Fair Value's Affect on Accounting's Ability to Predict Future Cash Flows

AbstractThis study assesses the ability of the outputs from an accounting system to predict future cash flows. Specifically, we focus on a "complete fair value" accounting system's ability to predict future cash flows as compared to the predictive ability of an accounting system implementing a variety of accounting attributes (including, for example, historical cost and fair value, among others). We find that the outputs from an accounting system implementing a variety of accounting attributes has greater information content for future cash flows than the outputs from a "complete fair value" accounting system. The results of this study imply that moving toward a fair value accounting system may reduce accounting data's predictive ability for future cash flows.(ProQuest: ... denotes formulae omitted.)IntroductionThis study assesses the ability of the earnings and book value of equity derived from two different financial accounting systems to predict future cash flows. The two different accounting systems used in this study are (1) the accounting system based on the implementation of current accounting standards (hereafter referred to as a mixed attribute accounting system) and (2) mar1 ket data where the market data is utilized as a proxy for a "complete fair value" accounting system.2,3> 4While "fair value measurement" has a variety of meanings and definitions, it appears that the IASB is inherently using "market value" as its definition of fair value.5 The IASB specifically discusses "exit value" as its measure of fair value but as this term is utilized by the IASB, "exit value" will often equal market value (Penman, Richardson, and Tuna [2007]). One may argue that the IASB does not intend for a "complete fair value" system to be implemented. However, the IASB has noted that many if not all of the assets and liabilities currently recorded under a different accounting system (such as historical cost) will be recorded under fair value accounting under certain circumstances. A listing of the standards that will be affected by fair value measurement can be found at http://www.iasplus.com/agenda/fairvalue.htm. Specifically included in this listing are the following two standards: IAS 16 (Property, Plant and Equipment) and IAS 38 (Intangible Assets).We find that, on average, a mixed attribute accounting system outperforms a "complete fair value" accounting system in predicting future cash flows, possessing both greater relative and incremental information content. This finding highlights a potential cost of the current movement towards fair value accounting. That is, a mixed attribute accounting system is more likely to meet financial accounting's predictive objective than a "complete fair value" accounting system.6In this study, we utilize market price and the change in price plus dividends as reasonable proxies for the reported values of book value of equity and earnings under a "complete fair value" accounting system.7 In essence, this market data is utilized as the equity and earnings that would be reported under a "complete fair value" accounting system.8 Throughout this paper, it is important to remember that under this application of a fair value accounting system, the book value of equity is equal to the market value of equity.9 In addition, income is the change in value exclusive of dividends; in other words, income equals the market return in dollars.The next section describes the sample characteristics. Subsequently, we discuss the research design. We then review the relative and incremental explanatory power between the two accounting systems, followed by a summary and concluding comments.Sample DescriptionUsing this concept of "complete fair value" accounting, book value will be reporting the fair value of shareholders' equity, that is, the market capitalization; and income will be reporting the change in the fair value of shareholders' equity plus dividends. …