In this study, I investigate the effect of adopting the FIRS standard for fixed asset revaluation by examining the relationship between changes in revaluation reserves and stock prices. Out of the 1 5 countries used for the analyses, five countries have revaluation reserves that are statistically significant in explaining the market value of equity, suggesting that revaluation reserves are value relevant for those countries. I further break down the sample countries and categorize them based on the legal system to which they are subject, whether common law or code law.
The results suggest hat revaluation reserves of common law countries are value relevant, while those of code law countries are not. This study contributes to the international accounting literature by suggesting that the effect of adopting new FIRS rules, such as AS 16, may differ in each country due to various legal, economic, cultural, and social forces. [Keywords] International accounting; value relevance; asset revaluation; revaluation reserves Introduction In August 2008, the Securities and Exchange Commission (SEC) of the U. S. Outlined a “road map” promoting the acceleration of the nonviolence effort of US firms to adopt International Financial Reporting Standards (FIRS). It proposes that by 2014, all U. S. Firms will be required to issue financial statements in accordance with FIRS (see SEC for Immediate Release 2008-184). In this study, I investigate the effect of adopting the FIRS standard for fixed asset revaluation (AS 16) using companies in the countries where firms follow FIRS and are able to choose either the cost method or the fair value method to value their long-term fixed assets.
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If firms choose the fair value method, hey revalue their fixed assets annually as measured by market value, and the revaluation reserves of fixed assets affect the equity value of the firms. In this study, I specifically investigate the relationship between changes in revaluation reserves and stock prices in various countries. The sample for this study includes 1 5 countries, each with at least 30 companies that have valid revaluation reserves data for the year 2005.
Using multivariate analyses, which examine the relationship between the amount of revaluation reserves and the market value of equity, I find that five of the 15 countries selected in the sample have revaluation reserves that are statistically significant in explaining the market value of equity, suggesting that revaluation reserves are value relevant for those countries. The revaluation reserves for the other 10 countries are not statistically significant, signifying that for those countries, revaluation reserves are not considered for investment decisions and are, therefore, not value relevant.
I further examine the value relevance of revaluation reserves by partitioning the sample countries into two different country groups. I categorize countries based on their legal system to which they are subject, whether common law or code law, as suggested by Redheaded, Sidney, and Black (2006) and Sheehan and Lou (2008). The results suggest that revaluation reserves of common law countries are value relevant, while those of code law countries are not.
This paper contributes to the existing knowledge on the value relevance of asset revaluations by examining equity valuation based on variables other than those commonly used, such as net income and the book value of equity for various countries. By doing so, this study intrigues to the 73 international accounting literature by suggesting that the effect of adopting new FIRS rules, including ASSAI, may differ due to the legal, cultural, and social differences of each country.
This study also makes predictions regarding the value relevance of revaluation reserves for US firms once they are required to adopt FIRS and are, thus, allowed to report fixed assets based on fair market value. The rest of the paper is organized as follows: I discuss the background of FIRS, international accounting rules for fixed assets, and the review of prior search regarding fixed asset revaluations in section two. In section three, I discuss the research questions of this study and explain the hypotheses. I discuss the data collection procedures and methodology in section four.
In section five, I discuss the main results and the general implications of the results. Finally, in section six, I make concluding remarks. Background and Prior Research on Revaluation Reserves Difference between US GAP and FIRS on Fixed Asset Valuation To facilitate the need for comparability and to reduce the cost of financial statement reporting, the European Union (ELI) adopted FIRS in 2005. Many non-E countries around the world have also adopted FIRS or have outlined incremental steps for convergence in an effort to increase accessibility to foreign sources of equity capital. In the U. S. The government and regulatory bodies, as well as accounting standards setters, have made commitments and set agendas to reduce the differences between U. S. GAP and FIRS to move closer to convergence. In 2002 at a meeting in Norwalk, Connecticut, the SAAB and the FAST agreed to harmonize their agendas and to work toward reducing the differences between FIRS and U. S. GAP (the Norwalk Agreement). Beginning in 2008, foreign private issuers are permitted to file financial statements in accordance with FIRS without reconciliation to U. S. GAP. In August 2008, the SEC outlined a “roadman” that allows the early adoption of FIRS for some U.
S. Companies in 2010 and requires all companies to use FIRS in 2014 Monsoons 2009). Under U. S. GAP, the current rules and guidelines for measurement of long-term fixed assets, including property, plant, and equipment are presented in SFA 144. When fixed assets are acquired, they are initially recorded at cost. In subsequent years, when an asset’s book value deviates from market value, an accounting adjustment is required to reflect this change. SEAS 144 states that an impairment loss must be recognized when the sum of future undistorted cash flows of the asset is less than its carrying amount.
When this occurs, the asset is written down to its fair value, or discounted future cash flows, and the loss is recognized in the income statement. However, no upward revaluation is permitted when the market value of the asset rises above its carrying book value, and, therefore, no adjustments are dad to the financial statements. Under FIRS, the rules for measurement of fixed assets are presented in AS 16, which allows two valuation models for measurement of fixed assets: (1) The cost model and (2) The revaluation model.
Under the cost model, fixed assets are carried at historical cost less accumulated depreciation and impairments. Under the revaluation model, fixed assets are carried at fair market value at the date of revaluation less accumulated depreciation. Revaluations are to be made so that the carrying amount does not differ significantly from fair value. At the revaluation date, when the market value is higher than the carrying book value, the amount that the market value exceeds the book value is recognized as “revaluation surplus. This surplus bypasses the income statement and is credited directly to revaluation reserves in owner’s equity on the balance sheet in the year that the assets are revalued. In sum, under US GAP, when the market value of fixed assets rises above the book value at each reporting date, no adjustment needs to be made on the financial statements. However, under FIRS, an upward revaluation equal to the amount by which the market value exceeds the carrying kook value is recognized and credited to the revaluation reserve account in owners’ equity on the balance sheet.
Prior Research on Revaluation Reserves Stock Price Relevance. Gaston, Eddy, and Harris (1993) use a sample of 100 large Australian 74 firms from 1981 to 1990 to examine the value relevance of revaluation reserves. They find that changes in asset revaluation reserves statistically explain stock price returns over the traditional earnings and earnings change variables, and that the level of revaluation reserves has significant explanatory power for price-to-book ratios.
Similarly, Birth and Clinch (1998) show that revalued assets are value relevant to stock prices, and the revalued amount correlates to the firm’s profitability in the future based on a sample of 776 companies in Australia during 1996. In the discussion paper of Gaston, Eddy, and Harris (1993), Bernard (1993) points out that a market-based test provides only indirect evidence about the relation between revaluation reserves and future operating performance.
Following Barnyard’s suggestion, Body, Birth, and Asking (1999) examine a sample of I-J firms and show that asset revaluations are significantly and costively related to changes in future performance, measured by operating income and cash flows from operations. Jaggy and Thus (2001) examined fixed asset revaluation in Hong Kong from 1991 to 1995 and found a significant positive relationship between revaluation and future operating income, signaling the usefulness and relevance of the fair market value of assets to financial statement users.
In addition, Cotter and Simmer (1999) obtained a sample of Australian firms from 1987 to 1993 and found that the propensity to revalue fixed assets as related to the degree of management certainty that the value increase will be realized in future cash flows. Firm Characteristics and Asset Revaluations. Prior studies have examined what firm characteristics are related to the decision of revaluing fixed assets.
Brown, Azans, and LOL (1992) selected a sample of 204 Australian firms during 1974-1977 (higher inflation) and 206 Australian firms from 1984-1986 (lower inflation), and have shown that firms revaluing long-term assets are large in size, have high leverage, and are close to violation of debt covenants. Cotter and Simmer (1995) and Whittier and Chain (1992) used Australian firm data, and showed that management incentives for asset revaluation were closely associated with declining cash flows from operations and corresponded to the demand of creditors for collateral borrowings.
Missioner-Piper (2007) uses a sample of industrial and commercial firms in Sweden during 1994, 1997, 2000, and 2005 to show that asset revaluation improves creditworthiness of companies relying on debt financing and has the effect of increasing companies’ borrowing capacity. Similarly, Nichols and Burger (2002) find that German banks give significantly higher loans to companies valuing fixed assets using the fair value method. In sum, prior studies have provided strong evidence of a relationship between the decision of revaluing fixed assets and firms’ financing need.
Additionally Line and Peasants (2000) examined a sample of I-J firms that revalued fixed assets during 1989 to 1991 and found that upward revaluation was associated with depletion of equity, indebtedness, poor liquidity, size, and fixed asset intensity. Greenback and Buglers (1999) used a sample of Belgian industrial impasses from 1989 to 1994 to show that successful firms in those industries with a high variance in performance or with low equity-to- debt ratios, are less likely to revalue assets, and that firms that move closer to technical default or violate covenants are more likely to revalue assets.
Regarding superiority between the fair value method and the cost method, Herrmann, Quadrangular, and Thomas (2006) find that for long- term assets, fair value is superior to historical cost because of the characteristics of predictive value, feedback value, timeliness, neutrality, representational faithfulness, comparability, and consistency. Cotter and Richardson (2002) use a sample of Australian firms during the period from 1981 to 1999 and find that asset revaluations are more reliable from independent appraisers than from the company’s board of directors, with reliability being measured as upward revaluation write-downs in subsequent years.
Hypotheses The focus of this study is to examine whether the annual revaluation reserves of fixed assets are value relevant to firm equity values. Because assets by definition are probable future economic benefits to entities, the upward asset revaluation to fair value must be due to n increase in probable future benefit. 75 I predict that the event of an upward asset revaluation is positively correlated with stock price because of the perceived increase in value of assets and the probable future cash flows associated with the higher fixed asset value.
My first hypothesis, therefore, is HI : Revaluation reserves are value relevant. Furthermore, revaluation reserves are positively related to stock prices. I further partition countries into two different country groups, and test the value relevance of revaluation reserves. I categorize countries based on their legal system? neutrinos subject to a common law system and countries subject to a code law system (Redheaded, et al. , 2006).
Common law refers to a legal system in which court decisions are based on prior authority of similar cases or precedent. Code law, on the other hand, refers to a legal system that is based on statutes enacted by the legislature. Countries included in common law or code law groups are presented in Table 1 . Table 1 . Common vs.. Code Law Country Classification Common Law Australia Bermuda Great Britain Hong Kong India Malaysia Philippines Singapore Code Law Brazil Cayman Islands
Greece Indonesia Japan Korea Thailand I predict that in a common law system, the reliance on precedents results in relatively precise guidance on terms of contract and expectations of performance, and, therefore, stock markets operating under it will provide information that is relatively transparent and complete. In contrast, companies in a code law system may not fully disclose financial information when there is no precedent to be based upon because the probability of potential violation of the law is assessed to be low.
Therefore, stock markets operating under a code law yester may be less efficient and less information transparent than those under a common law system. Therefore, I predict that stock markets operating under a common law system are more efficient and reliable than those operating under a code law system to the extent that the information of fixed asset revaluation reserves in countries under a common law system are to be more informative for creditors and investors. My second hypothesis, therefore, is H2O: Revaluation reserves are more value relevant in countries under common law than in those under code law.
Sample Selection and Methodology Sample I include all countries available in the Global Industrial/Commercial database found in the Communist Global database. I collect data for revaluation reserves, net income, and the book value of equity for the year 2005. To obtain the 2005 annual revaluation reserve amounts, I collect data for the ending balance of revaluation reserve for both 2004 and 2005 and then subtract the ending reserve balance of 2004 from 2005 to arrive at annual revaluation reserve amounts for 2005.
Many countries in the database have no revaluation reserve balance or 2004 or 2005 either because they were not permitted to revalue their fixed assets upward under their accounting rules or because no deviation of book value from the market value existed at the balance sheet date. I exclude these companies from my analysis. I further exclude 65 countries from my analysis due to their small sample size of companies and I am left with 15 countries that have a sample size of at least 30 companies. Firms’ market values are calculated by multiplying stock price by the number of shares outstanding.
I collect stock rice and common shares outstanding data from Global Security Daily found in the Communist Global database. I use stock price three months after the company’s fiscal year end and the number of shares at that date because I, along with many prior value-relevance studies 76 (see for example, Barley, et al. , 2007), assume that the market takes an average of three months to absorb information regarding changes in asset values for pricing firm’s securities. Methods I use the regression model to conduct the value relevance analysis on fixed asset revaluation.
I include annual change in revaluation serves as well as net income and the book value of equity as independent variables to control for their effect on price. All independent variables are scaled (divided) by number of shares. I then run the regression against the dependent variable, the stock price three months after fiscal year end. Revaluation reserve is my variable of interest as I analyze its market value relevance. The equation of the regression model is: price = Alan + babe + rear + E Where: IN is the net income reported by companies at fiscal year end. BE is the book value of shareholders’ equity on the balance sheet ate.
OR is the annual change in the revaluation reserve balance that adjusts the book value of fixed assets to market value Results Value Relevance Analysis for Each Country Table 2 presents findings for the value relevance of revaluation reserves, net income, and book value of equity for each country. It reveals that the revaluation reserves for Great Britain and Bermuda are statistically significant at the 1 percent level in explaining stock prices, and the revaluation reserves for Australia, Hong Kong, and the Philippines are statistically significant at the 5 percent level.
However, revaluation reserves for the other ten countries are not value relevant. Also the signs of the coefficients of revaluation reserves for Australia, Bermuda, and the Philippines are opposite of the predictions. The negative significant coefficients of revaluation reserves may indicate that regardless of the upward revaluation of fixed assets, the market pays more attention to other negative financial and accounting performance of reevaluating companies. In sum, only two countries, Great Britain and Hong Kong, support my hypothesis, HI .
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