The Effect of Fair Value Method Adoption: Evidence from Real Estate Firms in the EU

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Author Information : Chinmoy Ghosh (University of Connecticut)
Mingwei (Max) Liang '22 Ph.D. (Syracuse University)
Milena Petrova (Syracuse University)

Year of Publication : Journal of Real Estate Finance and Economics (2020)

Summary of Findings : Requiring firms to disclose the fair value of their investment properties reduces information asymmetry and leads to higher pricing efficiency and improved liquidity.

Research Questions : Test the hypothesis that the adoption of IAS 40 reduces information asymmetry for investors and increases pricing efficiency.

Examine whether lower information asymmetry leads to greater pricing efficiency and hence lower differences between property firms’ observed prices and net asset values (NAVs).

Test whether that higher transparency in financial reporting enhances investor confidence and leads to higher frequency of trading and liquidity.

What we know : A comprehensive and transparent financial reporting system is critical for investors to gain insight into the firm’s financial standing and make investment decisions. In its efforts to facilitate more accurate financial reporting the International Accounting Standards Board (IASB) mandated the implementation of the International Accounting Standard 40 (IAS 40) in 2005 by public companies in the EU whereby firms were required to disclose the fair value of their investment properties. Investment property is one of the largest asset classes in the world and represents a significant store of wealth for many individuals, so inconsistencies in the valuation of investment properties could significantly affect the information that investors receive and the financial decisions they make. As such, the implementation of IAS 40 provides a unique opportunity to investigate whether the adoption of the fair value method affects the quality of financial reporting and whether increased transparency in financial reporting leads to reduced information asymmetry.

Novel Findings : Our research extends the growing literature on the impact of fair value reporting, particularly as it relates to information asymmetry. Existing studies have used bid-ask spread as a measure of information asymmetry which may be confounded with noisy information, including currency and market liquidity variations. We further provide evidence on the impact of regulatory and financial reporting environment on firm valuation and liquidity. We additionally show that these effects are stronger for larger firms. We find that although post-IAS 40 asymmetric information decreases and liquidity increases, the disclosure of fair value does not lead to lower NAV deviations. Finally, our results suggest that fair value disclosure exacerbates NAV deviation and illiquidity during the crisis period.

Novel Methodology : Existing studies have used simple OLS models and therefore have ignored the multi-level structure of the data, which consist of firms from different countries and there could be different between-country and within-country effects. In our study we use use random effects models where we control for year and firm effects.

Implications for Practice : Our study provides valuable insights on the importance of improved quality of financial reporting on mitigating information asymmetry for smaller firms. We demonstrate the importance and relevance of availability and disclosure of appraised property values in closing the gap between private and public real estate valuation.

Full Citations : Ghosh, C., Liang, M. & Petrova, M. J Real Estate Finan Econ (2020) 60: 205. https://doi.org/10.1007/s11146-019-09721-z

Abstract : The adoption of the International Accounting Standard 40 (IAS 40) in 2005 by public companies in the European Union required firms to disclose the fair value of their investment properties. We study whether this increase in the transparency in financial reporting reduces information asymmetry and leads to higher pricing efficiency and improved liquidity. We investigate this question in the context of the real estate industry, which due to its unique structure stands to be affected the most by the adoption of the fair value method. We observe that post regulation the coefficients of variation of trading volume and daily turnover decreased significantly, while turnover ratio increased significantly. In addition, these effects are stronger for larger firms. We further note that although post-IAS 40 asymmetric information decreases and liquidity increases, the disclosure of fair value does not lead to lower NAV deviation. Furthermore, our results suggest that fair value disclosure exacerbates NAV deviation and illiquidity during the crisis period.

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Milena Petrova

Professor Petrova is an associate professor of finance­. Her primary research interests are in the areas of real estate capital markets, REITs, commercial real estate, corporate finance and corporate governance.
Milena Petrova
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