The reliability of investment property fair value estimates

Journal of Accounting and Economics 30 (2001) 125}158

The reliability of investment property fair value estimates夽 J. Richard Dietrich , Mary S. Harris
, Karl A. Muller III* Fisher College of Business, The Ohio State University, Columbus, OH 43210, USA
School of Management, Syracuse University, Syracuse, NY 13244, USA Smeal College of Business Administration, Pennsylvania State University, University Park, PA 16802, USA Received 10 March 1999; received in revised form 6 July 2000

Abstract We investigate the reliability of mandatory annual fair value estimates for UK investment property. We "nd that appraisal estimates understate actual selling prices and are considerably less biased and more accurate measures of selling price than respective historical costs. Investigations of managerial discretion over fair value reporting reveal that managers select among permissible accounting methods to report higher earnings, time asset sales to smooth reported earnings changes, smooth reported net asset changes and boost fair values prior to raising new debt. Finally, we "nd that the reliability of appraisal estimates increases when monitored by external appraisers and Big 6 auditors.  2001 Elsevier Science B.V. All rights reserved. JEL classixcation: M41 Keywords: Fair value accounting; Forecast accuracy; Earnings management; External monitoring

夽

We thank Anne Beatty, John Fellingham, David Harris, Steve Huddart, Young Kwon, Jim McKeown, Rama Ramamurthy, Edward Riedl, Joshua Rosett, Richard Sloan (the referee), Bob Thompson, Ross Watts (the editor), and workshop participants at George Washington University, The Ohio State University and Virginia Commonwealth University for useful comments and discussions. We also thank Shouli Zhang for her research assistance. * Corresponding author. Tel.: #1-814-865-0601; fax #1-814-863-8393. E-mail address: [email protected] (K.A. Muller III). 0165-4101/01/$ - see front matter  2001 Elsevier Science B.V. All rights reserved. PII: S 0 1 6 5 - 4 1 0 1 ( 0 1 ) 0 0 0 0 2 - 7

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1. Introduction Debate on the adoption of current value accounting revolves around the potential increase in relevance versus the potential decrease in reliability. Relative to historical costs, fair value estimates are more likely to be relevant but less likely to be reliable. Prior research examining fair value estimates for tangible assets in the United Kingdom and Australia has documented a positive association between these estimates and stock prices or returns (e.g., Barth and Clinch, 1998). Sloan (1999) comments that this association provides evidence that investors "nd fair value estimates to be relevant, but that inferences regarding reliability are indirect and limited by the fact that stock prices re#ect many factors other than the fair value estimates. This study provides direct evidence on the reliability of fair value estimates for UK investment property "rms. Sloan (1999, p. 200) recommends that in future research `the ex post realizations that are used should correspond more closely to the attributes being estimated.a In addition, he suggests that research investigating the impact of contracting cost incentives on the measurement of current value estimates has the greatest potential to be of interest to standard setters. Consistent with these suggestions, we "rst investigate the reliability (i.e., bias and accuracy) of reported fair value estimates for investment properties in the UK using realized selling price as the benchmark, and, for comparison, corresponding historical cost amounts. We then investigate managerial manipulation of fair value estimates reported in the "nancial statements of UK investment property companies. We also investigate whether the reliability of fair value estimates for investment property varies according to the relation between the appraiser and the "rm (internal versus external appraiser) and by the reputation of the auditor (Big 6 versus non-Big 6). We investigate the reliability of fair value estimates for tangible assets for three primary reasons. First, reliability has been a central issue in the debate on extending fair value accounting to tangible assets in the US. Critics have argued that fair value estimates for "xed assets are unreliable (AICPA, 1995). Perhaps for this reason, a survey of analysts concluded that `most oppose extending mark-to-market accounting from "nancial assets to real assetsa (AIMR, 1993, p. 38). Our evidence may provide insights on this issue. Second, analysts, investors and other users in the US and other countries must interpret "nancial statements that are prepared using fair value estimates for real assets. Because these estimates typically are included in non-US "rms' "nancial statements, in US "rms' de"ned bene"t plans and in loan applications, "nancial statement users may bene"t from evidence on the reliability of these fair value estimates. Finally,  Realized selling price is an intuitively appealing measure of fair value; however, selling price may be a biased measure of fair value if sales are a consequence of buyers who o!er to pay more than fair value.

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because opportunities to examine the bias and accuracy of accounting estimates are rare (e.g., Petroni, 1992), our investigation of appraisers' estimates of investment property is interesting in its own right. We examine reliability in the context of the UK investment property industry for four reasons. First, in contrast to other industries where UK GAAP permits voluntary revaluation of tangible assets, investment property companies are required to have chartered surveyors (i.e., appraisers) appraise their real estate assets annually. The appraised amounts are reported on the balance sheet, re#ecting the `cumulative revaluation increment,a which represents the di!erence between the current appraised value of the property and its historical cost. The cumulative revaluation increment is reported as a component of owners' equity; reported income is not a!ected by the annual revaluation amount. Because real estate represents the primary operating assets for these "rms, the cumulative revaluation increment represents an economically signi"cant amount that is examined by analysts and investors. Second, this context allows us to estimate the reliability of fair value estimates by measuring the bias and accuracy of these amounts relative to actual selling price when investment property is sold. Third, we can estimate discretionary and non-discretionary components of the annual revaluation increment because market-wide, capital appreciation measures are readily available for the assets examined. Finally, we can investigate the e!ects of appraiser a$liation and auditor reputation because UK GAAP requires investment property to be appraised by external appraisers at least every "ve years; in other years, company employees (i.e., internal appraisers) may conduct appraisals. Further, UK auditing standards require auditors to assess the reasonableness of appraisers' fair value estimates in their annual audit. The results of our bias and accuracy tests indicate that, on average, appraisers' start-of-year, fair value estimates represent conservative estimates of actual selling prices across our sample period of 1988}1996, regardless of whether property values are increasing or decreasing. Our results also indicate  The UK investment property industry is comprised of "rms that invest in, develop, and construct real estate.  Prior research has examined the in#uence of contracting cost incentives on the voluntary decision to revalue long-lived tangible assets (e.g., Brown et al., 1992) and value acquired brand names (Muller, 1999). This prior research, however, does not investigate the in#uence of such incentives on the bias in appraised amounts themselves.  Prior research in the UK property literature provides evidence that appraisers' fair value estimates exhibit a conservative bias relative to selling prices (e.g., Drivers Jonas/IPD, 1997) and provides descriptive evidence of the range of appraisers' errors (see Crosby et al., 1998a for a recent review). However, other studies fail to "nd such bias (e.g., McAllister, 1995) or "nd that when industry-wide changes in property values are taken into account, appraisers' estimates are generally unbiased (e.g., Blundell and Ward, 1997). These studies do not investigate the bias and accuracy of appraisers' estimates by appraiser and auditor type, or the accuracy of appraisers' estimates as current value deviates from original acquisition cost.

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that fair value estimates are considerably less biased and more accurate measures of selling price than respective historical cost amounts. In addition, our results indicate that appraiser accuracy declines as original acquisition cost becomes less representative of selling price, suggesting that disclosure of historical cost can assist "nancial statement users to assess the reliability of property appraisal estimates. The results of our managerial manipulation tests indicate that, prior to the adoption of Financial Reporting Standard 3 (FRS 3) (Accounting Standards Board, 1992, revised 1993), which eliminated historical cost as a basis to record gains and losses on property sold, managers recorded income from property sales using the basis (i.e., historical cost or fair value) that resulted in higher earnings. In addition, managers smoothed changes in earnings using fair value gains and losses from sales of investment property. We are unable to document such a result for the period after the adoption of FRS 3. This e!ect may be due to a disclosure change imposed by FRS 3. Enhanced disclosure may eliminate managers' ability to mislead "nancial statement users. As a consequence, managers may discontinue smoothing changes in earnings via asset sales. Our results also indicate that managers exercise discretion with annual revaluation increments to smooth the reported change in net assets (a primary performance indicator under mandatory current value accounting) and boost reported property fair values prior to raising new debt. We do not "nd such results associated with changes in reported leverage or for issuance of new equity. Our tests examining the type of appraiser and auditor employed indicate systematic di!erences and lead to four primary inferences. First, appraisals conducted by external appraisers result in relatively more reliable fair value accounting estimates (i.e., less conservative bias, greater accuracy and less managerial manipulation). Second, fair value estimates prepared by internal appraisers exhibit less conservative bias and greater accuracy if Big 6 auditors audit the "nancial statements. Third, we also "nd some evidence that appraisals are more accurate when conducted by external appraisers not audited by a Big 6 "rm than when conducted by internal appraisers and audited by a Big 6 "rm. Finally, we "nd evidence that monitoring by external appraisers

 Prior to FRS 3, gains and losses from the disposal of property could be combined with other amounts on the pro"t and loss statement. FRS 3 requires that income from property sales be disclosed separately on the pro"t and loss (i.e., income) statement.  Our "ndings are somewhat consistent with Gaver and Paterson's (1998) "nding that underreserving by weak property-casualty insurers is mitigated when "rms use both auditors and actuaries from Big 6 accounting "rms. However, our external monitoring "ndings indicate that monitoring by either an external property appraiser or Big 6 audit "rm can lessen the bias and improve the accuracy of property appraisal estimates. Thus, unlike Gaver and Paterson, our results provide evidence that Big 6 auditors can still contribute to higher quality "nancial information even when work is conducted by relatively low quality `expertsa (i.e., internal appraisers).

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and Big 6 auditors decreases the conservative bias observed in appraisers' fair value estimates. These results, combined with our managerial manipulation results, are consistent with the hypothesis that biased fair value estimates are attributable to managers' incentives to undervalue property expected to be sold in order to increase reported earnings. The remainder of the paper is organized as follows. Section 2 describes the UK property industry and UK accounting rules for investment property. Section 3 discusses our sample selection procedures and descriptive statistics. Section 4 presents our analyses of the bias and accuracy of appraisers' fair value estimates using selling price as a benchmark. Section 5 presents our analyses of managerial manipulation of "nancial statements under UK GAAP for investment property. Section 6 presents our analyses of e!ects of external monitoring on appraisers' fair value estimates. The "nal section summarizes and concludes the paper.

2. Background Investment property in the UK, the primary asset of our sample companies, is required to be revalued every year by an appraiser at its `open market valuea at "scal year end (Statement of Standard Accounting Practice 19 (Accounting Standards Committee, 1981, amended July 1994)). The term open market value is de"ned by the Royal Institution of Chartered Surveyors' Appraisal and Valuation Manual (1995) as `an opinion of the best price at which the sale of an interest in property would have been completed unconditionally for cash consideration on the date of valuation, assuming: (a) a willing seller; (b) that prior to the date of valuation, there had been a reasonable period (having regard to the nature of the property and the state of the market) for the proper marketing of the interest, for the agreement of price and terms and for the completion of the sale; (c) that the state of the market, level of values and other circumstances were, on an earlier assumed date of exchange of contracts, the same as on the date of valuation; (d) that no account is taken of any additional bid by a prospective purchaser with a special interest; and (e) that both parties to the transaction had acted knowledgeably, prudently and without compulsion (Practice Statement 4).a According to Hunt and Hilton (1997), a leading industry guide on UK property companies, the determination of open market value is generally based on

 Property under development is explicitly excluded from investment property.

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evidence from recent transactions of similar property. As open market value is not a measure of a property's existing use, such estimates may omit "rm-speci"c bene"ts from ownership. In addition, the determination of open market value excludes taxes that may arise from disposal (Hunt and Hilton, 1997). Because "rm-speci"c bene"ts and tax e!ects are omitted, actual sales prices from disposals are consistent ex-post measures against which to evaluate appraisers' estimates. In general, appraisers estimate open market value by applying an `investment yielda to the actual or estimated net rental income stream of the property being valued. The investment yield is a capitalization factor that is based on evidence from open market transactions in similar property (Hunt and Hilton, 1997). In practice, appraisers rarely observe contemporaneous transactions for identical property. According to Hunt and Hilton (1997, p.31), `the art of valuation often involves subjective adjustments to evidence of transactions which are not wholly comparable together with interpretation of trends in value.a They further state that appraisers `must exercise skill, experience and judgement in valuing and in making such adjustments and comparisons, even to the extent of making an open market valuation (of a property for which it is thought there would have been a market) in the absence of any direct transaction evidence.a Because appraisers rely on subjective assumptions and exercise considerable judgement, managers may have discretion to manipulate property appraisal estimates. SSAP 19 requires that `where investment properties represent a substantial proportion of the total assets of a major enterprise (e.g., a listed company) the valuation thereof would normally be carried out: (a) annually by persons holding a recognized professional quali"cation and having recent post-quali"cation experience in the location and category of the properties concerned; and (b) at least every "ve years by an external valuer.a Appraisals performed by a chartered surveyor who is an employee or o$cer of the company are referred to as internal appraisals (or directors' valuations). External appraisals are performed by an individual or "rm organized to provide appraisals as chartered surveyors. Each year, investment property "rms may utilize solely internal appraisals, solely external appraisals, or a combination of internal appraisals for some properties and external appraisals for others, as long as each property is appraised externally every "ve years. The reasonableness of appraisers' fair value estimates, including those made by external appraisers, is required to be assessed by the company's auditors in the annual audit (Statement of Auditing Standards 520 (Accounting Practices Board, 1995)). Under SSAP 19, the revalued amount is reported on the balance sheet and the related historical cost amount is disclosed in the notes. Changes in the market value of investment property are recorded in the revaluation reserve (a component of owners' equity); reported earnings are not a!ected by this revaluation. Accounting for investment property sales changed somewhat during our sample period. Prior to the introduction of FRS 3, although investment property was

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reported on the balance sheet at fair value, "rms could use either historical cost or fair value to compute the gain or loss on a disposal. In addition, the gain or loss on investment property sold could be reported separately or combined with other amounts on the pro"t and loss statement. Alternatively, it could be excluded from `bottom-linea earnings if a "rm chose to classify the gain or loss as an extraordinary item or as a reserve transfer. In contrast, after the introduction of FRS 3, the gain or loss on a property disposal is required to be calculated as the di!erence between the selling price and the revalued carrying amount (i.e., estimated start-of-year fair value). In addition, to increase transparency, the gain or loss is required to be reported separately as a component of reported income on the face of the pro"t and loss statement. With the exception of "rms computing gains or losses on disposal using historical cost as the basis (pre-FRS 3), the cumulative di!erence between the fair value and historical cost of the property sold is transferred between di!erent owners' equity accounts when property is sold.

3. Sample selection and descriptive statistics 3.1. Sample selection The empirical analyses employ all "rms in the UK property industry, as classi"ed by Datastream International, between the years 1988 and 1996. We construct two primary samples. Our tests of managerial discretion over the annual revaluation increment employ all available observations (property-held sample). Our tests that rely on the gain or loss of property sold are based on observations for which investment property was sold during the year (propertysold sample). Basic "nancial statement and market value data are obtained from Datastream International. We hand-collected the following items from "rms' "nancial statements: the annual revaluation increment; the beginning and end of year fair value of investment property; the source of the appraisal (i.e., solely external, solely internal, or a combination); and the auditor employed (i.e., Big 6 or non-Big 6). Reported amounts are aggregates across all investment property; information about each individual property held is not disclosed separately. A market-wide, investment property, capital growth index compiled by the Investment Property Databank was obtained from Datastream International. The property-held sample consists of 76 "rms and 451 "rm-year observations for which all required data are available.  The amount typically is transferred from the revaluation reserve to the pro"t and loss reserve account, which is analogous to the retained earnings account typically presented in US GAAP "nancial statements.

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Observations are included in the property-sold sample if: (1) investment property was sold during the year, (2) the carrying value (i.e., estimated open market value) for the investment property sold was available, (3) either the historical cost or fair value gain or loss was available, and (4) the cumulative di!erence between the historical cost and fair value of the disposed property was available. These amounts were hand-collected from the footnotes of sample "rms' annual reports. The selling price of disposed investment property was calculated by adding the fair value of the disposed property to the related pre-tax, fair value gain or loss. In the years prior to the implementation of FRS 3, some "rms reported the recognized gain or loss on disposal using historical cost as the basis. For these observations, we subtracted the cumulative di!erence between the historical cost and fair value of the disposed property from the historical cost gain or loss to obtain the fair value gain or loss on disposal. After implementing the sample selection criteria, the property-sold sample consists of 355 "rm-year observations. 3.2. Descriptive statistics Table 1 presents descriptive statistics for investment property assets, the annual revaluation increment and gains and losses on investment property sold. The table shows, not surprisingly, that UK investment property companies' assets are comprised primarily of investment property, 78% at the median across all years and that these holdings typically are greater than owners' equity, 150% at the median across all years. Table 1 also shows that the annual revaluation increment as a percentage of the end-of-year fair value of investment property has a mean and median value near zero, re#ecting the o!setting of positive and negative revaluation increments over the sample period. The absolute value of the annual revaluation increment as a percentage of the end-of-year fair value of investment property, however, indicates that the annual revaluation increment generally represents a sizable adjustment, 5% at the median. In addition, the absolute value of the annual revaluation increment as a percentage of the absolute value of the change in owners' equity suggests that the annual revaluation increment represents a large proportion of the annual  Analyses in Section 6 employing the property-sold sample and investigating di!erences across appraiser and auditor types employ a reduced sample of 242 "rm-year observations. The reduced sample size is due to the additional requirement that the prior year "nancial statements, which disclose appraiser and auditor types for property sold in the following year, be available. Analyses in Section 5 employing the property-sold sample and investigating managerial discretion over gains and losses from property sold employ a reduced sample of 88 (183) "rm-year observations for the pre-FRS 3 (post-FRS 3) period. The reduced sample size is due to the elimination of "rm-year observations for which the gain or loss on disposal was not reported in `bottom-linea earnings during the pre-FRS 3 period (i.e., the gain or loss was either a reserve transfer or reported as an extraordinary item).

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Table 1 Descriptive statistics for investment property at fair value, the annual revaluation increment, and investment property gains and losses from sales. The samples are comprised of all available "rm-year observations for the period 1988}1996 .

Variable

Mean

Median

Standard deviation

Inter-quartile range

N

Investment property at fair value PROP}F< ¹A

0.72

0.78

0.23

0.62}0.89

451

PROP}F< OE

2.10

1.50

6.52

1.10}1.94

451

Investment property revaluation increment RI PROP}F<

0.00

0.00

0.11

!0.05}0.04

451


RI
PROP}F<

0.08

0.05

0.08

0.02}0.12

451


RI

OE


1.27

0.71

4.97

0.19}1.01

451

Investment property gains and losses from sales
PROP}G¸

E


0.29

0.08

0.65

0.02}0.26

355


PROP}G¸
F<

0.27

0.09

1.61

0.03}0.21

355

(PROP}F<)/¹A is the ratio of end-of-year fair value of investment property to total assets, (PROP}F<)/OE is the ratio of end-of-year fair value of investment property to owners' equity, RI/(PROP}F<) is the ratio of the annual revaluation increment to end-of-year fair value of investment property,
RI
/(PROP}F<) is the ratio of the absolute value of the annual revaluation increment to end-of-year fair value of investment property,
RI
/
OE
is the ratio of the absolute value of the annual revaluation increment to the absolute value of the annual change in owners' equity,
PROP}G¸
/
E
is the ratio of the absolute value of the reported gain or loss on investment property sold to the absolute value of reported earnings, and
PROP}G¸
/F< is the ratio of the absolute value of the reported gain or loss on investment property sold to the start-of-year fair value of the investment property sold.

change in net asset values during the year, 71% at the median. Finally, Table 1 shows that the gain or loss on investment property sold during the year can be relatively large in comparison to reported earnings and the fair value of the property sold. Speci"cally, the absolute value of the gain or loss on investment property sold to the absolute value of reported earnings (fair value of the property sold) is 8% (9%) at the median.

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As many of the variables presented in Table 1 and those in our later tests appear to have non-normal distributions, our univariate analyses employ, where possible, both parametric and non-parametric tests. Similarly, our multivariate analyses employ rank regression to accommodate possible non-linearity in the relationships we investigate and to reduce the in#uence of `outliersa. 4. Bias and accuracy of fair value and historical cost measures In this section, we provide evidence on the bias and accuracy of appraisers' fair value estimates and, for comparison, corresponding historical cost amounts. First, we provide descriptive evidence of the magnitude of the bias and accuracy of appraisers' fair value estimates by comparing these estimates to their realized selling price. According to SFAC No. 2 (FASB, 1980), `accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent.a Therefore, realized selling price is the appropriate benchmark for measuring the reliability of fair value estimates because these estimates are intended to portray open market values. We also present comparable bias and accuracy measures calculated using historical cost amounts. Finally, we investigate whether the accuracy of appraisers' fair value estimates decreases as property values deviate from acquisition cost. 4.1. Descriptive tests of the bias and accuracy of fair value and historical cost measures In Table 2, we present measures of the magnitude of bias and accuracy of appraisers' fair value estimates. Systematic fair value gains are consistent with systematic conservative bias in appraisers' estimates relative to actual selling prices. Systematic historical cost gains are consistent with increases in property values over time, and with managers selectively selling property that has appreciated in price. Our analysis is conducted on a year-by-year and a pooled basis. With respect to bias, appraisers' fair value estimates are typically conservative estimates of actual selling prices. Speci"cally, appraisers' fair value estimates are  See Conover and Iman (1976), Iman and Conover (1979) and Conover (1999) for a discussion of the advantages of the rank transformation in regression analysis.  Selling prices may di!er from start-of-the-year fair value estimates because of changes in fair value during the year and because of forced sales of large amounts of properties. We investigate the e!ect of `stalenessa and `forced liquidationsa on observed fair value gains and losses in Section 6.  We report gains and losses scaled by selling price. Alternative scale factors, such as the fair value of the disposed property, produce the same inferences.

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6% below selling prices across all years at the median, which is statistically signi"cant at a 1% level. On a year-by-year basis, this systematic underestimation is statistically signi"cant at a 10% level (two-tailed) in seven out of nine years. This conservative bias may re#ect appraisers' and/or auditors' incentive to undervalue property to protect themselves from litigation if property is sold for less than its appraised value. Alternatively, this conservative bias may re#ect managers' incentive to undervalue property to increase reported earnings. Under FRS 3, annual revaluation increments do not a!ect earnings directly; earnings are a!ected only by the di!erence between carrying value and selling price of investment property sold. As a consequence, and despite the transparency imposed by FRS 3, managers may prefer conservatism in fair value estimates in order to minimize the likelihood of reporting a loss when property is sold. Relative to historical cost gains and losses, fair value gains and losses exhibit considerably less bias. Speci"cally, the median historical cost gain or loss is signi"cantly greater than the median fair value gain or loss on a pooled basis and in all nine years on a year-by-year basis at a 10% level (two-tailed). Across all years examined, the median fair value gain or loss (6%) is only one-fourth of the median historical cost gain or loss (24%). With respect to accuracy, the variance of fair value gains and losses is signi"cantly less than the variance of historical cost gains and losses on a pooled basis and in all nine years on a year-by-year basis at a 10% level (two-tailed) using parametric tests and at a 1% level (two-tailed) using non-parametric tests.  In untabulated tests, we "nd that appraisers' fair value estimates underestimate properties' selling price in all three years of our sample period during which property values were increasing (as indicated by the return on the Investment Property Databank Capital Growth Index) and in four of the six years during which property values were declining. This suggests that the conservative bias in appraisal estimates is relatively una!ected by whether property values are increasing or decreasing.  As discussed earlier, the accounting treatment for calculating and reporting gains and losses on the disposal of investment property changed after FRS 3 and may have changed managers' incentives to manipulate property fair value estimates. Speci"cally, FRS 3 requires gains and losses be calculated using the latest fair value estimate, creating a greater incentive for managers to understate property fair value estimates for properties expected to be sold. Alternatively, FRS 3 requires such gains and losses to be disclosed separately on the face of the pro"t and loss statement, making the reporting of such amounts more transparent, reducing managers' ability to mislead "nancial statement users. Consistent with FRS 3 resulting in more transparent accounting, the median error declined after this accounting standard change; however, the decline is not statistically signi"cant.  From 1985 to 1990, bank lending resulted in a fourfold increase in outstanding debt for property companies (Foster et al., 1998). As property values declined, some property companies were forced to sell their assets to satisfy borrowing obligations to banks, a large proportion of which were secured by investment property. In addition, the number of company bankruptcies increased substantially in the early 1990s (Foster et al., 1998). These factors led to a signi"cant increase in litigation between lenders and appraisers alleging professional negligence (Crosby et al., 1998b).

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Across all years examined, the variance of fair value gains and losses (3%) is only one-twelfth of the variance of historical cost gains and losses (36%), suggesting that fair value amounts are considerably more accurate estimates of selling prices than are historical cost amounts. Thus, the results demonstrate that fair value estimates are considerably less biased and more accurate measures of selling price than respective historical cost amounts; this evidence is consistent with a conservative bias in appraisers' fair value estimates. The results in Table 2 indicate that, on average, selling price exceeds estimated fair value which exceeds historical cost for assets sold. We investigate three possible explanations for this result. In the next subsection, we investigate whether the results may be attributable to appraiser accuracy being a!ected when property values deviate from their historical cost as historical cost becomes an increasingly stale estimate of open market value. Another explanation is that managers in#uence fair value estimates in order to manipulate accounting measures. We examine the relationship between fair value estimates and managerial incentives in Section 5. Finally, these results may be attributable to price increases of assets sold since the balance sheet date. We examine the e!ect of `stalenessa in Section 6. 4.2. Appraiser accuracy as property values diverge from historical cost In this subsection, we investigate the relation between accuracy of appraisers' estimates and acquisition cost. We hypothesize that appraisers' fair value estimates become less accurate (i.e., exhibit greater variance) as the di!erence between the current value, i.e., selling price, and historical cost of investment property increases. To investigate this possibility, we separate the sample into two groups according to whether the current value is above or below historical cost. For each sub-sample, we rank the observations from low to high based on the di!erence between estimated fair value and historical cost scaled by historical cost (i.e.,
F
 We do not use selling price as our proxy of current value because changes in selling price could, by construction, lead us to "nd the hypothesized relationship (i.e., changes in selling price would have a similar impact on both (SP!FV)/FV and (SP!HC)/HC variables). Our inferences are identical if selling price rather than estimated fair value is used as the proxy of current value.

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Table 2 Tests comparing the distribution of historical cost and fair value gains and losses. The sample consists of 355 "rm-year observations involving a disposal of investment property during the years 1988}1996 . Median PROP}G¸&!

PROP}G¸$4

Year

SP Di!erence (Z-statistic)
(Z-statistic)
(Z-statistic)  &!

F-statistic Z-statistic

SP

 $4

(p-value)

(p-value)

1988 (n"25)

0.36 (5.00)

0.15 (4.60)

0.21 (4.07)

0.05

0.01

3.57 (0.00)

3.03 (0.00)

1989 (n"37)

0.47 (6.08)

0.17 (5.10)

0.30 (4.90)

0.08

0.02

4.73 (0.00)

4.20 (0.00)

1990 (n"38)

0.34 (4.87)

0.10 (1.95)

0.24 (4.18)

0.17

0.04

4.20 (0.00)

2.54 (0.01)

1991 (n"34)

0.30 (3.77)

0.00 (0.69)

0.30 (3.75)

0.12

0.02

4.91 (0.00)

4.82 (0.00)

1992 (n"34)

0.21 (2.40)

!0.01 (!1.03)

0.22 (3.24)

0.13

0.08

1.60 (0.09)

2.28 (0.01)

1993 (n"32)

0.11 (2.47)

0.02 (2.12)

0.09 (1.65)

0.18

0.03

6.79 (0.00)

4.46 (0.00)

1994 (n"51)

0.20 (4.62)

0.06 (5.46)

0.14 (2.86)

0.37

0.02

21.69 (0.00)

4.65 (0.00)

1995 (n"49)

0.19 (4.14)

0.06 (3.29)

0.13 (2.31)

0.23

0.03

8.86 (0.00)

3.09 (0.00)

1996 (n"55)

0.16 (4.99)

0.05 (4.18)

0.11 (3.23)

1.22

0.02

72.61 (0.00)

4.43 (0.00)

All (n"355)

0.24 (12.79)

0.06 (8.97)

0.18 (9.55)

0.36

0.03

11.77 (0.00)

10.76 (0.00)

(PROP}G¸&!)/SP is the historical cost gain or loss from disposed investment property divided by the selling price of the investment property disposed; (PROP}G¸$4)/SP is the fair value gain or loss from disposed investment property divided by the selling price of the investment property disposed;  is the variance of (PROP}G¸&!)/SP; and  is the variance of (PROP}G¸$4)/SP. &! $4
The Z-statistic reports the result of a non-parametric sign test that the median is zero. The Z-statistic reports the result of a non-parametric Wilcoxon test of di!erences between the medians for the historical cost and fair value gains and losses. The F-statistic reports the result of a parametric test of equality of the variances. P-values are based on one-sided tests. The Z-statistic reports the result of a non-parametric, squared ranks test for equality of variances (Conover, 1980). Reported p-values are based on one-sided tests. Indicates signi"cance at the 1% level using a two-sided test. Indicates signi"cance at the 10% level using a two-sided test. Indicates signi"cance at the 5% level using a two-sided test.

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Table 3 Tests comparing appraiser' accuracy as property values deviate from historical cost. Observations are ranked by the absolute value of the di!erence between fair value and historical cost of property sold. The sample consists of 355 "rm-year observations involving a disposal of investment property during the years 1988}1996 . F
F
( 

N

( 

N

Observations with absolute value greater than median

0.16

138

0.13

26

Observations with absolute value less than median

0.02

137

0.04

26

F-statistic
(p-value)

7.85 (0.00)

2.97 (0.00)

Z-statistic (p-value)

8.03 (0.00)

!0.77 (0.78)

(  is the variance of (SP!F<)/F< where SP is the selling price and F< is the fair value, and (F
In Table 3, we present the results of our tests comparing appraiser accuracy as property values deviate from original acquisition cost. Inferences are based on non-parametric Z-statistics because of the likely violation of the normality assumption. For sales of property that have appreciated in value since original acquisition, the variance of the di!erence between appraisers' estimates and selling prices become greater (i.e., appraisers' fair value estimates become less accurate) as the di!erence between fair value and historical cost of the disposed property increases. Speci"cally, for observations where the fair value estimate is greater than historical cost, the variance for observations above the median is 0.16 compared with 0.02 for observations below the median. This di!erence is statistically signi"cant (Z"8.03). For sales of property that have declined in value since original acquisition, the variance of the di!erence between appraisers' estimates and selling price is 0.13 for observations above the median and 0.04 for observations below the median. This di!erence is not signi"cant at conventional levels of signi"cance (Z"!0.77). Taken together, the results of tests in this subsection indicate that appraisers accuracy declines as original acquisition cost becomes less representative of

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selling price. This "nding suggests that, under mandatory fair value accounting, reporting historical cost amounts separately can assist "nancial statement users' assessment of the reliability of property appraisers' fair value estimates. Another possible explanation for the observed di!erences between selling prices and fair value estimates is that managers opportunistically in#uence appraisers' fair value estimates. Indeed, managers may exercise discretion under UK GAAP to manipulate both balance sheet and income statement amounts via reporting methods and biased fair value estimates. We examine managerial manipulation issues in the next section.

5. Managerial manipulation using UK GAAP for investment property Because appraisers use judgment in estimating the fair value of investment property, the estimates, at least to some degree, are subjective. Managers may use their discretion in selecting among permissible accounting alternatives for investment property to manipulate reported earnings. In addition, managers may select properties to be sold, at least in part, to achieve speci"c income manipulation objectives. Managers also may exert in#uence on appraisers to manipulate fair value estimates and thereby achieve certain managerial objectives. In this section, we investigate managerial manipulation of "nancial statements under UK GAAP for investment property. In Section 5.1, we investigate whether managers choose among permissible accounting methods to report gains and losses on sales of investment property so as to increase reported income. Section 5.2 provides evidence on whether managers time the reporting of income from property sales to smooth changes in reported earnings. In both of these subsections, evidence is derived from sales of investment property. In Section 5.3, we examine changes in fair value estimates of investment property held to investigate whether managers exert in#uence on appraisers to achieve certain reporting objectives. 5.1. Systematic reporting of higher earnings by choice of accounting method Prior to the adoption of FRS 3, managers could choose to report income from the sale of investment property using either the property's historical cost or fair value as the basis for the computed gain or loss. For property that appreciated (declined) in value between acquisition and the start-of-the-year balance sheet date during which the property was sold, the choice of historical cost (fair value) as the basis would result in a higher gain or lower loss being reported in earnings. We investigate whether managers' choice of basis prior to the adoption of FRS 3 was determined by its impact on earnings using the following

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Table 4 Logit regression predicting "rms' decisions to recognize gains and losses from the disposal of investment property using fair value as the basis for the calculation. The dependent variable, F<}BASIS , is an indicator variable set equal to one (zero) if a "rm computed the gain or HR loss using fair value (historical cost) as the basis. The sample is comprised of 88 "rm-year observations involving the recognition of a gain or loss in ordinary earnings during the pre-FRS 3 period .

Variable

(Exp. sign)

Intercept (?) (G¸$45G¸&!) (#) HR Number of observations with F<}BASIS "1 HR Number of observations with F<}BASIS "0 HR

Coe$cient estimate !0.41 1.66

Model  (1 d.f.) Maddala R

Asymptotic t-statistic !1.66 2.69

p-value
0.10 0.00

42 46 8.52 0.09

(G¸$45G¸&!) is an indicator variable set equal to one if "rm j's fair value gain (loss) from the HR disposal of investment property during year t is greater (less) than or equal to the historical cost gain (loss) and zero otherwise.
Reported p-values are based on one-sided tests for the variables having an expected sign. Exceeds 99th percentile of  distribution.

logit model: F<}BASIS " # (G¸$45G¸&!) #
HR   HR HR

(1)

where F<}BASIS is a dichotomous variable set equal to one if a "rm comHR puted the gain or loss from the sale of investment property during the year using fair value as the basis and set equal to zero otherwise; (G¸$45G¸&!) is an HR indicator variable set equal to one if "rm j's fair value gain (loss) from the disposal of investment property during year t is greater (less) than or equal to the historical cost gain (loss) and set equal to zero otherwise; and
is an error term. HR The subscripts j and t refer to company and year. A positive coe$cient for (G¸$45G¸&!) would provide evidence consistent with the hypothesis that HR managers chose to record income from property sales using either the fair value or historical cost basis so as to report higher earnings. We estimate Eq. (1) using a subset of the property-sold sample. This sample is comprised of "rms having gains and losses on investment property sales that were recorded in earnings prior to the adoption of FRS 3. The logit estimation results are presented in Table 4. The coe$cient of the (G¸$45G¸&!) variable HR is positive and signi"cant at less than the 1% level (t"2.69); this result is consistent with the hypothesis that managers chose to record income from

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property sales using the valuation basis that resulted in the higher earnings in the pre-FRS 3 period. 5.2. Smoothing reported earnings using gains and losses from property sales Trueman and Titman (1988) examine earnings smoothing and demonstrate that smoothing reduces the estimated volatility of the underlying earnings process and thus the estimated probability of bankruptcy by various claimants (i.e., lenders, customers, workers, and suppliers). Smoothing, therefore, potentially bene"ts shareholders by reducing borrowing costs and improving terms of trade. Further, Dye (1988) demonstrates that earnings management bene"ts current shareholders by minimizing compensation costs for shareholders' preferred actions (internal or stewardship reasons) and by in#uencing prospective investors' perceptions of the company's value (external reasons). Bartov (1993) provides empirical evidence that managers smooth changes in reported earnings by timing the sale of long-lived assets and investments carried at their historical cost. We extend this investigation by examining whether managers smooth changes in reported earnings by timing the sale of investment property under two alternative accounting methods. In general, as reported in Table 2, net gains and losses are smaller in magnitude when fair value, rather than historical cost is used as the basis. Therefore, after FRS 3 required gains and losses to be calculated based on the start-of-the-year fair value estimate, the opportunity to smooth changes in reported earnings using asset sales may be reduced. Alternatively, if managers have discretion over the reporting of fair value amounts, income smoothing using asset sales may persist after the adoption of FRS 3. Recent research by Black et al. (1998) provides evidence that UK "rms that revalued a portion of their assets smoothed changes in reported earnings using gains and losses from asset sales before the implementation of FRS 3, but fails to "nd such evidence after the implementation of FRS 3. Their study does not investigate gains and losses calculated on a fair value basis separately from those calculated on a historical cost basis; therefore, their "ndings do not indicate whether income from the sale of assets carried at fair value are used to smooth changes in reported earnings.

 Based on Noreen's (1988) suggestion that OLS may perform better when sample sizes are small, we also estimate Eq. (1) using OLS. Our inferences are unchanged. In addition, because the pre-FRS 3 sample includes one observation for each year that a sample "rm meets the inclusion criteria, we examine the e!ect of including multiple observations for some "rms by re-estimating Eq. (1) using OLS and allowing for dependence among observations for the same "rm using the method outlined by Froot (1989). In untabulated tests we "nd that our inferences remain unchanged. In subsequent tests, we employ the Froot (1989) method to adjust for dependency where applicable. We "nd that our inferences are una!ected by this adjustment.

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We use the following model to investigate whether managers smooth changes in reported earnings using income from the sale of investment property carried at fair value: PROP}G¸ " # E # %SO¸D # HR   HR  HR HR

(2)

where PROP}G¸ is the recognized gain or loss during the year from the HR disposal of investment property scaled by the start-of-year market value of equity; E is the change in reported net income exclusive of income from the HR sale of investment property for the year scaled by the start-of-year market value of equity; %SO¸D is the percentage of property sold during the year; and  is HR HR the error term. We predict a negative coe$cient for E if managers use HR income from the sale of investment property to smooth changes in earnings. As Table 2 shows, investment property, on average, is sold at a gain. Therefore, the reported gain or loss should be increasing in the amount of asset sales. Accordingly, we predict the coe$cient for %SO¸D will be positive. HR Prior to the adoption of FRS 3, investment property companies could recognize income from asset sales using either the historical cost or fair value as the basis of the property. Therefore, we allow the coe$cient of E to di!er HR depending on the basis chosen. This leads to the following equation for the  Bartov (1993) provides evidence that leverage, bonus plan, and tax variables are positively associated with historical cost gains and losses from asset sales. Speci"cally, Bartov "nds that "rms with greater leverage, which he characterizes as a proxy for closeness to violating debt-covenant agreements, undertake income increasing asset sales; "rms increase earnings through asset sales when earnings are within bonus plan upper and lower bounds; and "rms minimize taxes through the recognition of asset sale losses. In our setting, managers can report property at fair value; as a consequence, managers do not face an incentive to sell property to increase equity and thus reported leverage ratios. For this reason, we do not include leverage as a control variable in the analysis reported in the text. Including leverage as a control variable, however, does not alter the inferences discussed below. We also do not include a variable to control for bonus plan incentives because we are unable to directly observe managers' compensation contracts. In addition, we do not include a variable for tax minimization incentives because UK "rms typically can &roll-over' the tax basis of their disposed assets.  Arguing that investors focus on pre-tax income rather than net income, Bartov (1993) uses the change in pre-tax ordinary income in his tests. In untabulated tests, our results are insensitive to the use of pre-tax income.  The modeled relationship between PROP}G¸ and %SO¸D is not monotonic, as HR HR PROP}G¸ can take negative values for losses on the sale of investment property. To investigate the HR impact of this on our results, we follow Bartov (1993) and make the sign of %SO¸D negative for HR observations with losses from investment property sales. Our results and inferences are insensitive to this adjustment; in particular, the coe$cient of E ;F<}BASIS in the pre-FRS 3 analysis HR HR remains negative and signi"cant (t"!4.08). In addition, our results and inferences are insensitive to the exclusion of the %SO¸D variable. As we are concerned that making an adjustment to the HR independent variable based on knowledge of the sign of the dependent variable results in biased coe$cient estimates, we do not incorporate the transformed %SO¸D variable into our tabulated HR "ndings.

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Table 5 Rank regression predicting "rms' recognized gains and losses from the disposal of investment property. The dependent variable, PROP}G¸ , is the recognized gain or loss during the year from HR the disposal of investment property scaled by the start-of-year market value of equity. The sample is comprised of 88 (183) observations involving the recognition of a gain or loss in ordinary earnings during the pre-FRS 3 (post-FRS 3) period . Coe$cient estimate

t-statistic

p-value


Variable

(Exp. sign)

Panel A: Pre-FRS 3 period Intercept E ;F<}BASIS HR HR E ;HC}BASIS HR HR %SO¸D HR Adj. R

(?) (!) (!) (#) 0.40

29.00 !0.29 !0.07 0.53

4.58 !3.19 !0.68 6.20

0.00 0.00 0.25 0.00

Panel B: Post-FRS 3 period Intercept E

HR %SO¸D HR Adj. R

(?) (!) (#) 0.03

69.58 0.05 0.19

7.08 0.65 2.60

0.00 0.74 0.01

E is the change in reported net income exclusive of income from the sale of investment HR property for the year scaled by the start-of-year market value of equity; F<}BASIS is an indicator HR variable set equal to one if a "rm computed the gain or loss from the sale of investment property during the year using fair value as the basis and zero otherwise; HC}BASIS is an indicator variable HR set equal to one if a "rm computed the gain or loss from the sale of investment property during the year using historical cost as the basis and zero otherwise; and %SO¸D is the percentage of property HR sold during the year.
Reported p-values are based on one-sided tests for the variables having an expected sign.

pre-FRS 3 period: PROP}G¸ " # E ;F<}BASIS # E ;HC}BASIS HR   HR HR  HR HR # %SO¸D # (3)  HR HR where F<}BASIS (HC}BASIS ) is an indicator variable set equal to one HR HR if a "rm computed the gain or loss from the sale of investment property during the year using fair value (historical cost) as the basis and set equal to zero otherwise. Panel A of Table 5 presents the results for the pre-FRS 3 period. The coe$cient of E ;F<}BASIS is negative and signi"cant at less than the 1% HR HR level (t"!3.19), providing evidence that managers smoothed changes in earnings using fair value gains and losses from sales of investment property. In addition, the coe$cient of %SO¸D is positive and signi"cant at less than the HR 1% level (t"6.20), indicating that income from sales of investment property increased as the percentage of property sold increased. The coe$cient of

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E ;HC}BASIS is negative, but insigni"cant at conventional levels HR HR (t"!0.68). To investigate further whether managers select the valuation basis that leads to the smoothest earnings in the pre-FRS 3 period, we compare the variance of earnings as reported to what it would have been under the alternative valuation basis. Using the 88 "rm-year observations that recognized a gain or loss in ordinary earnings during the pre-FRS 3 period, we separate observations into two groups based on the valuation basis employed (historical cost or fair value.) We compute the change in reported net income for the year scaled by the start-of-year market value of equity. We next construct the change in reported net income under the alternative valuation basis. We "rst subtract from current period earnings income from investment property sales under the chosen valuation basis and then add income from investment property sales under the alternative basis. In an untabulated, non-parametric, squared ranks test for equality of variances (Conover, 1999), we "nd that the variance of the change in earnings are signi"cantly lower for the basis chosen, providing further evidence that managers were selecting the valuation basis to smooth earnings. The Z-statistics for "rm-year observations choosing fair value and historical cost as the valuation basis are !6.10 and !1.98, respectively. Results from the post-FRS 3 period are presented in Panel B. The estimated coe$cient for E is not signi"cantly di!erent from zero (t"0.65). The HR estimated coe$cient for %SO¸D is positive and signi"cant (t"2.60). Taken HR together, this evidence re"nes the inferences that may be drawn from the Black et al. study. Because Black et al. do not distinguish between historical cost and fair value during the pre-FRS 3 period, their results are consistent with two inferences: one is that smoothing occurred only when historical costs were used; the other inference is that changes in the disclosure requirements altered managers' use of property sales to smooth reported earnings. In particular, prior to FRS 3, income from property sales could be combined with other amounts on the pro"t and loss account. FRS 3 required income from property sales to be disclosed separately on the pro"t and loss (i.e., income) statement. Our results suggest that the disclosure requirement, rather than elimination of using the historical cost basis to report gains and losses, altered managers' actions.

5.3. Manipulation of reported net asset value changes using fair value estimates of investment property In the UK, the vast majority of investment property companies' assets are carried at fair value. Net asset value and its change are widely used as performance measures by analysts and investors. Articles in the "nancial press often compare investment property companies' market value (annual returns) to their

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reported net asset value (change in net asset value). In fact, reported net asset value has been referred to as `the usual valuation yardstick applied to property sharesa (London, 1996). Further, due to the importance of reported net asset value in this industry, analysts commonly forecast net asset values for listed UK investment property companies. In response, investment property companies typically feature in their press releases and "nancial statements some measure of net asset value per share. From a valuation perspective, changes in net asset values for investment property companies are analogous to earnings for other companies. Smoothing changes in net asset values is, therefore, analogous to smoothing earnings for companies in other industries. Thus, managers of UK investment property companies are likely to view changes in reported net asset value per share in the same manner that managers of other "rms view earnings per share amounts and face similar smoothing incentives. As bank "nancing often relies on net asset values as well, Trueman and Titman's (1988) argument that smoothing reduces the estimated volatility and the probability of bankruptcy provides additional incentives for managers to smooth net asset values. Due to "nancial statement users' reliance on reported net asset values, we predict that managers face the same incentives to smooth changes in reported net asset values as they do to smooth changes in reported earnings. More speci"cally, we predict that managers use available discretion to manipulate the annual revaluation increment (i.e., the annual change in the estimated fair value of investment property held) to smooth exogenous changes in other reported net asset values. As discussed in Section 2, the annual revaluation increment is a relatively large accrual that, because of its subjectivity, may be susceptible to managerial in#uence. We further predict that managers face an incentive to bias the annual revaluation increment upward to minimize the probability of violating accounting-based debt covenants. Citron (1992) reports that bank loan o$cers in the UK rely on gearing (i.e., borrowings-to-equity) ratios to monitor loans. Because "rms in our sample rely on banks as their primary debt providers, we predict that "rms with high gearing ratios exercise discretion to increase reported revaluation increments. By increasing the reported revaluation increment, the denominator of the gearing ratio increases, and the probability of  Consider these examples: `By o!ering concentrated exposure to the booming residential market, it has found strong favour with investors who in recent months have helped boost the share price to a demanding premium of between 25 and 30 percent to net asset value. Bradford's problem is that with forecast net asset value for next year still only 250p}260p, the shares look fully valued relative to the sectora (extract from `Housing recovery lifts Bradford Property,a Suzman, M., 1997, The Financial Times (London), June 12, 30); and `MEPC has turned in a gratifying set of results, prompting analysts to raise their 1998 forecasts of net asset value from 590p to 600p. At last night's close, the shares look a "rm buy at an 8 per cent discount to prospective net asset value, when other large diversi"ed property companies are trading at discounts of 3 to 6 per centa (extract from `MEPC outlines shift in strategy and management,a Cohen, N., 1997, The Financial Times (London), December 4, 28).

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violating accounting-based debt covenants declines. In his survey of bank loan contracts, Citron (1992) found that the revaluation reserve was entirely excluded from only two of "fteen actual contracts and none of eight standard contract templates. He also found evidence that for two actual loan contracts, the revaluation reserve would be excluded if the revaluation was not kept current and not conducted by an external appraiser. So, although some lenders appear to minimize or eliminate potential manipulation of loan covenants through revaluation, others do not. Accordingly, we predict that, as gearing increases, managers use available discretion to bias the annual revaluation increment upward to reduce reported leverage. We also predict that managers will bias the annual revaluation increment downward following a decline in gearing to retain the ability to exercise discretion over reported fair value estimates in future periods. Trueman and Titman (1988) suggest that, under certain conditions, managers have incentives `to increase reported income prior to the sale of securities (so as to project a higher mean)a (p. 138). According to Lovell and French (1995), banks use appraised estimates of property values directly to determine loan-tovalue ratios for secured loans and indirectly for unsecured loans. Further, as discussed earlier, investors rely on appraised estimates for valuation purposes; however, such estimates may not be explicitly incorporated into the fairness opinions of new issues. Following Trueman and Titman's (1988) suggestion, we predict that managers induce an upward bias in the annual revaluation increment in the period prior to the issuance of new debt or equity securities. To investigate these predictions, we adopt an approach similar to that adopted by McNichols and Wilson (1988) to examine the provision for bad debts. First, we use the contemporaneous, market-wide capital growth in investment property values as an estimate of the `non-discretionarya revaluation increment, i.e., the increase in fair value that is predicted by market-wide, investment property in#ation. The contemporaneous, market-wide capital  Citron's analysis included "rms that could revalue assets voluntarily. All "rms in our sample are required to revalue assets annually. Therefore, all "rms in our sample maintained current revaluation reserve amounts.  We predict that this incentive should be greatest for "rms close to violating a gearing covenant; however, we are unable to observe actual bank covenant agreements to determine the actual closeness to violation.  Lenders occasionally rely directly on appraisers' estimates commissioned by borrowers (Crosby et al., 1998a).  In untabulated tests, we also control for "rm-speci"c capital value changes due to changes in "rm-speci"c net rental income di!ering from related market changes. Speci"cally, we use as an alternative measure of the discretionary revaluation increment the residual term plus the constant term from a regression of the market-adjusted revaluation increment onto contemporaneous and one-year ahead, market-adjusted changes in net rental income. We calculate market changes in net rental income using three Investment Property Databank indices: the Rental Income Growth Index, Rental Income Return Index and Capital Growth Index. Our results and inferences are insensitive to the use of this alternative measure of the discretionary revaluation increment.

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growth in investment property values is measured using the Investment Property Databank (IPD) Capital Growth Index. The index is de"ned as the increase in the value of the properties held throughout the year, net of capital expenditure, expressed as a percentage of the capital employed over the year (Investment Property Databank, 1997). The IPD Capital Growth Index appears to provide a reasonable estimate of the non-discretionary revaluation increment because it explains an extremely large portion of the variability of the "rm-level revaluation increment scaled by the start-of-year fair value of investment property. The Spearman rank correlation between the two variables exceeds 70%. We estimate the discretionary portion of the revaluation increment by subtracting the non-discretionary amount from the scaled reported revaluation increment. The discretionary portion of the revaluation increment in millions of pounds is then obtained by multiplying the scaled amount by the start-of-year fair value of investment property. We next examine managers' incentives to manipulate revaluation increments of investment property using the following model: DRI " # NA< # ¸E< # DEB¹ISS;E HR   HR  HR  HR> # EQ;I¹>ISS;E # DI<  HR>  HR # EQ;I¹>ISS;E # (4)  HR HR where DRI is the discretionary portion of the revaluation increment in millions HR of pounds scaled by the start-of-year market value; NA< is the change in HR reported net-asset-value before the discretionary revaluation increment exclusive of ordinary dividends, share repurchases and equity issuances during the year scaled by start-of-year market value of equity; ¸E< is the end-of-year HR long-term debt divided by total assets before the discretionary revaluation  This and other monthly indices published by the IPD are key performance benchmarks in the investment property industry in the UK.  It is important to note that the IPD Capital Growth Index is not simply a summation of our sample "rms' annual capital appreciation, which would re#ect the average cross-sectional discretionary bias for a given year; the index also includes the assessments of property held by life insurance funds, pension funds and property unit trusts. The number of properties included in the calculation of the index currently equals approximately 13,000, representing 85% of total UK institutional property investment (Investment Property Databank, 1999).  In the spirit of Dechow et al. (1998), we considered the e!ect of misclassifying non-discretionary revaluation increments as discretionary. A priori, we are unable to identify relationships between misclassi"cation errors and measures of managerial incentives in the direction that we hypothesize.  Net asset value is typically stated on a per-share basis. However, investment property "rms do not always disclose net assets per-share over the sample period and commonly do not report the basis used to calculate reported net assets per-share. In addition, for econometric reasons discussed by Easton (1998), we choose start-of-year market value over number of shares to scale the reported change in net asset value and other variables.

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increment, less start-of-year, long-term debt divided by total assets; DEB¹ISS;E is an indicator variable set equal to one if a "rm issued a signi"cant HR> amount of new debt (i.e., 5% of end-of-year total capital) in the subsequent year and set equal to zero otherwise; EQ;I¹>ISS;E is an indicator HR> variable set equal to one if a "rm issued a signi"cant amount of new equity (i.e., 5% of end-of-year total capital) in the subsequent year and set equal to zero otherwise; DI< is the ordinary dividends paid during the year scaled by HR start-of-year market value of equity; EQ;I¹>ISS;E is the amount of equity HR issued during the year scaled by start-of-year market value of equity; and  is HR an error term. In Eq. (4), we separate dividends paid during the year from other changes in net asset values because "rms experiencing above (below) market growth in property capital appreciation may make relatively higher (lower) dividend payments. Under this condition, annual revaluation increments above the market and negative changes in (other) net asset values (due to the payment of dividends) for reasons other than net asset value smoothing may be observed. The converse is also true*"rms that are `doing poorlya may need to raise additional capital. To control for this e!ect, we separate proceeds from equity issued during the year from the (other) change in net asset values. If contracting cost incentives in#uence managers to manipulate property appraisal estimates systematically, then the NA< coe$cient is expected to be negative and the HR ¸E< , DEB¹ISS;E , and EQ;I¹>ISS;E coe$cients are exHR HR> HR> pected to be positive. Eq. (4) is estimated by pooling observations across "rms and time. Table 6 presents the rank regression estimation results for the discretionary revaluation increment incentive equation. The coe$cient of NA< is negaHR tive and signi"cant at the 1% level (t"!3.49), suggesting that managers smooth changes in net asset values using discretion available with the annual revaluation increment. In addition, the coe$cient of DEB¹ISS;E is HR> positive and signi"cant at the 1% level (t"3.22), suggesting that managers bias the annual revaluation increment upwards when issuing signi"cant amounts of debt. The coe$cients of ¸E< and EQ;I¹>ISS;E are positive but HR HR> insigni"cant (t"0.94 and t"0.11, respectively). Consistent with their expected signs, both control variables are signi"cant at the 5% level; the coe$cient of DI< is positive (t"2.49) and the coe$cient of EQ;I¹>ISS;E is negative HR HR (t"!1.72). Taken together, the results presented in this section are consistent with the hypothesis that managers use their discretion in selecting among permissible  We investigate the sensitivity of using a 5% threshold by using a 10% threshold. Our results reported later are insensitive to this alternative cut-o! value.  In untabulated tests, we also measure the change in net asset value by including dividends paid during the year; our inferences are unchanged.

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Table 6 Rank regression coe$cient estimates for discretionary revaluation increment incentive equation. The dependent variable, DRI , is the discretionary portion of the annual revaluation increment HR scaled by the start-of-year market value. The sample is comprised of 451 "rm-year observations for the period 1988}1996 .

Variable

(Exp. sign)

Intercept NA<

HR ¸E< HR

DEB¹ISS;E HR>

EQI¹>ISS;E HR> DI< HR EQ;I¹>ISS;E HR Adj. R

(?) (!) (#) (#) (#) (#) (!) 0.06

Coe$cient estimate 222.56 !0.18 0.05 39.36 1.79 0.11 !0.06

t-statistic 10.22 !3.49 0.94 3.22 0.11 2.49 !1.72

p-value
0.00 0.00 0.17 0.00 0.45 0.01 0.04

NA< is the change in reported net-asset-value before the discretionary revaluation increment HR exclusive of ordinary dividends, share repurchases and equity issuances during the year scaled by start-of-year market value of equity; ¸E< is the end-of-year long-term debt divided by total assets HR before the discretionary revaluation increment, less start-of-year, long-term debt divided by total assets; DEB¹ISS;E is an indicator variable set equal to one if a "rm issued a signi"cant HR> amount of new debt (i.e., 5% of end-of-year total capital) in the subsequent year and zero otherwise;

EQ;I¹>ISS;E is an indicator variable set equal to one if a "rm issued a signi"cant amount HR> of new equity (i.e., 5% of end-of-year total capital) in the subsequent year and zero otherwise; DI< HR is the ordinary dividends paid during the year scaled by start-of-year market value of equity; EQ;I¹>ISS;E is the amount of equity issued during the year scaled by start-of-year market HR value of equity.
Reported p-values are based on one-sided tests for the variables having an expected sign.

accounting alternatives for investment property to manipulate reported earnings, that managers select properties to be sold, at least in part, to achieve speci"c income manipulation objectives, and that managers exert in#uence on appraisers to manipulate fair value estimates and, thereby, achieve certain managerial objectives. The adoption of FRS 3 appears to have mitigated managerial manipulation of reported earnings. In the next section, we examine external monitoring mechanisms that impede managerial manipulation of estimated fair values for investment property.

6. E4ects of external monitoring on fair value amounts Fair value estimates for investment property are prepared by chartered surveyors and are audited by chartered accountants. Chartered surveyors and chartered accountants may serve as monitoring mechanisms that are intended to restrict the discretion of managers. Alternatively, they may serve to enhance

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the credibility of management representations. In this section, we investigate the e!ects of surveyors (i.e., appraisers) and chartered accountants (i.e., auditors) on the reliability of property fair value estimates. Prior research by Barth and Clinch (1998) argues that external appraisal estimates may be relatively more accurate because external appraisers have greater expertise and are independent of the "rm. They alternatively argue that internal appraisal estimates may be relatively more accurate because directors have better private information concerning the assets being valued. A third alternative is that, because external appraisers are often consulted during years when internal appraisers are used (Hunt and Hilton, 1997), there may exist little di!erence between external and internal appraisers' estimates. In their tests, Barth and Clinch (1998) "nd little evidence of a di!erence between internal (i.e., director) appraisals and external appraisals. Prior research (e.g., DeAngelo, 1981; Teoh and Wong, 1993; Francis et al., 1996; Craswell et al., 1995; Becker et al., 1998; Gaver and Paterson, 1998) also predicts and "nds evidence of audit quality di!erences by type of audit "rm. In particular, prior research indicates that audits conducted by `Big 6a audit "rms result in "nancial statements with relatively lower "nancial misstatement than those conducted by `non-Big 6a audit "rms. Big 6 "rms are predicted to conduct higher quality audits due to a larger client base, and thus, a larger reputation loss due to audit failures. In our tests, we separate appraiser type into three categories: solely external, solely internal, or a combination of both external and internal. Consistent with prior research (e.g., Becker et al., 1998), we separate auditor type into two categories, Big 6 and non-Big 6. It is unclear a priori which type of appraiser would be less biased or more accurate, so we make no prediction concerning appraiser type. Our tests focus on (solely) internal and (solely) external appraisals because di!erences in managerial discretion should be most pronounced for these two categories. For completeness, we also present results based on "nancial statements that employ both types of appraisers in the same year. Following prior research, we predict that appraisal estimates audited by Big 6 auditors are less biased and more accurate relative to those conducted by non-Big 6 auditors. We present univariate evidence concerning the bias and accuracy of appraisers' fair value estimates by appraiser and auditor type. Appraiser error, the metric used in our tests, is de"ned as selling price less the start-of-the-year appraised fair value estimate (i.e., the fair value gain or loss during the year)  In the UK, the terms Big 6 and Big 8 refer to the same accounting "rms as in the US (Arthur Andersen, Coopers and Lybrand, Deloitte Haskins and Sells, Ernst and Whinney, Peat Marwick Mitchell, Price Waterhouse, Touche Ross and Arthur Young or their successors). The dichotomy between Big 6/Big 8 and other accounting "rms has previously been used in research investigating UK audit "rms (e.g., Pong and Whittington, 1994; Pong, 1999).

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scaled by the start-of-the-year appraised fair value estimate. Thus, appraiser error is measured as the percentage that appraised fair value is over- or under-estimated. We de"ne estimates that are closer to zero as less biased, and those with higher variance as less accurate. The results of our analysis, using a subset of the property sold sample for which appraiser and auditor types in the prior year are available, are presented in Table 7. In Panel A, we present average error, median error, and error variance by appraiser and auditor types. As can be seen in Panel A, there exists a general underestimation of the appraised value of investment property across appraiser and auditor type; the average error and median error amounts are signi"cantly greater than zero at less than a 5% level across all appraiser and auditor types. This "nding is consistent with our earlier tests that managers face incentives to increase income through the recognition of gains from sales of investment property. If managers are able to bias the annual revaluation increment, the result may be due to systematically understating fair value estimates of property to be sold.

Table 7 Univariate tests of appraiser' bias and accuracy by appraiser and auditor types. Appraiser error, ERROR , is the di!erence between selling price and estimated fair value, scaled by estimated fair HR value. The sample consists of 242 "rm-year observations involving a disposal of investment property during the years 1988}1996 . Panel A: Appraiser+ bias and accuracy by appraiser and auditor type

Appraiser/auditor BO¹H HR BIG6 HR NBIG6 HR EX¹ HR BIG6 HR NBIG6 HR INT HR BIG6 HR NBIG6 HR

Average ERROR HR (t-statistic)


Median ERROR HR (Z-statistic)

0.18 (2.21) 0.18 (1.89)

0.09 (3.57) 0.08 (2.18)

0.13

20

0.15

17

0.09 (4.10) 0.11 (3.01)

0.04 (3.53) 0.07 (3.67)

0.05

104

0.05

36

0.13 (3.64) 0.41 (3.32)

0.05 (2.52) 0.17 (3.44)

0.06

46

0.29

19

(  #00-0

N

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Table 7 (continued) Panel B: Comparison of appraiser+ bias and accuracy by appraiser and auditor types

Comparison di!erence Appraiser type BIG6 : EX¹ !IN¹ HR HR HR NBIG6 : EX¹ !IN¹ HR HR HR Auditor type EX¹ : BIG6!NBIG6 HR HR IN¹ : BIG6 !NBIG6 HR HR HR

(  #00-0

Average ERROR HR (t-statistic)

Median ERROR HR (Z-statistic)

(F-statistic)

!0.05 (!1.12)

!0.01 (!0.63)

(1.35)

!0.30 (!2.35)

!0.10 (!2.30)

(6.33)

!0.02 (!0.51)

!0.03 (!1.16)

(1.00)

!0.27 (!2.15)

!0.12 (!2.50)

(4.70)

(Z-statistic)

!0.02 (!1.70) !0.24 (!4.14)

!0.00 (!0.73) !0.23 (!3.93)

The type of appraiser conducting the appraisal in the year prior to the disposal of investment property is separated into three categories: a combination of both external and internal appraisers (BO¹H ), solely external (EX¹ ), and solely internal (IN¹ ). The type of audit "rm conducting the HR HR HR audit of the appraisal in the year prior to the disposal of investment property is separated into two categories: Big 6 audit "rms (BIG6 ) and non-Big 6 audit "rms (NBIG6 ). ERROR is the di!erence HR HR HR between selling price and estimated fair value, scaled by estimated fair value.
The t-statistic reports the result of a parametric test that the mean is zero. The Z-statistic reports the result of a non-parametric sign test that the median is zero. Indicates signi"cance at the 5% (10%) level using a one-sided test (two-sided test for the appraiser type tests). Indicates signi"cance at the 1% (5%) level using a one-sided test (two-sided test for the appraiser type tests). The t-statistic reports the result of a parametric test of di!erence in means between the average error amounts. The Z-statistic reports the result of a non-parametric Mann}Whitney test of di!erences between the median error amounts. The F-statistic reports the result of a parametric test of equality of the variances. The Z-statistic reports the result of a non-parametric, squared ranks test for equality of variances (Conover, 1980).

Indicates signi"cance at the 1% level using a two-sided test for the appraiser type tests.

The statistics presented in the panel also reveal considerable variation across appraiser and auditor combinations. Speci"cally, appraisals conducted by external appraisers that are audited by Big 6 audit "rms exhibit the least bias (median error"0.04) and greatest accuracy (variance"0.05). In contrast, appraisals conducted by internal appraisers that are audited by non-Big 6 audit "rms exhibit the greatest bias (0.17) and lowest accuracy (0.29). This suggests

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that external appraisers and Big 6 auditors reduce the bias in appraisal estimates, which reduces managers' ability to increase income through the sale of investment property. In Panel B of Table 7, we present results of formal tests comparing appraiser and auditor types. Due to likely violation of the normality assumption that underlies our parametric tests (i.e., t-statistics and F-statistics), our inferences are based on non-parametric tests (i.e., Z-statistics). As can be seen in the panel, when the audit is conducted by a non-Big 6 audit "rm, appraisals conducted solely by external appraisers are signi"cantly less biased (smaller median error) and more accurate (lower variance) than those conducted solely by internal appraisers (Z"!2.30; Z"!4.14, respectively). In addition, when the audit is conducted by a Big 6 audit "rm, appraisals conducted solely by external appraisers are signi"cantly more accurate than those conducted solely by internal appraisers (Z"!1.70). Turning to the e!ects of auditor conditioned on appraiser type, our results fail to identify any signi"cant bias or accuracy e!ect related to auditor when an external appraiser is employed. When an internal appraiser prepares the fair value estimates, however, appraisals audited by Big 6 audit "rms are less biased and more accurate (Z"!2.50; Z"!3.93, respectively). In untabulated tests, we "nd that the largest reliability di!erences occur for estimates prepared by external appraisers and audited by Big 6 auditors compared with those conducted by internal appraisers and audited by non-Big 6 auditors (median error di!erence"!0.14, Z"!3.10; variance di!erence"!0.24, Z"4.71). We also "nd that appraisals prepared by external appraisers and audited by non-Big 6 audit "rms are relatively more accurate than those conducted by internal appraisers and audited by Big 6 audit "rms (variance di!erence"!0.02, Z"!2.18). These univariate results must be tempered by the fact that di!erences between selling prices and estimated fair values may be due to the staleness of appraisers' estimates and to forced liquidations. In untabulated tests, we replicate the univariate tests after controlling for these factors. Speci"cally, we regress appraiser error on the market-wide change in UK investment property values since the last valuation (i.e., the balance sheet date) and the amount of property sold during the period. The market-wide change in property values is measured as the annual return on the IPD Capital Growth Index starting at the balance sheet date. We interact the intercept by each appraiser and auditor combination. We also interact the market-wide change in property value variable because its  For "rms that employ both external and internal appraisers and non-Big 6 auditors, the estimated bias and accuracy lie between the estimates of "rms using solely external or solely internal appraisers. For "rms that employ both external and internal appraisers and Big 6 auditors, however, the estimated bias is greater and the estimated accuracy is lower than those using solely external or solely internal appraisers, but only the di!erence in the estimated bias of both external and internal appraisers relative to (solely) external appraisers is statistically signi"cant.

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estimated coe$cient is also a function of appraiser bias. Our rank regression results indicate that staleness and forced liquidations do a!ect observed property appraiser errors. However, tests of the interacted intercept terms result in the same bias inferences as our univariate tests. In addition, tests of the variance of the error terms (calculated by converting the rank regression error terms into their respective unranked values) result in the same accuracy inferences as our univariate tests. As a "nal test of the e!ects of external monitoring, in untabulated tests, we examined the relation between monitor type and managerial manipulation. Speci"cally, we interact the NA< variable in Eq. (4) by appraiser and HR auditor types. The NA< variable is interacted by monitor type because all HR property "rms face an incentive to smooth changes in net asset values. The other variables of interest are not interacted because of the relatively small sample size for several of these interactions and because their interpretation is ambiguous. Only when external appraisers are employed are the coe$cients of NA<

HR not statistically signi"cantly di!erent from zero. Further, when Big 6 audit "rms conduct the audit and internal appraisers are employed, the coe$cient of NA< is signi"cantly greater than when Big 6 audit "rms conduct the audit HR and external appraisers are employed (t"2.00). These results are consistent with external appraisers mitigating bias in fair value estimates induced by managers' preference to smooth changes in net asset value. Other appraiser and auditor comparisons fail to provide evidence of signi"cant di!erences, and inferences reported earlier regarding the other included variables remain unchanged. Taken together, the results of tests in this section lead to three principal inferences. First, appraisals conducted by external appraisers result in relatively more reliable fair value accounting estimates. Second, when relatively unreliable appraisers (i.e., internal appraisers) conduct appraisals, audits by Big 6 auditors result in relatively more reliable fair value estimates. Third, although we "nd that appraisal estimates prepared by external appraisers or audited by Big 6 auditors exhibit relatively higher reliability, we "nd some evidence that appraisals conducted by external appraisers and not audited by a Big 6 "rm are more accurate than those conducted by internal appraisers and audited by a Big 6 "rm.

 For instance, as discussed earlier, loan contracts occasionally minimize or eliminate potential manipulation of loan covenants through revaluation, including the elimination of revaluation amounts from gearing ratios when the appraisals are conducted by internal appraisers. Thus, observed di!erences in the ¸E< variable by monitor type may be due to di!erences in loan HR covenant requirements. The interpretation of interacted DEB¹ISS;E and EQ;I¹>ISHR> S;E variables is also ambiguous as loan-to-value ratios do not always rely on appraisal HR> estimates commissioned by borrowers and fairness opinions for new equity issues may not always explicitly incorporate appraisal estimates.

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7. Summary and conclusion Debate on the adoption of current value accounting revolves around the potential increase in relevance versus the potential decrease in reliability. Relative to historical costs, fair value estimates are more likely to be subject to managerial discretion. This study contributes to this debate by providing evidence on the reliability of appraised property value estimates for UK investment property "rms during the 1988}96 period. We "nd evidence that fair value estimates understate actual selling prices by six percent at the median, suggesting a conservative bias in appraisers' estimates, and that fair value estimates are considerably less biased and more accurate measures of selling price than respective historical cost amounts. Further, we "nd that appraisers accuracy declines as original acquisition cost becomes less representative of selling price, suggesting that disclosure of historical cost can assist "nancial statement users to assess the reliability of property appraisal estimates. Our investigations of managerial discretion over reported property fair value estimates reveal that prior to the adoption of Financial Reporting Standard 3, which eliminated historical cost as a basis to record gains and losses on property sold, managers recorded income from property sales using the basis (i.e., historical cost or fair value) that resulted in higher earnings. This result suggests that managers select among permissible accounting methods to report higher earnings. In addition, we "nd evidence that, prior to the adoption of FRS 3, managers smoothed changes in earnings using fair value gains and losses from sales of investment property. We are unable to "nd such evidence after the adoption of FRS 3, which may be due to FRS 3's requirement that income from property sales be disclosed separately on the pro"t and loss (i.e., income) statement. We also "nd evidence that managers use discretion in determining annual revaluation increments to smooth the reported change in net assets (a primary industry performance measure) and to boost reported property fair values prior to raising new debt. We fail to "nd evidence that managers use this discretion to manage changes in reported leverage and prior to the issuance of new equity. Finally, our investigation reveals that the reliability of fair value estimates varies according to the relation between the appraiser and the "rm (internal versus external appraiser) and the reputation of the auditor (Big 6 versus non-Big 6). We "nd evidence that appraisals conducted by external appraisers result in relatively more reliable fair value accounting estimates (i.e., lower conservative bias, greater accuracy and lower managerial manipulation). In addition, we "nd evidence that when internal appraisers conduct appraisals, audits by Big 6 auditors result in fair value estimates that exhibit less conservative bias and greater accuracy. Finally, we "nd that appraisals conducted by external appraisers and not audited by a Big 6 "rm exhibit greater accuracy than those conducted by internal appraisers and audited by a Big 6 "rm. Our bias

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and accuracy results persist even in the presence of variables intended to control for staleness in fair value estimates and for selling prices a!ected by forced sales of investment property. Because reported investment property appraisal estimates tend to understate selling prices, we infer that this bias re#ects managers' incentives to undervalue property expected to be sold to increase reported earnings. This inference is based on our "ndings that managers have discretion over reported appraisal estimates and that the bias decreases when external appraisers or Big 6 auditors are involved. These results are inconsistent with an alternative explanation that appraisers and auditors seek to protect themselves from litigation if property is sold for less than its appraised value. Our results that managers systematically bias property appraisal estimates suggest that, relative to historical cost, appraised values are less reliable. Yet we cannot conclude that because current values are less reliable than historical costs, historical costs are more useful. Therefore, our evidence, coupled with evidence on the relevance of historical cost valuations relative to current cost valuations, may assist policymakers in assessing the relative tradeo!s of these two valuation approaches. Our results provide evidence on the reliability of fair value estimates in one setting, and must therefore be interpreted with caution. First, in the UK property industry, only the di!erence between the start-of-year fair value estimate and selling price is recorded as a gain or loss in current earnings. Settings in which year-to-year changes in fair value are recorded in earnings may create di!erent managerial incentives and, consequently, di!erences in fair value estimates. Second, relative to investment properties that trade in active secondary markets and exhibit broad similarities, fair value estimates for other long-lived assets are likely to be less reliable. As a consequence, the range of bias and accuracy measured for investment property may understate the variation in other settings. Third, the bias and accuracy of fair value estimates for properties expected to be sold may di!er from those not expected to be sold. For instance, as bias and accuracy become revealed through the sale of the property, appraisers may exercise relatively greater caution. Fourth, the use of gains and losses associated with property sales may introduce a bias if sellers o!er to pay more than fair value for some property and managers are more likely to accept these o!ers. Finally, observed di!erences in bias and accuracy across appraiser and auditor type may be attributable to unobservable di!erences in appraisal di$culty. Future research that examines fair value estimates in other settings may provide insights on these issues.

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