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

Abstract

AbstractThis study assesses the ability of the outputs from an accounting system to predict future cash flows. Specifically, we focus on a complete 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 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 accounting system. The results of this study imply that moving toward a 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 data is utilized as a proxy for a complete accounting system.2,3> 4While fair value has a variety of meanings and definitions, it appears that the IASB is inherently using market as its definition of value.5 The IASB specifically discusses exit as its measure of value but as this term is utilized by the IASB, exit will often equal value (Penman, Richardson, and Tuna [2007]). One may argue that the IASB does not intend for a complete 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 value accounting under certain circumstances. A listing of the standards that will be affected by 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 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 value accounting. That is, a mixed attribute accounting system is more likely to meet financial accounting's predictive objective than a complete accounting system.6In this study, we utilize 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 accounting system.7 In essence, this data is utilized as the equity and earnings that would be reported under a complete accounting system.8 Throughout this paper, it is important to remember that under this application of a value accounting system, the book value of equity is equal to the value of equity.9 In addition, income is the change in value exclusive of dividends; in other words, income equals the 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 accounting, book value will be reporting the value of shareholders' equity, that is, the capitalization; and income will be reporting the change in the value of shareholders' equity plus dividends. …