0.51 0.13 0.67 0.41 -0.10 0.65 1.00
17. Coverage 0.03 0.00 -0.05 -0.12 -0.08 0.00 0.17 -0.21 -0.28 -0.62 -0.34 -0.55 -0.42 -0.07 -0.47 -0.76 1.00
18. Current -0.03 -0.07 -0.09 0.16 0.07 0.16 -0.09 -0.32 0.05 -0.39 -0.30 -0.22 -0.50 -0.38 -0.21 -0.25 0.30 1.00
19. Convertible -0.04 -0.03 0.01 0.10 -0.04 0.11 0.07 -0.04 -0.04 -0.05 -0.05 -0.02 -0.06 -0.06 -0.01 -0.06 0.01 0.04 1.00
20. FairInvPr 0.06 1.00 0.45 -0.13 0.30 -0.06 -0.03 0.02 0.06 0.04 0.05 0.00 0.01 0.03 -0.01 0.00 0.00 -0.07 -0.03
Table, Panel A presents the summary statistics for our pooled (largest) sample. Panel B reports Pearson correlation statistics. All variables are defined in Appendix 3. Information regarding the
use of fair value is hand-collected from companies annual reports in Thompson One Banker. All other data is collected from the Worldscope database as of December 2005
differences when real estate is among a companys primary business activities.

Recall that the real estate industry is unique in that value changes in its main asset
(investment property) convey information about operating performance. Conse-
quently, H3 predicts that German real estate firms are more likely to switch to fair
value than German firms in other industries, while UK real estate firms are less
likely to switch to historical cost than UK firms in other industries. Finally, H4
suggests that leverage proxies predict the choice of fair value.
Table 8 presents the regression estimates for several specifications nested in
Eq. (1). The pseudo R-squared in Column (1) indicates that the country and Sic65
indicators explain a substantial portion (34 %) of the variation in the choice to use
fair value. Consistent with H1, the estimates indicate that companies domiciled in
Germany are significantly more likely to use historical cost after IFRS adoption
(b3). This effect, however, is significantly smaller for companies whose primary
industries include real estate (b3 ? b4), which in turn is consistent with H3.
Companies domiciled in the UK are more likely to use fair value under IFRS, and
this effect is stronger (and more significant) for companies in the real estate business
(b1 ? b2), which also supports H3. Observed switches to fair value among German
real-estate companies and to historical cost among UK non-real-estate companies,
when companies are no longer constrained by the local accounting regulation,
suggest that the real estate industry has net firm-specific benefits of fair value
accounting for investment property. In sum, the evidence indicates that the observed
accounting practices vary with country institutions (H1), which supports the
argument in Ball (2006) that the application of GAAP need not be uniform under
one set of standards and is specific to the institutional setting. The evidence is also
consistent with fair value for investment property being a superior measure of
economic performance in the real estate industry (H3).
Columns 2 through 6 of Table 8 examine whether the choice of fair value is
associated with reliance on debt as predicted by H4. The specification in Column 2
shows that companies relying on debt financing more heavily are more likely to
commit to fair value accounting for investment property. This is consistent with the
incremental costs of obtaining reliable fair value estimates for financial reporting
purposes being low when they are already produced for financing purposes
(Holthausen and Watts 2001). The other columns examine other leverage proxies
potentially used in debt contracts.16 We find that the ratio of total debt to operating
income has a positive relation to the use of fair value, while the coverage of interest
and the current ratios are negatively related to the use of fair value. The results are
consistent across different proxies for leverage and further support H4.
The split of leverage into its components deserves additional attention. Prior
literature suggests that companies may choose to revalue assets because the
revaluations allow them to relax covenants (Cotter and Zimmer 2003). While, as
discussed earlier, opportunistic motives are unlikely to explain the pre-commitment
to fair value accounting that comes with IFRS, we further investigate the role of
opportunism by decomposing leverage into its long- and short-term components and
16
We exclude leverage because these variables are highly correlated with leverage and therefore capture
aspects of the same construct.
123
Table 8 Determinants of fair value for investment property

Variables (1) (2) (3) (4) (5) (6)
UK (constant) 0.460* 1.240 1.370 3.084** 4.153*** 4.456**

[1.759] [0.949] [0.857] [2.011] [2.595] [2.120]
[0.079] [0.343] [0.391] [0.044] [0.009] [0.034]
UkSic65 2.215*** 2.115*** 2.792*** 1.873** 1.425** 2.090**
[3.818] [3.436] [3.231] [2.140] [1.996] [2.432]
[0.000] [0.001] [0.001] [0.032] [0.046] [0.015]
Germany 2.539*** 3.822*** 4.735*** 4.242*** 4.437*** 3.471***
[6.142] [6.133] [4.808] [5.374] [5.707] [3.743]
[0.000] [0.000] [0.000] [0.000] [0.000] [0.000]
GermanySic65 1.848*** 1.893*** 1.776** 1.672*** 1.632*** 0.298
[4.344] [3.586] [2.284] [2.714] [2.675] [0.302]
[0.000] [0.000] [0.022] [0.007] [0.007] [0.763]
Early 1.320** 1.866** 1.543*** 1.462** 1.151
[2.551] [2.174] [2.625] [2.486] [1.154]
[0.011] [0.030] [0.009] [0.013] [0.249]
Size 0.158* 0.214* 0.202* 0.204** 0.370**
[1.680] [1.789] [1.914] [1.991] [2.210]
[0.093] [0.074] [0.056] [0.046] [0.027]
MktLev 2.681***
[3.400]
[0.001]
MktLevShort 3.381***
[3.020]
[0.003]
MktLevLong 4.090**
[1.966]
[0.049]
Convertible 3.841**
[2.366]
[0.018]
DebtToOi 0.337**
[2.197]
[0.028]
Coverage 0.380***
[2.585]
[0.010]
Current 0.820*
[1.789]
[0.074]
123
Table 8 continued
Variables (1) (2) (3) (4) (5) (6)
Observations 275 244 172 182 192 140

Pseudo R- 0.335 0.409 0.508 0.437 0.426 0.434
squared
Table presents the estimates from the logistic regression of the IFRS fair value indicator on a set of
company-specific variables. All variables are defined in Appendix 3. Information on the use of fair
value is hand-collected from companies annual reports in the Thompson One Banker. All other data is
collected from the Worldscope database as of December 2005. The sample consists of 275 companies
(124 UK companies; 151 German companies) that hold investment property. Requiring non missing
values for explanatory variables further limits the sample in some specifications. ***, **, * indicate
statistical significance at less than 1, 5, and 10%, respectively
add a proxy for reliance on convertible debt (i.e., column 3). We find that short-term
leverage is as important as long-term debt in explaining the use of fair value. (Both
coefficients have similar economic magnitudes and exhibit no statistically
significant differences.) The coefficient on convertible debt is also significantly
positive. As accounting-based covenants are uncommon in short-term and
convertible-debt contracts, the results are inconsistent with the conclusion that
companies use fair value opportunistically to avoid covenant violations.
We provide further evidence on the non-directional prediction H4 by examining
whether companies that use fair value access debt markets more frequently
following IFRS adoption. If indeed the availability of reliable fair value estimates
relates to debt financing activities, fair value choices should predict more frequent
debt market access. Based on Worldscope data for 2006 and 2007, we construct
several proxies for debt financing. Specifically, we proxy for future debt financing
with the following variables: DebtIss1 (DebtIss2) indicates whether by 2007 total
debt (long-term debt) had increased by more than 10 % of the current market value
of assets; FtrLev1 (FtrLev2) proxies for the level of future total debt (long-term
debt) in 2007 while controlling for the level of current debt in the regression; and
DbtGrow1 (DbtGrow2) indicates growth in total debt (long-term debt). We regress
these financing proxies on the fair value indicator variable and the controls for the
company characteristics, which include country, size, leverage, and an SIC code 65
indicator.
Table 9, Columns (1) through (6), present regressions with the six proxies for
debt issuance used as the dependent variables. The fair value indicator is significant
for all proxies for debt issuance and indicates a positive relation between fair value
use and future debt financing.17 The relation between fair value use and future debt
17
While we have no strong prior for why equity market access should relate to fair value use, it can
correlate with debt market access. To rule out the possibility that our debt proxies are picking out equity
issuance, we use two proxies for future equity financing activity (first, an indicator of whether combined
net proceeds of equity issuance less proceeds from stock options exceed 10 % of market value of current
assets and second, the ratio of net proceeds to current market value of assets) and find that they are
insignificantly related fair value use. The results are untabulated.
123
Table 9 Future financing and the use of fair value accounting

Variable (1) (2) (3) (4) (5) (6)
DbdIss1 DbtIss2 FtrLev1 FtrLev2 DbtGrow1 DbtGrow2
Fair 0.181** 0.130* 0.665* 0.357* 0.444*** 0.445**

[2.084] [1.706] [1.729] [1.898] [2.724] [1.973]
[0.038] [0.089] [0.085] [0.059] [0.007] [0.050]
UK -0.0592 -0.105 -0.593 -0.245 -0.362** -0.322
[-0.714] [-1.437] [-1.552] [-1.358] [-2.256] [-1.450]
[0.476] [0.152] [0.122] [0.176] [0.025] [0.149]
Size 0.0399*** -0.00716 -0.0801 -0.0418 0.016 0.0222
[2.798] [-0.609] [-1.451] [-1.098] [0.677] [0.476]
[0.006] [0.543] [0.148] [0.273] [0.499] [0.635]
MktLev -0.133 -0.111 -0.155 0.0984 -0.985*** -1.179**
[-1.032] [-0.976] [-0.226] [0.220] [-3.586] [-2.424]
[0.303] [0.330] [0.821] [0.826] [0.000] [0.016]
Sic65 0.0905 0.209*** 0.115 0.351*** 0.030 0.155
[1.258] [3.159] [0.746] [3.234] [0.304] [0.758]
[0.210] [0.002] [0.457] [0.001] [0.761] [0.449]
Constant -0.0199 0.350** 1.936* 0.778 0.560 0.480
[-0.104] [2.233] [1.817] [1.161] [1.360] [0.815]
[0.434] [0.111] [0.115] [0.126] [0.024] [0.122]
Observations 244 244 230 229 230 197
R-squared 0.06 0.091 0.055 0.067 0.116 0.07
Table presents the estimates from OLS regressions of future financing choices on the IFRS fair value
indicator and a set of company-specific controls. All variables are defined in Appendix 3. Information
on the use of fair value is hand-collected from companies annual reports in the Thompson One Banker.
All other data is collected from the Worldscope database between December 2005 and 2007. The sample
consists of 275 companies (124 UK companies, 151 German companies) that hold investment property.
Requiring non missing values for explanatory variables further limits the sample in some specifications.
***, **, * indicate statistical significance at less than 1, 5, and 10 %, respectively
issuance is in line with the costs of recognizing fair value estimates being lower
when firms regularly access debt markets (H4).
4.3.2 What are the determinants of the commitment to fair value for PPE?
While the investment property sample offers richer variation, an understanding of

the choice of fair value for PPE, which is held by a much broader sample of firms, is
potentially more interesting. Unlike the investment property sample, we can hand-
collect the data for the fair value revaluation reserve from the annual reports. (There
is no revaluation reserve for investment property; see Appendix 1.) This enables
us to compute the book values of equity, PPE, and total assets as if companies used
historical cost. Thus we can add book-to-market and book leverage as explanatory
variables without being concerned with a possible mechanical relation between
book-to-market and fair value indicators. Similarly, this data also allows us to use
123
the ratio of PPE to total assets (PPEA) to examine whether PPE-heavy companies
are more likely to use fair value.
Table 10 presents the results of the logistic regression analysis for our pooled
cross-sectional sample. In line with the prior results for H1, German firms are
significantly less likely to use fair value for PPE (despite low economic
magnitudes). The coefficient on book-to-market indicates that companies with
relatively low investment opportunities are more likely to use fair value. Recall that
H3 indeed suggests that fair value facilitates performance measurement for
companies lacking investment opportunities.
In line with the evidence for investment property, we find a positive and
significant association between market leverage as well as book leverage and the
commitment to fair value accounting. Further analysis in column (3) reveals that,
once again, short-term debt is at least as important as long-term debt in this
association. The portion of convertible debt now exhibits no significant relation with
the fair value choice. As earlier, the evidence supports our conjecture that the
incremental costs of committing to fair value accounting decrease with the reliance
on debt financing.
Finally, two additional results are worth mentioning here. First, consistent with
the costs of fair value outweighing the benefits when an asset represents a small
portion of the balance sheet, we find a positive coefficient on PPEA. Thus the
likelihood of using fair value increases with the proportion of PPE to total assets.
Second, the positive coefficient on FairInvPr (Column 5) suggests that companies
applying fair value to investment property are more likely to also apply fair value to
PPE. Controlling for this effect, however, does not alter our findings with respect to
leverage or book-to-market.
5 Summary and discussion
Whether fair value accounting dominates historical cost accounting in a free market
for accounting policies is an important question that has been subject to much
controversy among academics and regulators. We study the choice between fair
value and historical cost for non-financial assets when market forces, rather than
regulators, determine the outcome of this choice. In light of the long-standing
debate over fair value accounting, understanding this choice is useful from both
regulatory and academic perspectives. Under the assumption of free market
discipline, the choices by management should be informative as to whether the net
firm-specific economic benefits associated with fair value accounting outweigh
those of historical cost. The key advantage of our setting is that IFRS, which
provides a choice between historical cost and fair value accounting for non-financial
assets, requires pre-commitment to either practice.
We collect and analyze data on accounting policies for intangible assets,
investment property, and PPE for a sample of 1,539 companies. With very few
exceptions, we find that fair value is used exclusively for property. We find that 3 %
of the companies use fair value for owner-occupied property, compared with 47 %
for investment property. The striking lack of companies that use fair value for all
123
Table 10 Use of fair value for property, plant, and equipment

Variable (1) (2) (3) (4) (5)
Germany -2.130*** -2.109*** -1.885*** -1.920*** -1.987***

[9.857] [4.130] [3.809] [3.843] [3.754]
[0.000] [0.000] [0.000] [0.000] [0.000]
PPEA 1.483*** 2.180*** 1.099** 1.732*** 1.043*
[3.559] [2.934] [2.031] [2.719] [1.670]
[0.000372] [0.0034] [0.0423] [0.00654] [0.0950]
Btm 0.490** 0.428* 0.737*** 0.768*** 0.458*
[2.179] [1.819] [2.935] [3.064] [1.945]
[0.0293] [0.0689] [0.0033] [0.0021] [0.051]
MktLev 2.736*** 2.693***
[3.749] [3.000]
[0.0002] [0.0027]
MktLevShort 3.311***
[3.607]
[0.0003]
MktLevLong 1.293
[0.811]
[0.417]
Convertible -4.161 -8.615
[-1.187] [-0.647]
[0.235] [0.518]
LevBook 0.309**
[2.391]
[0.0168]
LevBookShort 1.285*
[1.952]
[0.0510]
LevBookLong -0.286
[-0.207]
[0.836]
FairInvPr 1.129**
[2.407]
[0.0161]
Industry dummies Yes Yes Yes Yes Yes
Observations 1,068 1,067 1,068 1,067 1,068
Pseudo R-squared 0.186 0.196 0.16 0.172 0.202
Table presents the estimates from the logistic regression of the IFRS fair value indicator on a set of
company specific variables. All variables are defined in Appendix 3. Information on the use of fair
value is hand-collected from companies annual reports in the Thompson One Banker. All other data is
collected from the Worldscope database as of December 2005. The sample consist of 1,508 companies
(903 UK companies; 605 German companies) that hold PPE. Requiring non missing values for other
explanatory variables further limits the sample. Standard errors are clustered at industry level. ***, **,
* indicate statistical significance at less than 1, 5, and 10%, respectively
123
other non-financial assets is inconsistent with large net firm-specific benefits of fair
value accounting relative to historical cost for those assets. The use of fair value for
property alone is likely explained by lower costs to reliably measure fair values in
the presence of relatively liquid property markets. Among the strongest cross-
sectional determinants of fair value for both investment property and PPE is the
reliance on debt financing. When fair value estimates are constructed for financing
purposes, they are likely to be relatively reliable, and the incremental costs of also
recognizing them in financial reports are low.
Our findings suggest that, for non-financial assets, the market solution for the
choice between the two valuation methods lies with historical cost accounting:
firms managers, who represent outside stakeholders, generally reveal preferences
for historical cost accounting for a broad range of non-financial assets. The limited
cross-sectional variation in the choice between fair value and historical cost
indicates that market forces determine this managerial choice. The evidence broadly
suggests that managers resistance to the use of fair value is likely to be driven by
the costs of establishing reliable fair value estimates rather than a disagreement with
standard setters on the potential benefits of fair value accountingfirm managers
appear to view fair value accounting for non-financial assets as costly.
While markets are generally more effective at resource allocation than regulators,
possible externalities and market failure must be considered. Yet there are several
reasons to believe that market failures are not a major concern in our setting. First,
we do not see compelling externalities caused by either historical cost or fair value
accounting. For example, a positive network externality implies that a choice of fair
value by one firm increases the benefit of fair value to other firms. Hence if positive
network effects associated with fair value outweighed firm-specific costs, we would
not observe switches from fair value to historical cost in a setting where fair value
was used prior to IFRS adoption. Our evidence is rather inconsistent with positive
network effects because we observe that switches from fair value to historical cost
upon IFRS adoption are common in the UK among firms that used fair value under
UK GAAP.18 Second, as Germany and the UK are among the countries with the
most developed capital markets in the world, the principles of free exchange are
likely to be satisfied, and there is no straightforward source of market failure due to
coercion.19
Perhaps the most plausible source of market failure is the failure of atomistic
investors to discipline the management to act on their behalf. We do not view this to
be a compelling explanation for the observed choices for four reasons. First, the UK
and Germany have well-developed institutions and often rely on governance by
large stakeholders that should not fail at disciplining managers behaving oppor-
tunistically. Second, because the choice of accounting practices is fully observable,
the costs of coordinating atomistic investor action, which is typically caused by the
18
Among UK firms that hold investment property (PPE), 23 % (44 %) switch to historical cost. Yet only
1 % of UK firms that used historical costs for PPE under UK GAAP switched to fair value under IFRS.
19
For example, suppose auditors are not willing to audit fair value estimates due to high audit costs.
Companies should then be willing to compensate auditors for their services if fair value is sufficiently
beneficial to investors. It is not clear why auditors would fail to respond to such monetary incentives in
developed audit markets.
123
lack of incentives or ability to acquire information, are relatively low. Third, the
requirement to ex ante commit to one of the two accounting practices, as discussed
earlier, suggests that the choice is unlikely to be driven by opportunism even if
governance is imperfect. A commitment is made ex ante (in contrast to the literature
on asset revaluations), and the management therefore has incentives to commit to an
efficient accounting practicea practice that limits ex post opportunism (Watts
1986). Finally, the governance (market) failure should be rather extreme to explain
our finding that over 95 % of companies elect historical cost.
That said, we cannot empirically assess the extent to which market failures, e.g.,
due to managerial opportunism and externalities, affect the managerial choices we
observe and draw inferences from. Furthermore, in the presence of market frictions,
the efficient market solution may take some time to evolve, and we only have
evidence from the first year after IFRS adoption. Hence we caution the reader to
interpret our results carefully. More research is needed to fully understand potential
sources of market failures regarding the choice between fair value and historical
cost.
Overall, our evidence indicates that standard setters need to be careful in
requiring fair value accounting for certain non-financial assets. Unless compelling
reasons exist to believe that there is a market failure, a regulatory move towards
fair-value-based accounting standards is likely to impose costs on the economy.
Acknowledgment This research was funded in part by the Initiative on Global Markets at the
University of Chicago Booth School of Business. We benefited from helpful comments from two
anonymous referees, Ray Ball, Philip Berger, Jannis Bischof, Alexander Bleck, Christof Beuselinck,
Johan van Helleman, S.P. Kothari, Laurence van Lent, Christian Leuz, Thomas Linsmeier (discussant),
Paul Madsen, Karl Muller, Scott Richardson, Edward Riedl, Douglas Skinner, Richard Sloan (editor),
Abbie Smith, Stephen Zeff, Ross Watts, Li Zhang, participants at the Review of Accounting Studies
Conference 2012, EAA 2009 Annual Meeting, University of Chicago, University of North Carolinas
GIA Conference, Harvard Universitys IMO Conference, ISCTE, and Tilburg University. Michelle Grise,
SaeHanSol Kim, Shannon Kirwin, Ilona Ori, Russell Ruch, and Onur Surgit provided excellent research
assistance.
Appendix 1: The accounting treatment of long-term non-financial assets

under UK GAAP, German GAAP, and IFRS
In this appendix we describe the accounting treatment of long-term non-financial

assetsinvestment property, PPE, and intangible assetsunder UK GAAP,
German GAAP, and IFRS. For brevity, we use the term historical cost to describe
historical cost adjusted for depreciations, amortizations, and impairments.
Accounting for investment property
Investment property consists of land or buildings held to generate rental income or

capital appreciation. Under German GAAP, companies must value investment
property at historical cost, while under UK GAAP, companies are required to use
fair value (German HGB, para. 253, and SSAP 19). Net income is unaffected by
upward revaluations of this asset group under UK GAAP, as they are credited to the
123
revaluation reserve. IFRS offers companies the choice between recognizing

investment property at historical cost or fair value (IAS 40). Under IFRS, if a
company chooses to recognize investment property at historical cost, it must
systematically depreciate the acquisition costs and disclose the investment
propertys fair value in the notes accompanying the financial statements. In
contrast, if a company chooses to apply fair value, changes in the investment
propertys value become part of the operating income and the assets are not subject
to depreciation.
Accounting for property, plant, and equipment (PPE)
The only valuation method for PPE permitted under German GAAP is historical
cost less depreciations (German HGB, para. 253). Under both IFRS and UK GAAP,
PPE is initially recognized at cost but at each subsequent balance sheet date is
valued at either historical cost or fair value (IAS 16 and FRS 15). In either case,
these assets are subject to depreciation. When fair value is applied, positive changes
in an assets value are credited to the revaluation reserve, which constitutes part of
shareholders equity. Revaluations, therefore, only affect net income through future
depreciation charges (unlike for investment property). Finally, under IFRS, the
choice of valuation method must be consistent for all assets in the same asset class
(IAS16.29).
Accounting for intangible assets
Under German GAAP, historical cost is the only valuation method permitted for
intangible assets (German HGB, para. 253). Under both UK GAAP and IFRS,
however, intangible assets are to be carried at either historical cost or fair value less
any amortization and impairment charges (IAS 38 and FRS 10). Under fair value,
the accounting treatment is similar to that of PPE; that said, a company may only
apply fair value to an intangible asset in the rare circumstances where the intangible
asset has a readily ascertainable market value from an active market. The definition
of an active market is rather narrow, and for many intangible assets, such as brands,
patents, and trademarks, it is non-existent, due to their uniqueness and the
specificity of their application (IAS38.78). Hence for most intangible assets,
managers are in practice restricted to historical costs accounting, and the valuation
choice for intangibles therefore cannot be considered free to the same extent as it
can for investment property and PPE.
Appendix 2: Examples of accounting policies for PPE
This appendix presents examples of fair value and historical cost accounting from
the accounting policy section of annual reports of companies in our samples. Panel
A presents an example of a switch from fair value under UK GAAP to historical
cost under IFRS. Panel B presents an example of fair value accounting under both
123
UK GAAP and IFRS. Panel C presents an example of a German company that uses
fair value accounting under IFRS.
Panel A: Switch from fair value to historical cost
Annual report according to UK GAAP for 2004
AMEC PLC
All significant freehold and long leasehold properties were externally valued as at
31 December 2004 by CB Richard Ellis Limited in accordance with the Appraisal
and Valuation Manual of the Royal Institute of Chartered Surveyors.
For the United Kingdom, the basis of revaluation was the existing use value for
properties occupied by group companies and the market value for those properties
without group occupancy. For properties outside the United Kingdom, appropriate
country valuation standards were adopted that generally reflect market value.
No provision has been made for the tax liability that may arise in the event that
certain properties are disposed of at their revalued amounts.
The amount of land and buildings included at valuation, determined according to
the historical cost convention, was as follows:
Group Group Company Company

2004 2003 2004 2003
million million million million
Cost 39.2 46.4 9.3 8.6

Depreciation (10.61) (13.9) (2.5) (1.7)
Net book value 26.6 32.5 6.8 6.9
Annual report according to IFRS for 2005

AMEC PLC
Under UK GAAP, AMECs policy was to revalue freehold and long leasehold
property on a regular basis. Under IAS 16, AMEC has opted to carry property, plant,
and equipment at cost less accumulated depreciation and impairment losses. As
permitted by IFRS 1, AMEC has frozen the UK GAAP land and buildings
revaluations as at 1 January 2004 by ascribing the carrying value as deemed cost.
The impact of this change in policy is as follows:
the revaluation reserve is reclassified into retained earnings as at the date of
transition;
the results of the external revaluation as at 31 December 2004 are reversed,
reducing the value of property, plant and equipment as at 31 December 2004 by
9.6 million; and
as part of the 2004 external revaluation, certain properties were revalued
downwards. Under UK GAAP, these deficits were charged against previous
revaluations held in the revaluation reserve. Under IFRS, these downward
revaluations have been taken as indicators that the value of the relevant
123
properties is impaired and as such, they have been charged to the income
statement as impairment charges in 2004. This reduces the profit for the year
ended 31 December 2004 and the value of property, plant and equipment as at
31 December 2004 by 1.8 million.
Panel B: Fair value under both UK GAAP and IFRS

Annual report according to UK GAAP for 2004
The Wolverhampton & Dudley Breweries PLC
Freehold and leasehold properties are stated at valuation or at cost. Plant,

furnishings, equipment, and other similar items are stated at cost.
Freehold buildings are depreciated to their residual value on a straight line basis
over 50 years.
Other tangible fixed assets are depreciated to their residual value on a straight
line basis at rates calculated to provide for the cost of the assets over their
anticipated useful lives. Leasehold properties are depreciated over the lower of
the lease period and 50 years and other tangible assets over periods ranging from
three to 15 years.
Own labor directly attributable to capital projects is capitalized.
Valuation of properties: Trading properties are revalued professionally by
independent valuers on a five-year rolling basis. When a valuation or expected
proceeds are below current carrying value, the asset concerned is reviewed for
impairment. Impairment losses are charged directly to the revaluation reserve until
the carrying amount reaches historical cost. Deficits below historical cost are
charged to the profit and loss account except to the extent that the value in use
exceeds the valuation, in which case this is taken to the revaluation reserve.
Surpluses on revaluation are recognized in the revaluation reserve, except to the
extent that they reverse previously charged impairment losses, in which case they
are recorded in the profit and loss account. Any negative valuations are accounted
for as onerous leases and included within provisions (see note 20).
The Wolverhampton & Dudley Breweries PLC
Freehold and leasehold properties are stated at valuation or at cost. Plant,

furnishings, equipment, and other similar items are stated at cost.
Depreciation is charged to the income statement on a straight-line basis to
provide for the cost of the assets less residual value over their useful lives.
Freehold and long leasehold buildings are depreciated to residual value over
50 years.
Short leasehold properties are depreciated over the life of the lease.
Other plant and equipment is depreciated over periods ranging from 3 to
15 years.
Land is not depreciated.
123
Valuation of properties: Properties are revalued by qualified valuers on a regular

basis using open market value so that the carrying value of an asset does not differ
significantly from its fair value at the balance sheet date. When a valuation is below
current carrying value, the asset concerned is reviewed for impairment. Impairment
losses are charged to the revaluation reserve to the extent that a previous gain has
been recorded, and thereafter to the income statement. Surpluses on revaluation are
recognized in the revaluation reserve, except where they reverse previously charged
impairment losses, in which case they are recorded in the income statement.
Panel C: Fair value accounting by German company
Hypo Real Estate Group
Property, plant, and equipment is normally shown at cost of purchase or cost of
production. As an exception to this rule, land and buildings are shown with their fair
value in accordance with IAS 16. The carrying amountsif the assets are subject to
wear and tearare diminished by depreciation in accordance with the expected
service life of the assets. In the case of fittings in rented buildings, the contract
duration taking account of extension options is used as the basis of this contract
duration is shorter than the economic life.
Appendix 3: Variable definitions
Fair One if a company uses fair value for at least one asset class within
a specific asset group following the adoption of IFRS and zero
otherwise
UK One if a company is domiciled in the UK and zero otherwise
UkSic65 One if a company has SIC 65 (real estate) among its first five SIC
codes and is domiciled in the UK and zero otherwise
Germany One if a company is domiciled in Germany and zero otherwise
GermanySic65 One if a company has SIC 65 (real estate) among its first five SIC
codes and is domiciled in Germany and zero otherwise
Early One if a company adopted IFRS before 2005 and zero otherwise
Size Log of market value of equity
PPEA Property, plant, and equipment less revaluation reserve divided by
total assets less revaluation reserve
MktLev Total liabilities divided by market value of assets (defined as book
value of liabilities plus market value of equity) as of December
2005
MktLevLong Long-term debt divided by market value of assets (liabilities plus
market value of equity) as of December 2005
MktLevShort Short-term liabilities defined as total liabilities less long-term debt
divided by market value of assets (liabilities plus market value of
equity) as of December 2005
123
LevBook Book leverage defined as total liabilities divided by total assets net
of fair value revaluation reserve
LevBookLong Long-term debt divided by total assets net of fair value revaluation
reserve
LevBookShort Ratio of total liabilities minus long-term debt to total assets net of
fair value revaluation reserve
Convertible Ratio of convertible debt to long-term debt
DebtToOi Total liabilities divided by operating income
Coverage Operating income divided by interest expense
Current Current assets divided by current liabilities
Dividend One if company pays dividends and zero otherwise
FairInvPr One if a company holds investment property recorded at fair value
and zero otherwise
DbtIss1 Change in total liabilities that took place from 2005 to 2007 scaled
by beginning-of-period market value of assets (liabilities plus
market value of equity)
DbtIss2 Change in long-term debt that took place from 2005 to 2007 scaled
by beginning-of-period market value of assets (liabilities plus
market value of equity)
FtrLev1 Total liabilities as of 2007 scaled by beginning-of-period market
value of assets (liabilities plus market value of equity)
FtrLev2 Long-term debt as of 2007 scaled by beginning-of-period market
value of assets (liabilities plus market value of equity)
DbtGrow1 Logarithmic growth in total liabilities from 2005 to 2007
DbtGrow2 Logarithmic growth in long-term debt from 2005 to 2007
Note: Unless otherwise stated, variables are measured as of December 2005 using
the Worldscope database.
Appendix 4: Fair value accounting and the book value of assets
Companies that follow historical cost accounting must periodically test their assets
for impairment. An asset is considered impaired under the IFRS when its carrying
amount is higher than (1) its fair value less costs to sell and (2) the present value of
the future cash flows it is expected to generate (IAS36.18). Thus under historical
cost accounting, companies in practice value assets close to fair value if the
depreciated historical costs exceed the fair value. In contrast, under fair value
accounting, companies revalue assets either upward or downward depending on the
change in the fair value estimate. This revaluation implies that the book values of
assets (equity) are likely to be higher for companies that use fair value accounting.
To provide evidence on the differences in balance sheet amounts of fair value versus
historical cost companies, we carry out the following analysis.
Table 11 compares the book value of total assets (book value of equity) divided
by the market value of total assets (market value of equity) for companies that use
fair value with that of companies that use only historical cost. We compute the
123
Table 11 Fair value accounting and book value of assets

Statistics BTM TA/MKT(TA) ROA PPE/MKT(EQUITY)
Panel A: Investment property

Mean
Historical cost mean 0.68 0.80 5.75
Fair value mean 0.87 0.93 4.98
Difference 0.18 0.13 0.77
% 26.78 16.11 13.46
t stat 3.24 4.20 0.56
p value 0.001 0.000 0.574
Median
Historical cost median 0.64 0.83 4.81
Fair value median 0.88 0.97 3.79
Difference 0.25 0.14 1.02
% 38.55 16.45 21.12
z stat 3.74 4.56 1.12
p value 0.00 0.00 0.26
Panel B: Property, plant, and equipment
Mean
Historical cost mean 0.50 0.71 7.47 0.40
Fair value mean 0.94 0.93 4.33 0.94
Difference 0.43 0.22 3.14 0.55
% 86.60 31.20 42.00 136.86
t stat 4.40 4.06 2.24 2.81
p value 0.00 0.00 0.14 0.01
Median
Historical cost median 0.44 0.73 5.97 0.11
Fair value median 0.83 0.93 3.33 0.46
Difference 0.40 0.20 2.64 0.35
% 90.89 26.65 44.22 309.86
z stat 3.91 3.60 1.83 3.12
p value 0.00 0.00 0.07 0.00
Table illustrates the differences in the book value of assets for fair value versus historical cost companies.
Information regarding the use of fair value is hand-collected from companies annual reports in
Thompson One Banker. All other data is collected from the Worldscope database as of December 2005.
Panel A presents a sample of 275 companies (124 UK companies, 151 German companies) that hold
investment property. Panel B is based on a matched sample of companies that began using fair value after
IFRS adoption. We match each fair value company with a historical cost companies on country, two-digit
industry group, and the log of market value of equity and take the closest match. This procedure, which
requires non missing market value of equity, yields 90 observations. BTM is book value of equity divided
by the market value of equity; TA is total value of assets; MKT(TA) is market value of equity plus book
value of liabilities; ROA is return on assets; and PPE/MKT(EQUITY) is book value of property, plant, and
equipment divided by the market value of equity
123
market value of total assets by the sum of the market value of equity and the book
value of liabilities. Panel A of Table 11 presents the evidence for investment
property, and Panel B of Table 11 presents the evidence for property, plant, and
equipment (PPE). Each company that recognizes PPE at fair value is matched on
country, industry, and market capitalization with a company that recognizes all
assets at historical cost. For investment property, we include all of the companies
that hold investment property because there is no pronounced imbalance between
the fair value and historical cost subgroups. We find that, on average, the ratio of
book value of total assets to market value of total assets is 16 % higher for
companies that recognize investment property at fair value; the ratio of book value
of equity to market value of equity is 27 % higher. Among companies that apply fair
value to PPE, we find that the ratio of the book value of total assets to the market
value of total assets and the ratio of the book value of equity to the market value of
equity are, respectively, 31 and 87 % higher than those of matched companies that
use only historical cost. The differences in the book values of assets and equity in
both the investment property and the PPE samples are all significant at the 1 %
level. We also examine how the return on assets (ROA) differs between fair value
and historical cost companies. We find a lower ROA in the PPE sample among
companies that recognize assets at fair value. In the investment property sample, we
also find a lower ROA among companies that use fair value accounting; this
difference, however, is statistically insignificant. (It is not surprising that fair value
accounting for property decreases ROA because while, on average, fair value
accounting increases the book value of assets, upward revaluations do not affect the
net income. For investment property this effect is smaller because upward
revaluations increase both net income and total assets. See Appendix 1.)
The evidence in Table 11 indicates that the decision to use the fair value method
is associated with economically significant differences in companies balance
sheets, which makes companies that use fair value accounting appear less
conservative in terms of their book-to-market ratios. We emphasize that one should
not interpret these results as causal because they are conditional on the companys
decision to use fair value.
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Does Fair Value Accounting For Non-Financial Assets Pass The Market Test PDF

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Rev Account Stud (2013) 18:734775

Does fair value accounting for non-financial assets pass

Hans B. Christensen Valeri V. Nikolaev

Published online: 29 May 2013

Keywords Fair value IFRS Non-financial assets Illiquid assets

JEL Classification M4 M41

H. B. Christensen (&) V. V. Nikolaev

To better understand whether preferences revealed by the managers reflect

to evolve.4 When making policy decisions, regulators need to consider potential

2 Distinctions of the IFRS-based setting and the institutional details

2.1 Fair value under IFRS versus settings in prior literature

consistent with the finding that leveraged companies in danger of violating

2.2 Accounting in the UK and Germany

Balance Income Balance Income Balance Income

Property, plant HC Depreciations/ HC or Both HC and HC or FV Both HC and

accounting.9 This change in focus is reflected, for example, in the conclusion of a

3.1 Cross-sectional predictions

Next, we examine whether managements decision to use fair value is explained by

depreciated. In contrast, fair value forces managers to incur rent on their

4.1 Sample selection

4.2 Valuation practices

In this section, we provide evidence on the prevalence of valuation practices in the

4.2.1 Valuation practices in the UK

Table 3 documents the valuation practices in the UK cross-sectional sample. We

Active companies (March 2008) 2,312

No. Industry name UK Worldscope UK IFRS UK cross-sectional UK switch

All All Excl. N/A

Industry distribution in the UK samples

No. Industry name UK Worldscope UK IFRS UK cross-sectional UK switch

34 Drugs, cosmetics, and healthcare 178 2 4 52 4 44 5 31 4

Panel B: The German sample

Active companies (March 2008) 1,437

No. Industry name German Worldscope German IFRS German sample

All All Excl. N/A

Industry distribution in the German sample

No. Industry name German Worldscope German IFRS German sample

Table 3 UK companies valuation practices after IFRS adoption

No. No. % No. % No. No. % No. %

13 Aerospace 5 5 5 100 0 0 5 5 100 0 0

No. Industry name Property, plant, and equipment Investment property

No. % No. % No. %a No. %b No. % No. %

No. Industry name Property, plant, and equipment Investment property

No. % No. % No. %a No. %b No. % No. %

4.2.2 Valuation practices in Germany

No. % No. % No. % No. % No. % No. %

13 Aerospace 1 1 0 0 1 100 0 0 N/A 0 N/A 1 0 0 1 100

No. % No. % No. % No. % No. % No. %

76 Tobacco 0 0 0 N/A 0 N/A 0 0 N/A 0 N/A 0 0 N/A 0 N/A

Table 6 Asset classes and the application of fair value accounting

4.3 Regression analysis of the choice to use fair value

Panel A: Summary statistics

Inv property dummy 0.182 0.386 0 0 0

differences when real estate is among a companys primary business activities.

Table 8 Determinants of fair value for investment property

UK (constant) 0.460* 1.240 1.370 3.084** 4.153*** 4.456**

Variables (1) (2) (3) (4) (5) (6)

Observations 275 244 172 182 192 140

Table 9 Future financing and the use of fair value accounting

Fair 0.181** 0.130* 0.665* 0.357* 0.444*** 0.445**

While the investment property sample offers richer variation, an understanding of

5 Summary and discussion

Table 10 Use of fair value for property, plant, and equipment

Germany -2.130*** -2.109*** -1.885*** -1.920*** -1.987***

UK (constant) 0.460* 1.240 1.370 3.084 4.153* 4.456**

Fair 0.181** 0.130* 0.665* 0.357* 0.444* 0.445

Germany -2.130* -2.109* -1.885* -1.920* -1.987***