The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets

ADIAC-00185; No of Pages 12 Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

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The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets Boochun Jung b, 1, Hamid Pourjalali a, 2, Eric Wen a, 3, Shirley J. Daniel a,⁎ a b

School of Accountancy, Shidler College of Business, University of Hawai'i at Mānoa, 2404 Maile Way, Honolulu, HI 96822, United States School of Business, Yonsei University, 134 Shinchon-Dong, Seodaemoon-Ku, Seoul, 120-749, Republic of Korea

a r t i c l e

i n f o

Available online xxxx Keywords: Fair value Value relevance FAS 157 FAS 159 Adoption of standards

a b s t r a c t SFAS 157 provides a common definition for fair value while SFAS 159 expands the applicability of the fair value option. This paper analyzes the responses of 209 CFOs of U.S. firms to a survey asking whether they would choose the fair value option for non-financial assets (FVONFA) and investigates the determinants of CFOs' responses to the option. One of our results suggests that CFOs in the U.S. are resistant to the FVONFA, consistent with prior studies based on firms in Europe and Australia. Our results also suggest that firm size, leverage, the amount of non-financial assets, and expertise in fair value measurements all positively affect the CFOs' responses to the FVONFA. © 2013 Elsevier Ltd. All rights reserved.

1. Introduction The Financial Accounting Standards Board (FASB) has issued two standards related to fair value accounting for financial instruments: SFAS 157 (2006), Fair Value Measurements, and SFAS 159 (2007), The Fair Value Option for Financial Assets and Financial Liabilities.4 SFAS 157 provides a common definition for fair value while SFAS 159 expands the applicability of the fair value option.5 The FASB has acknowledged that SFAS 159 is the first phase in a two stage process (Guthrie, Irving, & Sokolowsky, 2011). Phase two will more comprehensively address fair value measurement by mandating adoption and increasing the scope of eligible items, including non-financial instruments (FASB, 2007).6 U.S. GAAP requires ⁎ Corresponding author. Tel.: +1 808 956 3249; fax: +1 808 956 9888. E-mail addresses: [email protected] (B. Jung), [email protected] (H. Pourjalali), [email protected] (E. Wen), [email protected] (S.J. Daniel). 1 Tel.: +1 808 956 8461. 2 Tel.: +1 808 956 5578; fax: +1 808 956 9888. 3 Tel.: +1 808 956 7028; fax: +1 808 956 9888. 4 Although the FASB postponed the adoption of these two Statements for one year, the postponement period expired before 2008 and both Statements represent U.S. GAAP. Firms with fiscal years beginning after November 15, 2007 are required to adopt SFAS 157. 5 SFAS 157 establishes a three-level hierarchy to help clarify how to measure fair value. Level I inputs have active markets with quoted prices for identical assets or liabilities, Level II inputs have reasonably available prices and include quoted prices in markets for comparable assets and liabilities, while Level III inputs are unobservable. Thus, Level II and Level III inputs are more costly and difficult to obtain than Level I inputs. Information on Level II and Level III items is relatively less reliable than that on Level 1 items (Song, Thomas, & Yi, 2010). 6 FASB Staff Position, No. 157-2, partially delays the effective date of FASB Statement No. 157 for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).

fair value accounting for impairment of non-financial assets only and does not allow subsequent upward measurement for these assets. In contrast, the International Financial Reporting Standards (IFRS) allow subsequent upward revaluation as well as asset impairment for non-financial assets. Beginning in March 2008, the SEC has allowed multi-national corporations not based in the U.S. to file financial statements prepared according to the English version of IFRS without reconciliation to U.S. GAAP (SEC 2007).7 Many in the U.S. do not support this action, with their main opposition centering on the fact that U.S. GAAP and IFRS are different in many of their measurement and disclosure requirements.8 One of the main differences between U.S. GAAP and IFRS is the availability of alternative measurement choices (historical cost vs. fair value) for non-financial assets. Although academics and standard setters, as well as practitioners, are debating the use of the fair value option for non-financial assets (hereafter, FVONFA), our knowledge as to what the overall response of practitioners in the U.S. will be to this issue is limited. Our study attempts to fill this void. This paper analyzes the responses of CFOs of U.S. firms to a survey asking whether they would choose the FVONFA and investigates the determinants of CFOs' responses to the option. We mailed our survey questionnaire to the CFOs of 2488 firms subject to the Sarbanes– Oxley legislation compliance (i.e., their market value is greater than $75 million) in July 2008. We received 209 completed surveys, for a response rate of 8.4%. Of the 209 respondents, less than 10% indicate that they would use fair value accounting for non-financial assets,

7 In August 2007, the SEC issued a concept release stating it was considering allowing U.S.-based companies to choose whether to file financial statements according to U.S. GAAP or IFRS (SEC 2007b). 8 Please refer to the SEC's website to see many of the comments received by the SEC opposing the rule.

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Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

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consistent with findings that firms in the European Union (EU) were not willing to adopt fair value accounting for non-financial assets when the option was given (i.e., Christensen & Nikolaev, 2012). To examine the determinants of CFOs' attitudes toward the adoption of FVONFA, we develop five hypotheses regarding the following firm characteristics: firm size, leverage, profitability, the ratio of non-financial assets to total assets, and the extent of expertise in fair value measurements. With respect to firm size, we develop two competing hypotheses as to its relationship to managers' preference on the FVONFA. Since the cost of adopting fair value accounting is greater for smaller firms, we expect that smaller firms will be less willing to adopt the fair value option. However, it is also possible that managers of smaller firms have a greater incentive to choose the FVONFA in order to provide more value-relevant information to the market. The literature reveals that information on fair value is more value-relevant (Barth, Beaver, & Landsman, 2001) and thus reduces information asymmetry (Frankel & Li, 2004) and that the information content of accounting information is negatively related to firm size (e.g., Zeghal, 1984). We also predict a positive relationship between firm leverage and CFO preference for the FVONFA because the application of fair value accounting for non-financial assets usually increases the likelihood of overstating the book value of assets, resulting in a decrease in leverage ratio and thus enhanced borrowing capacity (Cotter & Zimmer, 1995). Our third hypothesis on the relationship between profitability and the adoption of the FVONFA is based on the proposition that upward revaluation for non-financial assets usually increases the book value of assets and thus decreases profitability (e.g., ROA). Therefore, we hypothesize that managers of less profitable firms are more reluctant to adopt the FVONFA. Our fourth hypothesis concerns the relationship between the proportion of non-financial assets to total assets and the adoption of the FVONFA. On one hand, since the cost of using fair value for non-financial assets increases with the amount of such assets, managers of firms with higher amounts of may be more reluctant to adopt the FVONFA. On the other hand, from the perspective of the value-relevance of accounting information, firms with higher amounts of non-financial assets have greater incentives to adopt the FVONFA to provide more value-relevant information to investors. Thus, the relation between the amount of non-financial assets and a firm's adoption of the FVONFA depends on opposing views. Finally, using the extent of fair value measurement for Level II and Level III items under SFAS 157 as a proxy for expertise in fair valuation since these items are complex and thus the fair value is difficult to estimate, we investigate how fair valuation expertise affects firms' attitude toward the adoption of the FVONFA. We hypothesize that expertise in fair value measurement for complex financial assets and liabilities will positively influence the CFO's response to the FVONFA. Our results are generally consistent with our predictions except for profitability. We find a higher likelihood to adopt the FVONFA among larger, more leveraged firms, firms with more non-financial assets, and firms with expertise in fair value measurement. However, since the number of firms that prefer the fair value option is only approximately 9% of our sample, one should be careful in generalizing our results to the universe of firms in the U.S. Very little research surveys executives with respect to the fair value accounting option. To the best of our knowledge, this study is the first to investigate responses of CFOs of U.S. firms to the FVONFA. Contemporary research by Christensen and Nikolaev (2012) empirically examines the FVONFA among firms in the U.K. and Germany. They find that those firms are less likely to shift toward the FVONFA after the IFRS adoption and those firms' preference on the FVONFA is positively related to reliance on debt financing, similar to our results based on U.S. firms. We contribute to this line of research by directly implementing surveys on U.S. CFOs' preferences on the FVONFA. In addition, one benefit of our research design being based on a survey is that we provide some

preliminary evidence of implementation of a proposed standard while nearly all research focuses on implementation of existing standards. Thus, our results can provide helpful and insightful information to standard setters while they are deliberating. We also contribute to the literature by showing that firms' decisions to adopt the FVONFA reflect the benefits and costs of the adoption. The results in our paper are also important because they can help predict which firms will face more costs or benefits – reflected in the cost of equity or debt capital – when adopting the FVONFA. 2. Background on fair value accounting in the U.S. Debates on historical cost vs. fair value are not new to accounting. For example, Weston (1953) advocated fair value accounting in spite of its higher costs. The requirement during the high inflation years of the late 1970s for U.S. public firms to disclose non-audited supplemental financial statement information using replacement cost and general price-level-adjusted amounts was perhaps the first real attempt in the U.S. to implement fair value measurements for non-financial assets such as property, plant, and equipment. While this requirement was dropped after inflation was brought under control, the debate about the shortcomings of historical-cost-based financial statements has not subsided. This debate has become more important in recent years as the fair value of the assets of financial institutions has decreased and reporting them using the SFAS 157 rules has resulted in regulatory intervention and/or bankruptcy proceedings. PriceWaterhouseCoopers (PwC) (2008) reflects on this debate from three aspects: the relevance of information to investors, the reliability of that information, and companies' ability to implement fair value cost-effectively. PwC supports fair value as the best available method for most financial instruments, particularly financial assets, and considers the use of fair value as the most effective method to reflect the economic realities of market conditions. However, given that liquid and primary markets can be limited or may not exist for many assets and liabilities (particularly non-financial assets, such as manufacturing facilities, distribution networks, and customer lists), it is challenging to determine fair values. As such, PwC questions the extension of fair value accounting to many assets and liabilities. Véron (2008) summarizes the criticisms of fair value accounting as “illiquidity” and “procyclicality.” The “illiquidity” criticism stems from an imbalance between supply and demand. That is, the prices may not reflect the true value of the items measured. This is true when, as a result of severe economic recessions, market participants do not act rationally. “Procyclicality” occurs when the observable prices are flawed because the market is imperfect. In general, fair market accounting is expected to provide more value-relevant information (Hitz, 2007). But when the economy suffers from a significant recession or experiences a bubble, information based on fair market accounting may result in misleading numbers (Leonard, 2008). Some attribute the financial crisis to fair value accounting. 9 As Véron (2008) reports, some financial leaders, such as Martin Sullivan, the ex-CEO of AIG, and Henri de Castries, the CEO of AXA, have singled out fair value and the related wide use of mark-to-market accounting as a major factor in the crisis.10 On September 30, 2008, in recognition of difficulties with the fair value measurement and reporting, the SEC issued a clarification providing additional guidance for preparing 9 For example, in her article in Forbes, Moyer (2008) argues that “This is a debate that has raged for months among auditors, bankers, pundits and politicians; finding a solution to please everyone has proven difficult. More than $350 billion of writedowns and losses later, confusion and uncertainty reign.” Source: http://www.forbes. com/2008/06/24/accounting-banking-sec-biz-cx_lm_0625sec.html, “How Fair Is FairValue Accounting?” (Liz Moyer, June 25, 2008). 10 Former FDIC Chair, William Isaac also places much of the blame for the subprime mortgage crisis on the SEC and its fair-value accounting rules, especially the requirement for banks to “mark-to-market” their assets, particularly mortgage backed securities (Sopelsa, 2008).

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

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financial reports based on the application of fair market values. In October 2008, the U.S. Congress responded to the financial crisis. Section 132 of the Emergency Economic Stabilization Act of 2008, “Authority to Suspend Mark-to-Market Accounting,” reaffirmed the SEC's authority to suspend the application of fair value measurement if the SEC determines that it is not in the public interest and does not protect investors. Furthermore, it required the SEC, in consultation with the Federal Reserve Board and the Department of the Treasury, to study the mark-to-market accounting standards as provided in SFAS 157, including their effects on balance sheets and their impact on the quality of financial information, among other matters, and to report its findings to Congress within 90 days.11 The SEC published the results of the study in its “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting” (SEC 2008). Interestingly, the study recommends that existing fair value and mark-to-market requirements not be suspended. However it recommends improvements to existing accounting standards and practice, including reconsideration of the accounting for financial asset impairments and development of additional guidance for determining fair value.12

3. Literature review and hypothesis development 3.1. Fair value accounting in IFRS Since the FVONFA is not allowed for U.S. firms, most of our literature review focuses on studies based on the European Commission's move to IFRS for all companies listed on European stock exchanges in 2005. Demaria and Dufour (2007) show that based on 120 French firms listed in the SBF 120 index, the use of the fair value option (i.e., fair value exemption of IFRS 1, IAS 16, 38 and 40) is unrelated to firm size, leverage, CEO's compensation, institutional ownership, and the existence of cross-listing, while the most significant predictor for adopting the fair value option is industry membership in the financial services. These results, they argue, suggest that French firms prefer to maintain historical cost. Cairns, Massoudi, and Tarca (2011) also document the lack of interest in fair value accounting in their investigation of the use of fair value measurement by 195 firms listed in the U.K. and Australia following the adoption of IFRS in January 2005. Their results show very little voluntary use of fair value measurement for tangible, intangible, or financial assets, suggesting that most firms in the U.K. and Australia prefer a conservative approach and lack incentives to use fair value measurements. In a more recent study based on 1539 U.K. and German firms (934 in the U.K. and 605 in Germany), Christensen and Nikolaev (2012) find that options in IFRS do not provide additional incentives for German and U.K. firms to switch to fair value accounting. Surprisingly, they find that U.K. firms which have traditionally used fair value for real estate, upon the adoption of IFRS, elect to switch to historical cost. Overall, Christensen and Nikolaev 11 The act mandated that the SEC, at a minimum, study the following six key areas: (1) The effects of such accounting standards on a financial institution's balance sheet; (2) The impact of such accounting on bank failures in 2008; (3) The impact of such standards on the quality of financial information available to investors; (4) The process used by the Financial Accounting Standards Board (FASB) in developing accounting standards; (5) The advisability and feasibility of modifications to such standards; and (6) Alternatives to accounting standards provided in FASB Statement No.157. 12 The study outlines eight recommendations (PwC 2008): (1) FASB Statement No. 157 should be improved, but not suspended; (2) Existing fair value and mark-to market requirements should not be suspended; (3) Additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates); (4) The accounting for financial asset impairments should be readdressed; (5) Further guidance should be implemented to foster the use of sound judgment; (6) Accounting standards should continue to be established to meet the needs of investors; (7) Additional formal measures to address the operation of existing accounting standards in practice should be established; and (8) The need to simplify the accounting for investments in financial assets should be addressed.

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(2012) show that firms generally perceive that the benefits of fair value accounting in IFRS do not exceed its costs. Hitz (2007) suggests that fair valuation is relevant from both a measurement perspective and information perspective. As such, investors may find information based on fair value more useful than information based on historical cost and in response, when given the choice, managers of U.S. firms may adopt fair value measurement and reporting if their foreign competitors choose to do so. Since foreign firms following IFRS have had the fair value option, managers of U.S. firms may choose to adopt fair value in lieu of historical cost valuation to make sure that they remain competitive. While U.S. firms may choose the fair value option because of their competition, it is also possible that, similar to their international companies subject to IFRS, they will show a lack of interest. 3.2. Fair value accounting for non-financial assets Although non-financial assets consist mainly of investment property, intangible assets, and property, plant, and equipment (hereafter, PPE) (Christensen & Nikolaev, 2012), prior studies usually focus on fair value accounting for PPE. The fair value option is more controversial for non-financial assets than for financial assets, as the estimations by managers that it requires are more subjective than are those for financial assets whose quoted prices are usually either available in the active market or observable from the price of comparable assets. Active markets for non-financial assets in many cases do not exist, particularly for operating assets, such as PPE. When active markets are not available, the fair value of non-financial assets should be determined based on the present value of estimated future cash flows or by qualified appraisals. It is one of the main challenges to the use of FVONFA. Even though an upward revaluation of non-financial assets is prohibited in the U.S., it is practiced in many European and Asian countries. Furthermore, several studies show that managers exercise discretion on the timing and the magnitude of revaluation (Brown, Izan, & Loh, 1992; Gaeremynck & Veugelers, 1999; Jaggi & Tsui, 2001; Lin & Peasnell, 2000; Missonier-Piera, 2007). Thus, the reliability of revaluation amounts is highly controversial and the revaluation of fixed assets calls for ongoing intense debate (e.g., Aboody, Barth, & Kasznik, 1999; Lin & Peasnell, 2000). However, the accounting literature asserts that information asymmetry on the firms' assets value can be reduced by this departure from the historical-cost principle. Through revaluation, a firm may disclose to investors the underlying economic value of its fixed assets and hence its actual financial situation (Brown et al., 1992). Brown et al. (1992) contend that when an asset's book value differs substantially from its fair value, managers should make relevant adjustments to reduce information asymmetry even if doing so may lead to increasing the book value of the asset in question and violate historical-cost and conservatism principle. 3.3. Determinants of adoption of fair value option for non-financial assets Prior studies examine various motivations behind the decision to revalue non-financial assets by comparing fundamental differences between firms using revaluation and firms not using revaluation. Lin and Peasnell (2000) suggest that the likelihood of equity depletion in the current period or near future motivates managers in the U.K. to revalue assets upwards. They argue that equity depletion leads to violating debt contracts, and if upward asset revaluation reduces the debt-to-equity ratio to within the acceptable range of borrowing limits, such revaluation enables firms to avoid the problems of violating debt contracts by increasing the amount of equity in the most reasonable manner. Brown et al. (1992) also provide empirical evidence that asset revaluations are motivated by borrowing considerations. Brown et al. (1992) further propose that assets revaluation by Australian firms may have helped decrease information asymmetries between the managers and capital market participants and is a way for managers

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

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to signal private information to the capital markets. Easton, Eddey, and Harris (1993) also find that, based on Australian firms, asset revaluations loosen debt constraints and enhance financial flexibility. In addition, they show that book values that include asset revaluation reserves are more aligned with the market value of the firm than book values that exclude asset revaluations, suggesting that asset revaluation reserves as reported under Australian GAAP provide a better summary of the current state of the firm. Accounting literature suggests that firm size influences revaluation decisions as well (Brown et al., 1992; Gaeremynck & Veugelers, 1999; Missonier-Piera, 2007). Gaeremynck and Veugelers (1999) find that firms revaluing PPE are larger and have larger property holdings and lower market-to-book values. Missonier-Piera (2007) finds that firms' cross-country listing status and ownership structure influence managers' accounting decisions. Since upward revaluation decreases profitability ratios, managers are less likely to revalue assets in a very spread ownership structure. 4. Hypothesis development In this section, we develop our hypotheses as to how the following firm characteristics may affect managers' attitudes toward adoption of the FVONFA: firm size, leverage, profitability, the amount of non-financial assets, and the extent of expertise for fair value accounting. Fundamentally, managers' decisions to adopt the FVONFA depend on the benefits and costs of the adoption to firm value. Thus, we hypothesize that firms with higher benefits (costs) from the adoption are more (less) likely to adopt the FVONFA. 4.1. Firm size There are two opposing views on the relation between firm size and the choice of FVONFA. The first view is based on literature showing that fair value measurement and reporting is more value-relevant than historical cost and thus helps investors make more efficient decisions. For example, Brown et al. (1992) argue that asset revaluation of Australian firms mitigates information asymmetries between managers and outsiders. Since the information environment is much richer (e.g., higher stock analyst coverage; more media attention) for larger firms than for smaller firms, investors in larger firms can access many different information sources. In contrast, investors in smaller firms are more likely to rely on financial reports to obtain financial information. Using fair value measurement and reporting for non-financial assets on financial statements will lower the information asymmetry between investors and managers to a larger extent for smaller firms (Barth & Clinch, 1998), and thus the benefit from using fair value accounting is lower for larger firms. Based on this view, one can predict that managers of smaller firms are more likely to choose the FVONFA to provide more value-relevant information to the market; that is, a negative relationship exists between firm size and the choice of FVONFA. The second view of the effect of firm size on the FVONFA is related to the cost of adopting the fair value accounting for non-financial assets. Since significant costs are associated with adopting the FVONFA, managers who consider the option will compare the costs with the economic benefits (e.g., Cotter & Zimmer, 1995). A significant portion of the cost of adopting the fair value measurement comes from a substantial fixed cost and is relatively higher for smaller firms, suggesting economies of scale for larger firms. There is also empirical evidence that firms that revalue assets of PPE are larger (e.g., Brown et al., 1992; Gaeremynck & Veugelers, 1999; Missonier-Piera, 2007). Therefore, the cost of fair valuation may not be as significant for larger firms as for smaller firms, and larger firms may consider the cost lower than do smaller firms when viewed as a proportion of their total assets. Furthermore, the literature provides convincing evidence that larger firms are more likely to provide more voluntary and more detailed disclosures (Ajinkya, Bhojraj, & Sengupta, 2005; Lang & Lundholm,

1993). Therefore, the relation between firm size and the adoption of the FVONFA depends on the dominance of one of the two opposing views. This leads to the following hypothesis: H1. Larger firms are more (or less) likely to adopt the fair value option for non-financial assets. 4.2. Leverage Firms that rely heavily on the debt market for financing, i.e., highly leveraged firms, are commonly required by independent appraisers to provide valuations of collateral under their credit arrangements (Lemmon, Roberts, & Zender, 2008). Debt-holders are particularly interested in the fair value of assets because they are eager to know their liquidation value (Christensen & Nikolaev, 2012). Consistent with this argument, Christensen and Nikolaev (2012) document a positive association between the adoption of fair value for non-financial assets and reliance on debt financing for U.K. and German firms. More importantly, the application of fair value accounting for non-financial assets increases the likelihood of overstating the book value of assets, resulting in lower leverage, and thus lower financial risk. Thus, firms choosing the fair value option to revaluate their non-financial assets upward may improve their ability to raise new loans by reducing the risk of violating accounting-based covenants as a result of a strengthened balance sheet (e.g., Brown et al., 1992; Jaggi & Tsui, 2001; Lin & Peasnell, 2000). Cotter and Zimmer (1995) find that firms with higher leverage, and thus higher likelihood of violating covenants, tend to revalue assets. Brown et al. (1992) and Easton et al. (1993) also claim that the primary motivation for asset revaluation of Australian firms is the need of firms to reduce debt-to-equity ratios. Therefore, we predict that a firm's reliance on debt financing is positively related to the choice of the FVONFA. This leads to our second hypothesis: H2. Firms with higher leverage prefer fair value accounting for non-financial assets. 4.3. Profitability We also examine how a firm's performance affects the choice to use the FVONFA. We conjecture that managers of firms with lower operating performance will be more reluctant to choose the FVONFA because fair value accounting for non-financial assets usually increases the book value of assets. While upward revaluations of non-financial assets do not affect the net income, particularly for property, plant, and equipment, an increase in the book value of assets reduces operation performance measures such as return on assets (ROA). Since managers have various incentives (including compensation related incentives) to avoid a decrease in firm performance, managers of less profitable firms will be less willing to adopt the FVONFA. This leads to the following hypothesis: H3. Lower profitability is negatively related to the adoption of fair value accounting for non-financial assets. 4.4. Amount of non-financial assets We also examine how the significance of the amount of non-financial assets compared to total assets will affect managers' choice to adopt the FVONFA. It is straightforward that the larger the proportion of non-financial assets to total assets, the greater the effect on firm value of adopting the FVONFA. On one hand, since the cost of using fair value for non-financial assets increases with the amount of non-financial assets, managers of firms with higher amounts of non-financial assets may be more reluctant to adopt the fair value option. On the other hand, from the perspective of value-relevance, firms with higher amounts of non-financial assets have greater

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

B. Jung et al. / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

incentives to adopt the fair value option to provide more valuerelevant information to investors. Barth and Clinch (1996) find that in Australia, the revaluation of fixed assets for mining firms, where the ratio of fixed assets to total assets is higher, has a significant relationship with share prices. Thus, it is an empirical question whether firms that have invested heavily in non-financial assets have greater incentive to adopt revaluation for those assets. This question leads to the following hypothesis: H4. Firms with more non-financial assets are more (less) likely to adopt the fair value option for non-financial assets.

4.5. Extent of expertise for fair value accounting Level II and Level III valuations for assets and liabilities are complex and costly because the absence of liquid markets leads to increased estimation errors, a lack of verification, and excessive subjectivity in these estimates. We conjecture that firms with more Level II and Level III inputs already have expertise in estimating fair value for assets for which liquid markets rarely exist and will be less reluctant to choose the option of fair value accounting for non-financial assets. Therefore, we expect a positive relationship between the adoption of FVONFA and the extent of expertise for fair value accounting. This leads to the following hypothesis: H5. Firms with more expertise in fair value measurements are more likely to adopt the option for fair value for non-financial assets.

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5.2. Analysis of response rate We received 209 completed surveys, for a response rate of 8.4%.14 Panel A of Table 1 shows the population distribution by industry categories and the number of respondents and non-respondents within each industry category. We categorized industries based on the North American Industry Classification System (NAICS). 15 Chi-square results (untabulated) indicate that the response rate seems biased toward some industries. Resource (manufacturing) industries appear to be more (less) inclined to respond to our survey. Firm size also influenced the response rates. 16 Panel B shows that based on the market value, the response rate was higher for larger firms. Our survey instrument was sent to 863 firms (35%) with supporting letters from managing partners of their audit firms and to 1622 (65%) without an additional cover letter. As Panel C of Table 1 shows, the response rate increased significantly when the CFO received a supporting letter from the auditing firm (130 of 863, or 15% versus 79 of 1622 or 5%). Panel C also shows the response rates by industry classification for those who received and those who did not receive the additional cover letter. CFOs in the resource industry were the most favorably influenced to respond when the additional cover letter was included with the survey instrument. We did not send a second survey to non-responders. To examine whether certain firm characteristics, including the variables in Table 1, affect the response rate, we ran the following logistic regression: RESPONSE ¼ β0 þ β1 SIZE þ β2 COVER þ β3 FOREIGN TAX þ ε

ð1Þ

where: 5. Sample development and analysis of response rate 5.1. Sample development We limited our sample to companies subject to Sarbanes–Oxley (SOX) compliance — U.S. public companies with market values greater than $75 million. This limit ensures that our sample firms are under the same regulatory requirements. Using available internet sites (mainly biz.yahoo.com), we compiled names of chief financial officers/chief accounting officers (or similar officers) and corporate mailing addresses. We designed a four-page survey questionnaire that included questions about CFOs' preferences with regards to different types of asset and liabilities valuation. The survey questionnaire was first sent to the managing partners of accounting firms and to several CFOs for comments.13 After revision, we tested the questionnaire again by asking a number of individuals in CFO (or similar) ranks to complete it. The final survey, two pages, contains six questions and takes approximately 10 min to complete. However, it may take longer if respondents choose to answer question number 6, which is an open-ended question. We contacted the local offices of the Big Four audit firms (Deloitte, KPMG, Ernst and Young, and PwC) and Grant Thornton, and asked whether the managing partners would be willing to write a support cover letter to be included with our survey in an attempt to increase our response rate. The managing partners of two accounting firms (Deloitte and KPMG) wrote cover letters in support of our research. Using the Compustat database, we identified firm auditors, and in the letters to the CFOs of firms audited by Deloitte and KPMG, we included the cover letter from a managing partner of the firm. The final version of the questionnaire was mailed to 2488 companies in July 2008. Although the responses allowed us to indentify companies that responded, in the cover letter we indicated that responses to our surveys were considered confidential and the results of our study would be reported only in an aggregate format.

13

Please see Appendix A for the survey questionnaire.

RESPONSE is a dummy variable with 1 (0) indicating response (no response); SIZE is firm size based on the logarithm of market value (CSHO ∗ PRCC_F in Compustat); COVER is a dummy variable indicating whether a cover letter is included in our survey from the local office of Deloitte or KMPG; FOREIGN_TAX is a dummy variable indicating whether a company operates in foreign countries, which is determined by using information regarding foreign taxes paid. FOREIGN_TAX is included because firms with higher levels of international operations may be more likely to respond to our study because of their interest in fair market valuations arising from their international counterparts. Four industry dummies (Industry1, Industry2, Industry3, and Industry4) are included in the regression for the following industries: Resources, Manufacturing, Trade, and Services respectively. Table 2 reports the results of estimating the logistic regression (1) above. The results reveal that the only significant explanatory variable is COVER, which indicates that the letter from the audit firms positively influenced the response rate. On the other hand, the response rate is not related to firm size, operation in foreign countries, or industry category. 14 One of the limitations of the survey questionnaire is that there is no guarantee that the respondents are those to whom the surveys were mailed (CFOs in our case). It is possible that a CFO requested his/her subordinate to complete the survey on his/her behalf. While we share this limitation with all survey studies, we are assured that at least those who requested to be notified of the results of the study were CFOs (about 40 CFOs requested to be notified of the results of the study). 15 The sample size is reduced from 2488 to 2485 because NAICS is not available for 3 observations. 16 The sample size is reduced further from 2488 to 2374 due to the availability of the firm size information in Compustat. With this sample, the number of responses is reduced from 209 to 205 observations. Missing variables reduced the usable responses for our analysis to 201.

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

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B. Jung et al. / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

Table 1 Descriptive statistics on number and percentage of respondents and non-respondents. Panel A: By industry membership Industry

Respondents

Resources Manufacturing Trade Services Other Total

Non-respondents

N

%

N

%

41 89 26 36 17 209

13.0% 7.5% 8.0% 7.5% 9.6% 8.4%

274 1099 299 444 160 2276

87.0% 92.5% 92.0% 92.5% 90.4% 91.6%

N

%

N

%

15 59 31 70 30 205

10.3% 9.0% 9.9% 8.7% 6.7% 8.6%

130 600 281 739 419 2169

89.7% 91.0% 90.1% 91.3% 93.3% 91.4%

Panel B: By firm size based on market value Firm size Respondents

Over $10,000 million $1000–$10,000 $500–$1000 $75–$500 Under $75 Total

Total observations

Non-respondents

Total observations

Panel C: A supporting letter from the CFO's public accounting firm was included with the survey questionnaire Industry Respondents Non-respondents

Resources Manufacturing Trade Services Other Total

N

%

30 45 20 25 10 130

25.0% 12.4% 13.9% 14.7% 14.9% 15.1%

N 90 317 124 145 57 733

Panel D: No additional supporting letter was included with the survey questionnaire Industry Respondents N Resources Manufacturing Trade Services Other Total

11 44 6 11 7 79

5.6% 5.3% 3.3% 3.5% 6.4% 4.9%

145 659 312 809 449 2374

Total observations % 75.0% 87.6% 86.1% 85.3% 85.1% 84.9%

Non-respondents

%

315 1188 325 480 177 2485

120 362 144 170 67 863

Total observations

N

%

184 782 175 299 103 1543

94.4% 94.7% 96.7% 96.5% 93.6% 95.1%

195 826 181 310 110 1622

Industry categories are based on the North American Industry Classification System (NAICS). All percentages are ratios of the number in the cell to the total observations of the cell's row.

6. Descriptive statistics 6.1. On the adoption of IFRS In addition to questions about the adoption of the FVONFA, the survey asked whether the CFOs favored the option to adopt IFRS. About half (52%) of the respondents would prefer this option, suggesting that most respondents are receptive to having the option to adopt IFRS. We expected to see a larger percentage of the respondents preferring this option. It is possible that respondents do not know the extent to which IFRS and US GAAP are different, that they fear non-comparability of financial Table 2 Analysis of response rate. RESPONSE = β0 + β1SIZE + β2COVER + β3FOREIGN_TAX + ε Variables

Estimate

Standard error

Pr > ChiSq

Intercept SIZE COVER FOREIGN_TAX Industry1 Industry2 Industry3 Industry4

−2.985 0.036 0.558 −0.000 0.534 0.002 −0.156 −0.138

0.391 0.043 0.092 0.000 0.367 0.316 0.370 0.347

b0.0001 0.4050 b0.0001 0.8030 0.1460 0.9960 0.6740 0.6910

statements issued by US companies, and/or that they do not understand the significance of the question. It is also possible that the respondents do not want to support an eventual integration of IFRS and US GAAP.17 Choosing to have the option of using IFRS, discussed later, does not mean that the CFOs would also choose to use the FVONFA (as available in IAS 16 and IAS 38). Many of those in favor of adopting IFRS commented that adopting IFRS would improve comparability and uniformity of financial statements, resulting in global consistency. 6.2. On use of fair value accounting for non-financial assets Panel A of Table 3 reports descriptive statistics on our sample firms. All variables except for indicator variables are winsorized at 1% and 99% levels of their distributions. Following the literature (e.g., Lin & Peasnell, 2000), LEVERAGE is measured as the amount of long-term debt divided by the amount of shareholders' equity (DLTT/SEQ in Compustat). We 17 We originally included clarifying questions with respect to this question, but removed those questions based on the feedback we received in our pre-tests. We received many comments from those who opposed this option. Comments were related to the following issues: IFRS is not as mature as U.S. GAAP, does not have appropriate GAAP for regulated companies, is principle-based and requires more judgment and does not allow LIFO, the costs of using IFRS exceed the benefits, and adopting IFRS would require additional costs for training, would increase the complexity for the users, and would result in less comparability.

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

B. Jung et al. / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

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Table 3 Descriptive statistics of CFOs' opinions on fair value option for non-financial assets and long term liabilities. Panel A: Descriptive statistics for the entire sample Variable

Mean

Std Dev

Median

25th

75th

SIZE LEVERAGE ROA TANGIBILITY SFAS_RATIO Q BIG4 INSTITUTION_HOLD FOREIGN_TAX

7.0398 0.4087 −0.0048 0.6172 0.0495 3.4164 0.8706 0.6973 0.5025

1.6370 0.7532 0.2332 0.4636 0.1167 2.7565 0.3364 0.2716 0.5012

6.7998 0.0938 0.0497 0.4902 0.0000 2.5719 1.0000 0.7760 1.0000

5.8486 0.0000 −0.0030 0.2548 0.0000 1.7618 1.0000 0.5138 0.0000

8.0288 0.3988 0.0938 0.9150 0.0365 4.0725 1.0000 0.9176 1.0000

Panel B: Descriptive statistics based on the adoption of fair value for non-financial assets Non-adoption (N = 183)

Adoption (N = 18)

Difference in mean

Variable

Mean

Std Dev

Median

25th

75th

Mean

Std Dev

Median

25th

75th

p-Value

SIZE LEVERAGE ROA TANGIBILITY SFAS_RATIO Q BIG4 INSTITUTION_HOLD FOREIGN_TAX

7.0045 0.3799 −0.0039 0.5968 0.0469 3.4383 0.8689 0.7026 0.5027

1.6364 0.7110 0.2421 0.4628 0.1168 2.8447 0.3385 0.2709 0.5014

6.7841 0.0851 0.0544 0.4624 0.0000 2.5708 1.0000 0.7860 1.0000

5.8054 0.0000 0.0055 0.2159 0.0000 1.7104 1.0000 0.5075 0.0000

7.9942 0.3978 0.1009 0.9100 0.0313 4.0725 1.0000 0.9191 1.0000

7.3989 0.7016 −0.0131 0.8238 0.0765 3.1931 0.8889 0.6437 0.5000

1.6451 1.0778 0.1116 0.4307 0.1154 1.6418 0.3234 0.2808 0.5145

7.2329 0.1057 0.0083 0.7595 0.0219 2.8190 1.0000 0.6769 0.5000

6.3416 0.0000 −0.0232 0.4962 0.0000 1.8976 1.0000 0.5624 0.0000

8.8192 1.2537 0.0451 1.1403 0.0734 4.5292 1.0000 0.8321 1.0000

b0.0001 0.0004 0.8124 b0.0001 0.0100 0.0018 b0.0001 0.0002 0.0026

deleted 8 observations because the amount of shareholders' equity is negative. 18 The mean (median) of LEVERAGE in our sample is 40.9% (9.4%). The average ROA (NI/AT in Compustat) in our sample is − 0.48% of total assets while the median of ROA is almost 5%. The average amount of property, plant, and equipment relative to total assets (i.e., TANGIBILITY) (PPEGT/AT in Compustat) is 61.7% while the median value is 49%. We use TANGIBILITY as a proxy for the significance of the amount of non-financial assets. SFAS_RATIO is measured as Level II and Level III assets scaled by total assets (COMPUSTAT AT). Information for “Level II and Level III assets and liabilities” is obtained from 10-Qs. When 10-Qs do not disclose this information, we assume that missing values are zero. Q indicates Tobin's Q which is measured as the market value of equity divided by the book value of equity (CSHO ∗ PRCC_F / SEQ in Compustat). BIG4 is equal to 1 if a firm's auditor is one of the Big 4 auditors and 0 if otherwise. INSTITITUTION_HOLD indicates the amount of institutional shareholdings. All other variables are defined as previously. The amount of PPE is the most significant portion of non-financial assets, and most prior studies focus on PPE. SFAS_RATIO is measured as the amount of Level II and Level III assets and liabilities, scaled by total assets. The information for “Level II and Level III assets and liabilities” was hand-collected from firms'10-Qs at the end of the first quarter after the effective date of SFAS 157 and 159. When the 10-Qs do not disclose this information, we consider the missing values as zero.19 The mean (median) of SFAS_RATIO is 5.0% (0.0%). Of our sample firms, 87.1% are audited by the Big 4 auditors. The mean (median) of INSTITUTION_HOLD is 69.7% (77.6%), indicating that our sample firms are significantly held by institutional investors. Approximately half of our sample firms pay foreign taxes, suggesting that half of them are operating out of the U.S. Panel B of Table 3 shows descriptive statistics after splitting our sample firms into two groups based on the responses to the question “If you were given the option, would you adopt fair value for non-financial assets?” Of 201 responses with complete data, 8.96% (18) indicate that they would use the FVONFA and 91.04% (183) indicate they would not. These results are consistent with prior studies showing that few European firms are willing to adopt the FVONFA when given the option (e.g. Cairns et al., 2011; Christensen & Nikolaev, 2012).

With respect to the relationship between firm size and managers' response to the FVONFA, firms saying “YES” to the adoption are larger. The average size for firms not adopting is lower than the average for firms adopting, which seems to support the hypothesis that the cost of adoption of the fair value accounting option for non-financial assets is higher for smaller firms. LEVERAGE is higher for adopters compared to non-adopters (70.2% vs. 38.0%) suggesting that the higher the leverage, the more likely the firm is to adopt fair value accounting for non-financial assets, similar to the results of the U.K. and German firms in Christensen and Nikolaev (2012). The univariate results for the relationship between ROA and managers' response do not support H2. Firms which are willing to adopt fair value accounting are less profitable. ROA for adoption (non-adoption) firms is −1.3% (−0.4%). The amount of fixed assets compared to total assets is higher for firms which are willing to adopt the FVONFA compared to non-adopters (82.4% vs. 59.7%). SFAS_RATIO also seems to influence the adoption of fair value for non-financial assets. SFAS_RATIO is higher for adopters than non-adopters (7.7% vs. 4.7%), consistent with our hypothesis. Other variables are generally similar for both groups except for INSTITUTION_HOLD. The amount of institutional shareholdings is higher for non-adopters compared to adopters. 7. Regression results To examine how various firm characteristics affect managers' choice of the option of fair value accounting for non-financial assets, we estimate the following logistic regression model (2) with the predicted sign for each variable indicated: ðþ=−Þ ðþÞ ðþÞ ðþ=−Þ ðþÞ YES ¼ β0 þ β1  SIZE þ β2  LEVERAGE þ β3  ROA þ β4  TANGIBILITY ð2Þ þβ5  SFAS RATIO þ β6  Q þ β7  BIG4 þβ8  INSTITUTION HOLD þ β9  FOREIGN TAX þ ε where: YES

18 19

Our measures of LEVERAGE and SIZE need positive shareholder equity. We also report results when we delete these missing values for SFAS_RATIO.

is equal to 1 if the response to the question “If you were given the option, would you adopt fair value for non-financial assets?” is “Yes” and 0 if otherwise.

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

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B. Jung et al. / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

Table 4 Association between various firm characteristics and CFO opinions on fair value option for non-financial assets. YES = β0 + β1 ∗ SIZE + β2 ∗ LEVERAGE + β3 ∗ ROA + β4 ∗ TANGIBILITY + β5 ∗ SFAS_RATIO + β6 ∗ Q + β7 ∗ BIG4 + β8 ∗ INSTITUTION_HOLD + β9 ∗ FOREIGN_TAX + ε Panel A

Panel B

Variable

Predicted Sign

Estimate

Standard error

Pr > Chisq

Estimate

Standard error

Pr > Chisq

INTERCEPT SIZE LEVERAGE ROA TANGIBILITY SFAS_RATIO Q BIG4 INSTITUTION_HOLD FOREIGN_TAX Adjusted R2 N

? (+/−) (+) (+) (+/−) (+)

−3.9842 0.2309 0.4831 −1.1594 0.9609 2.6030 −0.1378 −0.0809 −1.3448 0.6381

1.4300 0.1917 0.2858 1.3911 0.5663 1.9839 0.1226 0.9321 1.0464 0.6261

0.0053 0.2285 0.0455 0.2023 0.0897 0.0946 0.2609 0.9309 0.1987 0.3081 11.25% 201

−5.1087 0.4760 0.7583 −1.5010 1.2582 3.2116 −0.2322 −0.9948 −1.4545 0.3932

1.9371 0.2436 0.3464 1.8334 0.6959 2.3522 0.1686 1.2030 1.4874 0.8198

0.0084 0.0507 0.0143 0.2065 0.0706 0.0861 0.1685 0.4083 0.3281 0.6315 20.62% 122

Q

indicates Tobin's (1969) Q which is measured as the market value of equity divided by the book value of equity (CSHO ∗ PRCC_F / SEQ in Compustat). BIG4 is equal to 1 if a firm's auditor is one of the Big 4 auditors and 0 if otherwise. INSTITUTION_HOLD indicates the amount of institutional shareholdings.

All other variables are defined as previously. Other than the five testable variables of interest, we also add various control variables which may affect managers' incentives (or disincentives) to adopt the FVONFA – growth potential (Q), auditor status (BIG4), institutional shareholdings (INSTITUTION_HOLD), a dummy variable for foreign tax payment (FOREIGN_TAX) – to model (2). Q, a proxy for growth opportunities, controls for growth potential effect on managers' accounting choice. BIG4 controls for auditors' influence on managers' decision to choose the FVONFA. Lin and Peasnell (2000) show that auditors' influence is greater on downward revaluation (e.g., assets impairment) than on upward revaluation due to the accounting conservatism exercised by most auditors, suggesting that BIG4 may not significantly affect managers' choice of the FVONFA. With respect to the inclusion of INSTITUTION_HOLD, on one hand, the amount of institutional holdings controls for institutional shareholders' demand for accounting information based on fair value measurements for non-financial assets. On the other hand, from the managers' perspective, since upward revaluation for non-financial assets likely reduces profitability, managers of firms with higher institutional shareholdings may be reluctant to adopt the fair value option. The literature (e.g., McCahery & Vermeulen, 2009) shows that institutional shareholders are more likely to intervene when they are not satisfied with managers' performance. FOREIGN_TAX is also included to control for the effect on the results of international competition from firms which already adopted the FVONFA. The results of estimating model (2) are shown in Table 4. In Panel A of Table 4, we use all observations for estimation while in Panel B, we use only firms for which data on SFAS_RATIO is available. In other words, in Panel B, instead of setting missing values as zero, we drop those observations with missing SFAS_RATIO. In this case, we lose 79 observations. In Panel A, when we use all observations, the coefficient of SIZE is not significant, suggesting that firm size does not matter in managers' decisions over fair value accounting for non-financial assets. The coefficient on LEVERAGE is significant and positive (p-value = 0.0455, one-tailed), supporting the argument that firms with higher leverage are more willing to adopt fair value accounting for non-financial assets. The coefficient on ROA is not significant, not supporting our hypothesis. The coefficient on TANGIBILITY is significantly positive, suggesting that firms with higher amounts of fixed assets are more willing to adopt the fair value option to provide more value-relevant information to

investors. Finally, the coefficient on SFAS_RATIO is positive and marginally significant (p-value = 0.0946, one-tailed), indicating that expertise in using fair value accounting for complicated items such as Level II and III items is positively related to managers' choice of the fair value accounting option for non-financial assets. 20 None of the coefficients on control variables are statistically significant. The insignificant coefficient on BIG4 is consistent with the findings of Lin and Peasnell (2000). Results in Panel B, where we drop observations if SFAS_RATIO is missing, are generally similar (in fact, stronger) except for firm size. In this specification, SIZE becomes significantly positive (p-value = 0.0507), supporting the argument that the cost of adopting the FVONFA is larger for smaller firms and thus such firms are more reluctant to adopt the option.21 8. Additional analysis 8.1. Use of fair value accounting for long-term liabilities As a comparison to non-financial assets, we also examine managers' preference on the adoption of fair value accounting for long-term liabilities. Since long-term liabilities consist mostly of financial items, the fair value measurement of long-term liabilities is less complicated than that for non-financial assets, and future cash outflow from long-term liabilities is easier to project. Therefore, we conjecture that CFOs must consider and analyze the implications of fair value accounting for long-term liabilities on financial statements differently from those for non-financial assets. Panel A of Table 5 shows descriptive statistics on firm characteristics after splitting the sample into two groups based on the responses to the following question: “Under SFAS 159, firms have the option to use fair value for long-term liabilities. Do you intend to use the fair value option for long-term liabilities?” Again, only 9.45% (19) of the CFO respondents indicate that they will use the fair value option for long-term liabilities. Although the patterns for SIZE, LEVERAGE, and ROA are similar between adoption firms and non-adoption firms, the differences between the two groups are not as pronounced as those related to non-financial assets. The differences in TANGIBILITY and SFAS_RATIO between the two groups are trivial. We also estimate model (2) with an indicator variable

20

The results are similar when we do not consider SFAS_RATIO in the regression. We also estimate model (2) when ‘YES’ is defined based on the following question related to IFRS: “Does your firm want to have the option to choose between IFRS and U.S. GAAP for financial reports filed in the U.S.?” Results (untabulated) show that no coefficients on variables of interest are significant, similar to the finding of Demaria and Dufour (2007) which show that based on 120 French firms, the fair value option is unrelated to firm size, leverage, CEO's compensation, institutional ownership, and the existence of cross-listing. 21

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

B. Jung et al. / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

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Table 5 Association between various firm characteristics and CFO opinions on fair value for long-term liabilities. Panel A: Descriptive statistics based on the adoption of fair value for long-term liability Non-adoption (N = 182)

Adoption (N = 19)

Difference in mean

Variable

Mean

Std Dev

Median

25th

75th

Mean

Std Dev

Median

25th

75th

p-Value

SIZE LEVERAGE ROA TANGIBILITY SFAS_RATIO Q BIG4 INSTITUTION_HOLD FOREIGN_TAX

7.0583 0.3953 0.0026 0.6168 0.0497 3.4114 0.8681 0.7025 0.5110

1.6145 0.7513 0.2272 0.4647 0.1198 2.8341 0.3393 0.2690 0.5013

6.8005 0.0952 0.0552 0.4884 0.0000 2.5714 1.0000 0.7901 1.0000

5.8738 0.0000 0.0075 0.2533 0.0000 1.7104 1.0000 0.5138 0.0000

7.9942 0.3970 0.0990 0.9215 0.0320 4.0243 1.0000 0.9176 1.0000

6.8628 0.5370 −0.0757 0.6207 0.0476 3.4643 0.8947 0.6477 0.4211

1.8779 0.7794 0.2815 0.4652 0.0843 1.9122 0.3153 0.2984 0.5073

6.6604 0.0938 −0.0030 0.5809 0.0056 2.6437 1.0000 0.6690 0.0000

5.3553 0.0000 −0.1534 0.2775 0.0000 1.8845 1.0000 0.4664 0.0000

8.3355 0.8895 0.0451 0.8821 0.0692 4.5318 1.0000 0.9555 1.0000

b0.0001 0.0059 0.1565 0.0004 0.1008 0.0005 b0.0001 0.0001 0.0093

Panel B: Regression analysis YES = β0 + β1 ∗ SIZE + β2 ∗ LEVERAGE + β3 ∗ ROA + β4 ∗ TANGIBILITY + β5 ∗ SFAS_RATIO + β6 ∗ Q + β7 ∗ BIG4 + β8 ∗ INSTITUTION_HOLD + β9 ∗ FOREIGN_TAX + ε Panel B

Panel C

Variable

Estimate

Std error

Pr > Chisq

Estimate

Std error

Pr > Chisq

INTERCEPT SIZE LEVERAGE ROA TANGIBILITY SFAS_RATIO Q BIG4 INSTITUTION_HOLD FOREIGN_TAX Adjusted R2 N

−2.2939 −0.0010 0.2199 −1.0642 0.0623 −0.6311 −0.0167 0.5010 −0.6389 −0.1202

1.3366 0.1982 0.2894 1.0326 0.5744 2.2174 0.0986 0.8627 0.9574 0.5624

0.0861 0.9961 0.4473 0.3027 0.9136 0.7759 0.8654 0.5615 0.5046 0.8307 3.29% 201

−1.5685 0.0970 0.1407 0.5259 −0.3894 −1.1884 −0.0583 −0.2804 −0.2508 −0.6594

1.4832 0.2148 0.3479 1.5406 0.6650 2.5195 0.1329 1.0112 1.2215 0.7034

0.2903 0.6515 0.6860 0.7328 0.5581 0.6371 0.6610 0.7815 0.8373 0.3486 3.19% 122

for YES to the fair value option for long-term liabilities as the dependent variable. The results are presented in Panels B and C of Table 5. Again, similar to Table 4, in Panel B (Panel C), we use all observations (only firms with data on SFAS_RATIO available) for estimation. In both panels, none of the coefficients on the variables of interest are significant, implying that managers' preferences on fair value accounting for long-term liabilities are distinct from those for non-financial assets. 22

fair value is too prohibitive,” which is also consistent with the positive coefficient on SIZE reported in Table 4 for non-financial assets. They also rank the “adverse influence on debt or bonus contracts” as the least important reason for resisting the FVONFA, somewhat consistent with our results on leverage. 23 Tables 7 and 8 provide more details about reasons for the choice of fair value for non-financial assets and the choice of fair value for long-term liabilities. 9. Limitations of our study

8.2. Further analysis on reasons for YES or NO Our survey questionnaire allowed the CFOs to include the reasons for their support or lack of support for the FVONFA and to rank their reasons on a five-point Likert-type scale, with 1 being the most important and five being the least important. To have a better sense of the comparisons among the reasons, we computed a single score for each reason by assigning linearly descending weights to the responses as follows: five points for the most important reason, four points for the second-most important, three points for the third-most important, two points for the fourth-most important, and one point for the least important. Then, we ranked the reasons according to the score (both ranking and scores are reported in Table 6). When we compare the results in Table 4 with those in Table 6, we find that some results in Table 4 are consistent with reasons reported by the CFOs in Table 6. For example, the positive coefficient on LEVERAGE for non-financial assets is consistent with the CFOs' reasons for responding “YES” that “fair value will provide a better picture of our firm's position.” The positive coefficient on LEVERAGE is also similar to the CFOs' responses that they believe that fair value will provide a lower cost of debt without regards to what others are doing. The most popular reason for responding “NO” is that “The cost of determining 22

Results without TANGIBILITY are qualitatively similar.

First, although we provide fresh evidence on the preference of managers of U.S. firms for the FVONFA, since the number of firms that are willing to adopt the fair value option is only approximately 9% of our sample, one should be careful in generalizing our results to the universe of firms in the U.S. 24 Second, non-financial assets are mainly composed of PPE, investment property, and intangible assets. It would be desirable to ask questions separately on PPE, investment property, and intangible assets because managers' preference for fair value accounting could be 23 We also received over 60 written comments regarding fair value accounting for non-financial assets and long-term liabilities. As expected, most comments were negative and included issues at the heart of the objectives of accounting: the relevance and usefulness of the fair value option. More than 20 comments suggest that this information would “not be useful,” “not be relevant,” would have “no economic value,” and would create “confusion in the market.” We also received more than 15 comments suggesting that such values would be difficult to measure, and using fair value measurements would create conflicts between and among the management, auditors, accountants, and those who help the company with the fair valuation. Ten CFOs commented that the management may abuse the fair valuation to manipulate, smooth, and create unreliable numbers. Several other comments suggest that since the SOX, no one is willing to take the risk of using personal judgment because the use of one's judgment can be an opening to lawsuits. Of course, the cost associated with measurement and disclosure is mentioned in written comments as well (more than 12 times). The details of these comments are available upon request. 24 The 9% is much smaller if we consider the number of non-responses for our survey. It is plausible that those who indicate ‘YES’ for fair value option for non-financial assets may have been more willing to respond to our survey.

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

10

B. Jung et al. / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

Table 6 Reasons for response to question on use of fair value option for non-financial assets. Rank

Score

Description

Panel A: Reasons for responding “Yes” to the question on the use of the fair value option for non-financial assets 1 90 Fair value will provide better picture of our firm's position. 2 63 Fair market value is here to stay and we need to use it now or in the near future. 3 49 Fair value will provide lower cost of capital without regards to what others are doing. 4 45 We have to use fair value, since the competition is doing it and not doing it will put us at a disadvantage. Panel B: Reasons for responding “No” to the question on the use of the fair value option for nonfinancial assets 1 822 The cost of determining fair value is too prohibitive. 2 819 The benefit of using fair value is unknown. 3 801 Fair value will confuse the users of our financial statements. 4 744 Fair value will introduce fluctuations in the balance sheet that we do not want. 5 678 The effect of using fair value on the income statement is unknown. 6 660 Required disclosures are too cumbersome. 7 402 The market sees through accounting numbers, so the choice of accounting method is irrelevant. 8 372 The competition does not use fair value for long term assets. 9 282 Fair value will adversely influence our debt or bonus contracts.

Table 7 Reasons for choice of fair value for non-financial assets (frequency of response to a selection). Reason

Most important 2

Panel A: Yes, would adopt fair value for long-term non-financial assets 1 Fair value will provide lower cost of capital without regards to what others are doing. 2 We have to use fair value, since the competition is doing it and not doing it will put us at a disadvantage. 3 Fair market value is here to stay and we need to use it now or in the near future. 4 Fair value will provide better picture of our firm's position. Panel B: No, would not adopt fair value for long-term non-financial assets 5 The cost of determining fair value is too prohibitive. 6 The benefit of using fair value is unknown. 7 The competition does not use fair value for long term assets. 8 Fair value will introduce fluctuations in the balance sheet that we do not want. 9 The market sees through accounting numbers, so the choice of accounting method is irrelevant. 10 The effect of using fair value on the income statement is unknown. 11 Fair value will confuse the users of our financial statements. 12 Fair value will adversely influence our debt or bonus contracts. 13 Required disclosures are too cumbersome.

3

4

Least important Total responses

0 0 3 9

6 5 4 4

4 4 5 2

4 3 2 1

2 4 2 2

16 16 16 18

71 67 14 59 17 46 80 11 32

55 59 24 49 25 53 44 15 56

22 21 48 32 50 28 19 42 44

10 8 34 16 29 21 8 39 16

6 8 33 5 35 10 10 45 12

164 163 153 161 156 158 161 152 160

3

4

Least important Total responses

Some respondents did not answer all questions.

Table 8 Reasons for choice of fair value for long-term liabilities (frequency of response to a selection). Reason

Most important 2

Panel A: Yes, would adopt fair value for long-term liabilities 1 Fair value will provide lower cost of capital without regards to what others are doing. 2 We have to use fair value, since the competition is doing it and not doing it will put us at a disadvantage. 3 Fair market value is here to stay and we need to use it now or in the near future. 4 Fair value will provide better picture of our firm's position. Panel B: No, would not adopt fair value for long-term liabilities 1 The cost of determining fair value is too prohibitive. 2 The benefit of using fair value is unknown. 3 The competition does not use fair value for long term assets. 4 Fair value will introduce fluctuations in the balance sheet that we do not want. 5 The market sees through accounting numbers, so the choice of accounting method is irrelevant. 6 The effect of using fair value on the income statement is unknown. 7 Fair value will confuse the users of our financial statements. 8 Fair value will adversely influence our debt or bonus contracts. 9 Required disclosures are too cumbersome.

1 1 3 5

6 3 6 5

4 8 8 7

7 2 1 2

2 6 2 2

20 20 20 21

79 59 16 59 20 43 64 12 33

48 49 26 61 32 59 54 15 54

24 39 59 33 51 41 32 54 44

13 14 28 13 32 19 12 37 23

9 9 36 6 32 8 12 45 15

173 170 165 172 167 170 174 163 169

Some respondents did not answer all questions.

different for different non-financial assets (Christensen & Nikolaev, 2012). 10. Conclusion More studies on fair value measurement and reporting, particularly for non-financial assets, are needed as the FASB and IASB continue

to work on their convergence projects and the SEC continues to move toward accepting IFRS as U.S. GAAP. Knowledge as to how capital market participants, including managers, sophisticated information intermediaries (e.g., stock analysts, credit rating agencies), and investors, react to the fair value option will help regulators provide a meaningful transition from U.S. GAAP to IFRS. Our study attempts to address the lack of such knowledge.

Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002

B. Jung et al. / Advances in Accounting, incorporating Advances in International Accounting xxx (2013) xxx–xxx

First, our results show that CFOs in the U.S. are resistant to the FVONFA, consistent with prior studies based on firms in Europe and Australia. Second, we examine how five firm characteristics – firm size, leverage, profitability, the amount of non-financial assets, and expertise in fair value measurements for complex items – affect the CFOs' responses to the FVONFA. The results show that firm size, leverage, the amount of non-financial assets, and expertise in fair value measurements all positively affect the CFOs' responses to the FVONFA. A summary of the responses from the CFOs to a direct question about their reasons for choosing or rejecting the FVONFA reveals that the main reason for their resistance is that determining the fair value is too costly, which corresponds to our results on firm size. The most dominating reason for CFOs' selecting the FVONFA is that it provides a better picture of the firm's position, which is also consistent with our results on leverage. Acknowledgments

Appendix A 1. Does your firm want to have the option to choose between IFRS and U.S. GAAP for financial reports filed in the U.S.? Yes __ No ___ No-Preference ___ 2. If you were given the option, would you adopt fair value for non-financial assets? Yes __ No ___ Do not know ___ If Yes, how important is the following factors (1 being the most important and 5 the lowest):

1 2 3 4 5 1 2 3 4 5

Fair value will provide lower cost of capital without regards to what others are doing. We have to use fair value, since the competition is doing it and not doing it will put us at a disadvantage Fair market value is here to stay and we need to use it now or in the near future. Fair value will provide better picture of our firm's position. Other (please explain)_______________________________

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

The cost of determining fair value is too prohibitive The benefit of using fair value is unknown. The competition does not use fair value for long term liabilities. Fair value will introduce fluctuations in the balance sheet that we do not want. The market sees through accounting numbers, so the choice of accounting method is irrelevant. The effect of using fair value on the income statement is unknown. Fair value will confuse the users of our financial statements. Fair value will adversely influence our debt or bonus contracts Required disclosures are too cumbersome. Other (please explain)_______________________________

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 1 1 1 1

2 2 2 2 2

3 3 3 3 3

4 4 4 4 4

5 5 5 5 5

4. Do foreign competitors in your industry utilize fair value for non-financial long-term assets? Yes__ No__ Do Not Know __ 5. Do foreign competitors in your industry utilize fair value for long-term liabilities? Yes__ No__ Do Not Know __ 6. Please provide us with your additional thoughts about the benefits and disadvantages of using either IFRS or US GAAP for financial reporting and your thoughts about how the application of fair-market value accounting, in the contest of SFAS 157 and 159, would affect firm's financial reporting vis-a-vis internal and external users of your financial statements.

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

If No, how important is each of the reasons in your decision (1 being the most important and 5 the lowest):

The cost of determining fair value is too prohibitive The benefit of using fair value is unknown. The competition does not use fair value for long term assets. Fair value will introduce fluctuations in the balance sheet that we do not want. The market sees through accounting numbers, so the choice of accounting method is irrelevant. The effect of using fair value on the income statement is unknown. Fair value will confuse the users of our financial statements. Fair value will adversely influence our debt or bonus contracts Required disclosures are too cumbersome. Other (please explain)_______________________________

3. Under SFAS 159, firms have the option to use fair value for long-term liabilities. Do you intend to use fair value option for long-term liabilities? Yes __ No__ If Yes, how important is the following factors (1 being the most important and 5 the lowest):

If No, how important are each of the reasons in your decision (1 being the most important and 5 the lowest):

We thank Paul Higo and Gary Nishikawa (Managing Partner and Partner of Deloitte at Hawaii) and Nancy Rose (Managing Partner of KPMG at Hawaii) for their help and guidance in requesting responses from U.S. companies. This paper has benefited from comments received from Jeffery Gramlich, Wayne Thomas, Sungwook Yoon and participants at the AIB 2010 Rio de Janeiro Conference and the 2010 American Accounting Association Annual Meetings (San Francisco). We are also thankful to Kimthien Truong and Leslie Fujii for their help with collecting data, and to Frances Griffin for her editorial assistance.

Fair value will provide lower cost of capital without regards to what others are doing. We have to use fair value, since the competition is doing it and not doing it will put us at a disadvantage Fair market value is here to stay and we need to use it now or in the near future. Fair value will provide better picture of our firm's position. Other (please explain)_______________________________

11

1 1 1 1

2 2 2 2

3 3 3 3

4 4 4 4

5 5 5 5

1 2 3 4 5 1 1 1 1 1

2 2 2 2 2

3 3 3 3 3

4 4 4 4 4

5 5 5 5 5

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Please cite this article as: Jung, B., et al., The association between firm characteristics and CFO's opinions on the fair value option for non-financial assets, Advances in Accounting, incorporating Advances in International Accounting (2013), http://dx.doi.org/10.1016/j.adiac.2013.03.002