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Fair Value Accounting and Earnings Quality Despoina Markou Foteini Tsitsoni Fair Value Accounting and Earnings Quality: Listed Real Estate Companies in Sweden Business Administration Master’s Thesis 15 ECTS Term: Spring 2013 Supervisor: Johan Lorentzon 4 ACKNOWLEDGEMENTS First of all, we would like to thank our supervisor Johan Lorentzon for his guidance and assistance in our master thesis. We also want to thank the managers of the companies who responded to our questionnaires, for their time and their contribution to our research. Their answers were precious. In addition, we would like to thank our teachers during the "Master Program in Accounting and Control" in Karlstad Business School for the knowledge they offered to us. This knowledge supplied us with the motivation and the necessary background to conduct our thesis. Finally, we would like to thank and express our appreciation to our families and friends, and especially to our parents for their support in our studies and in the challenges we chose to face. Despoina Markou Foteini Tsitsoni 5 ABSTRACT This master thesis has been written for the Karlstad Business School in the subject of "Accounting & Control". The research and writing period was from April until June 2013. Earnings are one of the most vital indicators of the financial position of a company. Earnings quality is a perplexing concept. The characteristics that make earnings of high quality are various and are a matter of subjectivity. After the adoption of IFRS in 2005, the listed real estate companies in Sweden had to prepare their financial statements relying on the new standards. IFRS introduced fair value accounting to the companies in order to evaluate their assets and liabilities. The aim with this thesis is to investigate if fair value accounting improved earnings quality in listed real estate companies in Sweden. In order to collect our data, a quantitative research was conducted. Self- completion questionnaires with open questions were sent to CFOs with the purpose of express their opinion about the term "earnings quality", the adoption of IFRS and fair value accounting and if the influence of these factors on earnings quality. The results showed that managers indeed believe that fair value accounting improved the quality of earnings in their companies. Moreover, they answered that they do not consider IFRS as a barrier in the accounting quality and that fair value provides reliable and accurate financial information which support the decision-making. Key words: earnings quality, fair value accounting, accounting quality, IFRS adoption, IAS 40, real estate, financial reporting. 6 Table of Contents 1. Introduction ..................................................................................................... 8 1.1. Background .............................................................................................. 8 1.2. Problem Definition and Research Question ........................................... 10 1.3. Research Method and Data Collection ................................................... 11 1.4. Results .................................................................................................... 11 1.5. Structure of the study ............................................................................. 12 2. Earnings Quality............................................................................................ 13 2.1. Background-History of Earnings Quality ............................................... 13 2.2. Usefulness of Earnings Quality .............................................................. 14 2.3. Definition of Earnings Quality ............................................................... 15 2.4. Measurement of Earnings Quality .......................................................... 17 2.5. Policies ................................................................................................... 20 3. IFRS & Accounting Quality ......................................................................... 21 3.1. IFRS & Earnings Quality ....................................................................... 22 3.2. Fair Value Accounting ........................................................................... 24 3.3. General Advantages & Disadvantages of Fair Value ............................. 25 3.4. Fair Value Accounting & Real Estate Companies ................................. 27 4. Methodology ................................................................................................. 29 4.1. Research Strategy and Design ................................................................ 29 4.2. Research Method .................................................................................... 29 4.3. Selection of the Sample .......................................................................... 30 4.4. Interview Guide ...................................................................................... 30 4.5. Data Collection: ...................................................................................... 31 4.6. Criteria for Quality ................................................................................. 31 4.7. Data Analysis.......................................................................................... 32 4.8. Limitations .............................................................................................. 32 5. Results ........................................................................................................... 33 6. Analysis ......................................................................................................... 35 6.1. Earnings Quality ..................................................................................... 35 6.2. IFRS & Earnings Quality ....................................................................... 36 6.3. Fair Value Accounting & Earnings Quality ........................................... 37 7. Conclusion .................................................................................................... 40 7.1. Future Research ...................................................................................... 41 8. References ..................................................................................................... 42 Appendix ............................................................................................................... 51 7 1. Introduction This chapter includes an introduction to our topic and our research. We present the background and we define the problem and the research question. A brief description of the research method and the results are following. The last paragraph describes the structure of the paper. 1.1. Background Since January 1st, 2005, listed companies on stock exchanges of European Union (EU) member states are required to prepare their annual financial statements and other reporting applying the International Financial Reporting Standards (IFRS) or International Accounting Standards (IAS). IFRS were developed and approved by the International Accounting Standards Board (IASB), an independent standard-setting body, member of the IFRS Foundation. The IFRS Foundation is an independent, not-for-profit private sector organization which works in the public interest (IFRS 2013). One of IASB's principle objectives was to develop "a single set of high quality, understandable, enforceable and globally accepted" accounting standards (IFRS 2013). This set of accounting standards poses as a requirement that the information of financial statements and other financial reporting must be of high quality, transparent and comparable. Thus, IFRS contribute to an improved quality of annual reports or accounting quality and further help capital market participants and other users to make appropriate economic decisions (Armstrong et al. 2010). European Commission's main target for adopting and implementing IFRSs were publicly listed companies. The goal was the protection of investors and the restoration of confidence in financial markets, especially after the outbreak of big financial scandals around the world and the increase of competitiveness of the European Union economy, globally. Also, European Commission's intention was the improvement of the accounting quality of all the financial statements of member states of the EU. Accounting quality is a term that describes the extent of the value that users give to the accounting information and one way to measure accounting quality is the degree of earnings quality (Dechow et. al (2010). Earnings quality is a multidimensional concept and despite that is widely used, there is no consensus about one common definition (Teets, 2002) or a generally accepted approach for measuring it (Schipper & Vincent 2003). As capital markets rely on relevant and credible financial reporting, everyone (e.g. managers, accountants, auditors, standard setters, regulators) in the financial reporting process are interested in earnings quality (Teets 2002). Dechow et. al (2010) define earnings quality as follows: "higher quality earnings provide more information about the features of a firm's financial performance that are 8 relevant to a specific decision made by a specific decision-maker". According to this definition "quality" is conditional on specific decision context (Dechow et. al 2010) and a matter of subjective determination (Siegel 1982). Generally, IFRS is considered to be a high quality standard, which contributes to the improvement of the quality of annual reports. But, at the same time, IFRS is considered to be
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