Findings – Authors have found out that the adoption of fair value of financial assets has increased the disclosure requirements and It gives more value to financial statements. Results obtained from research revealed that earnings have decreased due to convergence to ALAS 39 and Management has overall positive perception regarding adoption of fair value for financial assets. Key Words Fair value, Diversified holdings, Earnings per Share, Return on Investment Paper Type Research paper 1. Introduction For many years, the users of financial statements have sought relevant and timely Information about balancing instruments.
Traditionally, the elements of financial statements – assets, liabilities, Income and expenses ? have been recognized under the historical cost and as such, the financial instruments, not different from the rest, were measured at historical cost. During the sass, some categories of financial Instruments changed from being based entirely on historical cost to a mixed historical cost,’market value approach, reflecting developments in the accounting standards. For example, under this model the trading book in the banks is measured at market value while the banking book is measured at historical cost.
However, after sometime it became apparent that such a separation does not always reflect the way banks manage their books. Trading book Instruments are, for example, used to hedge the interest rate risk in the banking book. Over time greater use will probably be made of credit derivatives to hedge credit risk in the banking book. Where there is hedging of this kind, the trading book item has to be shown at book value. (Jackson, 2000; Lodge, 2000). Due to such discrepancies, the need for a revision of the measurement of financial instruments came into existence.
However, with the nonviolence to ALAS 39, the measurement of financial instruments was diverted to fair value. The superiority of fair value measurement over historical cost accounting has been gaining broad-based acceptance among accounting professionals and standard setters (Berth, 1994: Berth et al. , 1995). It Is believed that fair value measurements and recognition of these values in the financial statements, along with adequate disclosures, will provide accurate, comprehensive and timely information to evaluate an enterprise’s exposures to financial risks, as well as rewards In a proper Asia (Adamant, 2002; Ball, 2006).
Though there are detailed discussions as to why financial instruments should be recorded in the balance sheet at fair value, they do not explore the earnings process and the interrelationship between fair value ‘OFF evident that there is a lack of research in this area, and this study aims to fill this void. The purpose of this paper is to examine the academic literature on the effect of the adoption of Fair value for Financial Instruments on the earnings of an entity. In the study, we have focused on the effect of adoption of fair value for the financial stets on the earnings of Diversified Holdings, from the perspective of the company.
On the outlook, we test whether the level of earnings is significantly lower before the convergence to ALAS, and reported earnings is more value relevant during the FIRS period. This study covers the two time periods, one year before the convergence and one years after the adoption (FIRS period). Since there was no other change in the financial reporting environment of Sir Lankan during the period studied, we assume that the potential country-level factor that could affect firm’s earnings during the erred was the convergence FIRS.
Secondly, this work paper provides the impact of the change in accounting treatment on the Return of Equity and Return on Investments of the holding company. Finally, this study reviews the insights and perceptions of the managers of the holding companies on the adoption of fair value for the measurement of Financial Assets in their entities. 2. Literature Review 2. 1 Background Over the years there has been a burgeoning need among standard setting bodies, academia, shareholders and professional bodies in improving the comparability and reliability of financial statements.
To achieve this objective, SAAB introduced many relevant accounting standards including one of the most complex and debatable important standards namely, FIRS 13 and AS 39. FIRS 13- Fair Value Measurement defines the fair value, sets out framework for measuring fair value and discusses the disclosures required on fair value measurement. One of the major modules discussed in FIRS 13 is that fair value measurement of financial instruments. FIRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the assortment date (I. . An exit price). That definition of fair value emphasizes that fair value is a market-based measurement, and not an entity-specific measurement. (Ball, 2006). When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or liability under current market conditions, including assumptions about risk (Penn and Belly, 2010). According to AS 39 financial asset can be defined as any asset that is A. Cash, B. An equity instrument of another entity, a) a contractual right: I. O receive cash or another financial asset from another entity; or it. O exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity: or b) a contract that will or may be settled in the entity’s own equity instruments and is: I. A non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or I’. A derivative that will or may be settled other than by the exchange off fixed equity instruments.
For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery f the entities own equity instruments. 2. 2 Prior studies on Fair Value measurement of financial assets Previous research articles and case studies on fair value measurement adoption provide valuable insights on how other countries have dealt with its consequences and difficulties they have faced. A case study on how China has adopted fair value accounting (Penn and Belly, 2010) discusses on high degree of adoption of FIRS fair value measurement for financial instruments within China AGAPE.
Since China is an emerging country they place much attention on adopting international standards to attach with the investors’ information requirements. As per the proposals of Joint Working Group of standard setters, the reliability of financial statement figures plays an important role when providing information to the users of financial statements. With the fair value adoption for financial assets, it clearly gives an idea of true economic conditions of the financial assets. On the other hand it has an inherent risk of volatility incorporated in to financial statements.
In Fair Value Accounting and Future Financial Instruments Jackson and Lodge) discusses on the difficulties in adopting fair value accounting in banking sector as they have high amount of financial assets in their asset portfolio. Hence banking books are exposed to higher amount of volatility if fair value accounting is adopted. Also when bringing financial assets to fair value the discounts rate to be used is debatable; whether to use market rate or internal discount rate. Additionally banks might be taxed on unrealized gains if gains from fair value changes are used for tax purposes. When fair value measurements are calculated only for external financial reporting purposes, they often will not have been produced from a defined process with consistent valuation methods and systems and strong internal control. We are concerned that fair value prepared only for external reporting purpose, not used by the enterprise to manage its business and prepared without the benefit of major investment in systems and human resources, may be unreliable and frequently would present significant audit difficulties.
Although this situation present today with fair value disclosures for financial instruments and for hedging requirements of AS 39 and FAST Statement No. 33, the broader use of fair value measurements for all financial instruments in the primary financial statements would exacerbate the reliability and audit issues” explains Leister Wilson and Ernst & Young in his article Fair Value and Measurement; Where the conflict lie. 3. Methodology The main research question, as outlined above, is “Does the measurement of fair value for financial assets of diversified holdings improve the earnings? To provide a consistent platform for assessing the impact from the measurement of fair value for financial assets, this study examines the diversified holdings which had been listed at Colombo Stock exchange. Diversified Holdings are of particular interest for several reasons. Firstly, the core business of the diversified holding companies is engaging in considerably large amount of investments compared to that of the companies listed under other sectors in Colombo Stock Exchange.
Secondly, the focus on this study is on the Financial Information relating to the “company’ rather than the “group” because when taken as a group, the fair value impact of investments of companies might set off each other thus giving misleading results and conclusions. This study analyses the related information of four holding companies namely, John Keels Holdings PL, Carson Cumberland PL, Aitkin Spence PL and C T Holdings PL which represents 74% of the total market capitalization of diversified holdings listed in Colombo Stock Exchange as at 22nd November 2013. Refer appendix 01). Data for the study includes financial accounting information retrieved from the annual reports of the companies in the selected sample pertaining to the years 2012/13 and 2011/12 and non-financial data on the perception of the managers on the convergence, obtained in the form of open ended interviews with a set of limited questions. The variables used in this research paper to determine the effect of the earnings of the company as a result of convergence are earnings per share (PEPS) and return on investments (ROI).
Data analysis for the study includes both quantitative and qualitative methods. A Comparative Analysis has been used to study quantitative data and a perception analysis and they were conducted to identify the perceptions of financial mangers regarding the measurement of fair value for financial assets. To pursue its overall research goal, the study is organized to address the following three interrelated research objectives.
The first objective of the study is the examination of the change in accounting treatment and disclosure requirements due to the measurement of fair value for financial assets. For this purpose a disclosure analysis was conducted using the annual reports of the selected sample. Under this methodology, a comparison was carried out between the disclosures made in the annual reports of 2011/2012 and the disclosures made in 2012/2013 annual reports in order to ascertain the new disclosure and measurement requirements from the adoption of SLURS/ALAS.
The second objective of the study is the examination of the impact of the change on key performance indicators (PEPS, ROI). The hypothesis selected for the study supports this objective is “The measurement of fair value for financial assets has increased ROI and PEPS of diversified holdings”. The methodologies used for the analysis are mean, variation and regression analysis. The approaches were carried out in this study to pursue the above designated objectives.
As per the first time adoption of ALAS/SLURS, the companies were required to prepare conciliations to restate 2012 and 2011 financial statement figures in accordance with Sulfurs. The increase or decrease in fair value of financial assets due to adoption of Fires was obtained using these reconciliations. Then the delta of ROI and PEPS was calculated based on the change in fair value. Further, the mean and variation of such calculated ROI and PEPS was calculated using relevant formulas to identify the average impact on earnings due to the fair value measurement.
Then a relationship between particular variables was obtained using regression analysis to identify the eat value of variable to test the hypothesis of the study which states that there is a positive impact on ROI and PEPS due to the measurement of fair value. Variables used in regression analysis are the value of financial assets before the convergence of with regard to financial assets were obtained from 2011/2012 annual reports, which had been measured under cost and they were analyses against the comparatives in 2012/2013 annual reports which have been restated as per the ALAS 39.
As such, the outright change occurred as a result of the convergence to FIRS could be able to identify. The percentage difference between above two variables is used as X values of the regression graph and the resulted ROI and PEPS were taken to the Y axis. After conducting regression test we could identify beta values between the variables and the nature of relationship among them. The third objective of the study is to analyses manager’s perception regarding the measurement of fair value.
To achieve this, a set of open ended interviews were conducted with manages to identify their views on the convergence. Here we have not tested any hypothesis nonetheless generalized their own views. 4. Analysis and Discussion 4. 1 Disclosure Analysis Adoptions of Sulfurs significantly broaden the presentation and disclosure requirement. From the convergence, it is expected to reduce the risk of wrong decision making and give more relevant information (Ryan, 2008).
Based on the research carried out, it was identified that the quality of disclosure on financial assets has been improved. The financial statements prepared according to CLASS have not included any separate disclosures on financial assets, further the investments on financial assets have been recognized at cost and only the market value of the investments have been separately disclosed. In the examination of financial reports prepared according to the Sulfurs; after convergence to ALAS 39, it was evident that financial assets are disclosed separately and measured at fair value.
The convergence requires disclosing definition of fair value, hierarchy in determining fair value, fair value used in initial and subsequent measurement, and also the fair value used in impairment testing of financial assets. At the circumstances where the fair value of financial assets recorded in the statement of financial position cannot be rived from active markets, the fair values have been determined using valuation techniques and these valuation techniques have been disclosed in the notes to the financial statements.
If this is not feasible and a degree of Judgment is required in establishing fair values, the liquidity risk, credit risk and volatility have been disclosed as the basis for Judgments. 4. 2 Analysis of the impact of the change on the key performance indicators This analysis examines the impact of the change on key performance indicators, the Earnings per Share (PEPS) and Return on Investment (ROI). The ROI has been calculated using following formula and the calculations and are included in Appendix 01. ROI Earnings change due to convergence Total asset value as per ALAS transition to SLURS/ALAS.
Mean of ROI has decreased by 1. 25% which revealed that the fair value measurement for financial asset has a negative impact on the earnings. The PEPS has been calculated using following formula: = Earnings change due to convergence PEPS Weighted average number of shares The mean value of PEPS has increased to 15. 18%. The increment of ROI is largely due to the increased PEPS of CT Holdings. CT holdings PEPS has increased by a significant amount due to the lower number of shares. PEPS of John Keels Holdings and Aitkin Spence have decreased and PEPS of Carson has increased by a negligible amount.
Graphs for above discussed results are presented in Appendix 02. Graph 01 shows the relationship between the value of financial asset according to both ALAS and CLASS and the respective ROI. A trend line was obtained and the formula of the regression line was extracted. The beta value of the line is -10. The downward slope shows that there is a negative relationship between the earnings and the changes on air value measurement. Graph 02 shows the relationship between PEPS and the value of financial asset according to both CLASS and ALAS.
The slope of the regression line was -6. Under this also, a negative impact was identified. 4. 3 Perception Analysis This was carried out in order to address the perception of key financial managerial persons of the companies in the selected sample regarding the adoption of fair value for financial assets. The conversion process of Sir Lankan Accounting Standards with International Financial Reporting Standards (FIRS) has given an opportunity to the UAPITA market to raise confidence of stakeholders and promote good accounting practices.
But it’s human nature to dislike change, and most of the responses to the changes arising from the use of the new Standards have been negative. In some cases, despite a similar requirement being existent in the Sir Lankan Standards (Class) companies want to continue their past practices, not recognizing that accounting has also changed to keep pace with business and the environment. Therefore perception analysis has been carried out to get overall idea on organizations’ perception regarding fair value adoption and the results of the analysis has briefed below.
Approximately one fourth of the interviewees were in the perception that accounting for financial instruments considered a challenge as companies will be required to identify such instruments. FIRS provides detailed guidance on recognition, measurement and disclosure requirements for financial instruments. It requires all financial instruments to be initially recognized at fair value, while some instruments are re-measured at fair value at each reporting date. This will result in increased volatility in the income statement and/or equity.
Measuring at financial instruments at fair value is considered as cumbersome and external stakeholders and create awareness of the impact of adoption of fair value for financial assets. The rest of the interviewees claimed that the adoption of fair value in financial instruments has upgraded the quality of financial instruments to world class level. Suppliers, lenders, counter parties, customers, investor community and many other stake holders will give a premium for the best as they receive more reliable and up to date information through financial reports. . Conclusion The first objective of this study is to assess of the change in accounting treatment and disclosure requirements due to the measurement of Fair Value for Financial Assets. From the study performed, it could be identified that, quality of disclosure on financial assets under SLURS has improved after the convergence which in turn has increased the value of the financial statements. As per the second objective of this study, the impact of convergence on the change of key performance indicators (PEPS, ROI) of selected companies was analyses.
The hypothesis built up at the enhancement of the research is “The effect of adopting Fair value for Financial Assets has a positive impact on Key Performance Indicators”. Based on the results obtained from our research revealed that, the earnings have decreased due to the convergence to ALAS 39. This concludes that our hypothesis has rejected and null hypothesis has accepted as the conclusion. The final objective of the research was to obtain the perceptions of the convergence from the financial managers on the convergence to obtain an overall idea on the convergence of ALAS.