Amyotrophic Lateral Sclerosis (ALS): Physiology Treatment

Amyotrophic Lateral Sclerosis (ALS): Physiology Treatment Amyotrophic lateral sclerosis: Physiological traits Amyotrophic lateral sclerosis (ALS) more commonly referred to as Lou Gehrig’s disease, is a progressive and deadly disease. Many with ALS experience grief and many families of those affected endure the same. At present medical science has demonstrated great potential in finding a workable cure or efficacious therapy. However, at present no such cure or efficacious therapy exists. A number of treatments can prolong the fatal course of ALS but none can stop it and ALS continues to significantly shorten the sufferer’s lifespan. 3.9 in every 100,000 individuals will develop ALS in America, so while the prevalence is relatively low, ALS has generated a great deal of attention due in part to its severity, to numerous movements to raise funding for the disorder and for its generalized physiological symptoms and theoretical relation to other dementing illnesses such as Alzheimer’s. Definitive answers as to the causes of ALS are currently not known. Numerous theories have emerged and research has pinpointed causes which partially explain occurrence or have been found in rat studies but have yet to reach human testing. Promising treatments for the disease have been found however none have made it beyond the research stage. Exposure to different toxins has been suggested as a potential cause, ranging from occupational exposure and physical activity to military exposure and trauma. Males have a higher prevalence rate than females. Particularly, white males ages 60+ are at highest risk for the development of ALS. ALS is characterized by muscle spasticity, which rapidly progresses to muscle wasting and difficulty breathing, speaking, and swallowing. Most individuals with ALS live for 3 to 4 years. About 5% live longer than 10 years and a very select few live still longer. The disease’s symptoms are due to a result of the loss of upper and lower motor neurons. Present research effort include stage II testing in Israel and soon, the United States at the Mayo Clinic. Physiological Pathology A2A Adenosine receptors A2A Adenosine receptors have been thought to be a potential therapeutic objective but until a recent study (14) the neuromodulatory role of the aforementioned receptors has remained in question. A selective A2A agonist was applied known only as CGS 21680 at present. (Poff et al., 2014) The A2A agonist significantly enhanced average amplitude of endplate potentials (EPP’s) and enhanced frequency of miniature endplate potentials (MEPP’s) and giant end plate potentials (GMEPP’s). The A2A adenosine receptor is now under scrutiny for its potential therapeutic role for presenting symptoms of ALS (Poff et al., 2014). Cortical atrophy Cortical atrophy in patients suffering from ALS was linked to neuropsychiatric and cognitive changes. Acidotoxicity has been implicated as a potential cause or contributor to this phenomenon (Behan et al., 2013). With regard to patients with ALS-plus; cortical atrophy presented significantly across motor and somatosensory areas. Additional cortical atrophy was found in frontal and parietal areas of the brain. In patients with ALS no significant cortical atrophy was shown, only brainstem atrophy. In patients with ALS-FTD; atrophy also affected greater frontal area atrophy and temporal area atrophy in comparison with ALS-plus. Atrophy of the cortexes is implicated as a contributor to the presenting deficits of ALS (Mioshi, 2013). Genetic links The vast majority of ALS cases are sporadic and unrelated to genetics. However; 5-10% of ALS cases are thought to be hereditary. Mutations in TAR DNA-binding protein, fused in sarcoma (FUS), and superoxide dismutase 1 (SOD1) comprise the causes for about 30% of classic inherited ALS. A gene known as UBQLN2 which is responsible for the encoding of the protein â€Å"ubiquilin?2† can cause dominantly inherited, ALS and ALS/dementia. So although the majority of ALS cases occur from causes unknown, a select few cases can be explained by genetic mutation. Suggested from this data is the potential for retracing the steps of the gene and specifying the mechanism of action most exploitable in treatment for the disease. While genetically link ALS is rare the basic mechanism of action is widespread, thus insights into causes for the physiological outcome are valuable in treatment of ALS as a whole (Deng, 2011). White matter aberrations White matter has been examined for its aberrations in shape in patients with ALS. What has been found is a link between symptoms indicative of the disease however, not the physiological changes typical in the disease itself (Rajagopalan et al., 2013). Scientists suspect that the unidentified physiological link between white matter changes and physiological changes caused by ALS may play a large role in the disorder. White matter changes specifically have been correlated with the ALS-FTD-Q, a screening tool for behavioral disturbances in ALS. So while the behaviors correlate, the physiological changes beyond white matter shape change have not yet been linked specifically, leaving room for additional research in this area (Rajagopalan et al., 2013). Cervical roots and peripheral nerves A sonogram study found that in patients with ALS, cervical roots and peripheral nerves exhibit reductions in size in comparison to their former size and those in patients without ALS. The study found that the aforementioned both reduced in size and became physically thinner although more significantly the latter (Nodera et al., 2014). Although this phenomenon was measurable in patients with and without ALS it was not related to gender, progression of the disease, and severity of disease symptoms. Despite these setbacks it is suggested that peripheral root atrophy may present a viable marker for detection of the presence of the disease and thus increase progress made on treatment due to decreased false positive diagnoses (Nodera et al., 2014). Treatment Metabolic therapy (Deanna Protocol) Aside from motor neuron degeneration ALS is associated with metabolic dysfunction. A mouse study found that mice given the Deanna Protocol (DP); a metabolic therapy reported to result in some symptom alleviation in patients with ALS. The study found that mice given the treatment had significant extensions in survival time in ALS mice 7.5% (p Human stem cells Human stem cells have long been considered for their curative abilities toward various diseases. ALS is one such disease. The degeneration of motor neurons can theoretically be counteracted using motor neurons created from stem cells. (Lee et al., 2014; Morgan Srivastava, 2014). Stem cells present what seems to be a highly promising treatment for ALS. In one study, patients were injected with stem cells and followed up upon 12 months later and not acceleration of the disease was detected (Kim, Lee, Kim, 2013). A large proportion of future research will center upon investigation of this. Guanabenz Guanabenz is now under scrutiny for its therapeutic benefits to those suffering from ALS. Guanabenz was found to have an impact on post-apoptic protein synthesis such that scientists conducting the experiment hypothesized that its introduction would have therapeutic effects on ALS patients. In a mouse model female mice were given Guanabenz and were found to have delayed symptom onset, prolonged life span and increased motor ability (Jiang et. Al 2014). Thalidomide Inflammation from the cytokine tumor necrosis factor alpha TNFÃŽ ± is believed to be a critical factor in the development and pathology of ALS. TNFÃŽ ± is reduced by thalidomide. Thus the rationale for research surrounding the efficacy of the use of thalidomide in ALS patients. The study found no results suggesting that this theorized mechanism may need revision (Stommel et al, 2009). Discussion ALS as aforementioned is a neurodegenerative disease which causes the motor neurons to atrophy and die. Victims of ALS typically suffer from motor impairments which eventually exacerbate to impairments in breathing, swallowing and speaking. Sufferers experience many psychological symptoms as secondary effects from the physiological damage which occurs. Physiologically, impairments typically relate to motor movement. In some cases movement changes but in most cases it becomes more difficult. Numerous treatments are emerging in the research phase due in part to massive donations to the research of a cure or treatment for this disorder. While ALS is unique to other neurodegenerative disorders scientists suspect that some aspects of the treatments used and developed will translate due to the similarities ALS shares. Evidence has suggested that certain cases of ALS are inherited while others are developed due to toxins which has helped scientists narrow down the possible mechanisms of action which facilitate this disease. While some are known, the cause of most cases is yet to be determined the outcomes have been more apparent. ALS outcomes include changes in shape of the white matter in the brain, cortical atrophy and thinning of cortical and peripheral nerves. The treatment has made relative progress. Perhaps most promising is the use of stem cells as replacements for motor neurons. Stem cell research has had difficulty using stem cells in large quantities as a corrective measure however motor neuron use requires the use of less cells than most treatments making it especially promising. Other theoretical treatments such as metabolic therapy and Guanabenz have shown some potential in improving the lives of ALS sufferers and perhaps prolonging them somewhat. Guanabenz, an intervention targeted sp ecifically at cell apoptosis has demonstrated an effect on symptoms, speed of progression, and lifespan. Metabolic therapy has demonstrated an effect on symptoms and lifespan. Together therapeutic treatments have a supplementary benefit until a more lasting solution is found. Future research Future research implications include additional research on stem cells. Stems cells are highly promising and may be an effective treatment and perhaps eventually have curative effects. Studies at present have found a link between symptom stabilization and treatment in human studies. As with all medical research clinical trials must be completed before anything is open to the public. Additional concerns for this treatment include the political implications of this treatment as some political groups disagree with stem cell research as a whole. Future research should also continue to focus upon the clinical implications of therapeutic treatments such as Guanabenz and Deanna Protocol metabolic therapy. Conclusion At present ALS presents future challenges to scientists, doctors, and the people who suffer from it. While promising research and clinical trial have received unprecedented support; the reality is that ALS continues to shorten and end lives. Researchers are far from finding the multiple causes of ALS however, researchers are rapidly gaining ground on how to treat the effects of the disorder. Aside from stem cells, therapeutic treatments have emerged such as Gaunabenz and metabolic therapies such as the Deanna protocol. References Ari, C., Poff, A. M., Held, H. E., Landon, C. S., Goldhagen, C. R., Mavromates, N., D’Agostino, D. P. (2014). Metabolic Therapy with Deanna Protocol Supplementation Delays Disease Progression and Extends Survival in Amyotrophic Lateral Sclerosis (ALS) Mouse Model. Plos ONE, 9(7), 1-9. doi:10.1371/journal.pone.010352 Behan, à ., Breen, B., Hogg, M., Woods, I., Coughlan, K., Mitchem, M., Prehn, J. (2013). Acidotoxicity and acid-sensing ion channels contribute to motor neuron degeneration. Cell Death Differentiation, 20(4), 589-598. doi:10.1038/cdd.2012.158 Deng, H., Chen, W., Hong, S., Boycott, K. M., Gorrie, G. H., Siddique, N., Haines, J. L. (2011). Mutations in UBQLN2 cause dominant X-linked juvenile and adult-onset ALS and ALS/dementia. Nature, 477(7363), 211-215. doi:10.1038/nature10353 Lee, H. J., Kim, K. S., Ahn, J., Bae, H. M., Lim, I., Kim, S. U. (2014). Human motor neurons generated from neural stem cells delay clinical onset and prolong life in ALS mouse model. Plos ONE, 9(5), 1-9. doi:10.1371/journal.pone.0097518 Jiang, H. Q., Ren, M. M., Jiang, H. Z., Wang, J. J., Zhang, J. J., Yin, X. X., Feng, H. L. (2014). Guanabenz delays the onset of disease symptoms, extends lifespan, improves motor performance and attenuates motor neuron loss in the SOD1 G93A mouse model of amyotrophic lateral sclerosis. Neuroscience, 277132-138. doi:10.1016/j.neuroscience.2014.03.047 Kim, S. U., Lee, H. J., Kim, Y. B. (2013). Neural stem cell-based treatment for neurodegenerative diseases. Neuropathology, 33(5), 491-504. doi:10.1111/neup.12020 Mehta, P., Antao, V., Kaye, W., Sanchez, M., Williamson, D., Bryan, L., Horton, K. (2014). Prevalence of Amyotrophic Lateral Sclerosis — United States, 2010-2011. MMWR Surveillance Summaries, 63(7), 1-13. Retrieved from: http://ezproxy.pcom.edu:2048/login?url=http://search.ebscohost.com/login.aspx?direct=truedb=hehAN=97269966site=eds-livescope=site Mioshi, E., Lillo, P., Yew, B., Hsieh, S., Savage, S., Hodges, J., Hornberger, M. (2013). Cortical atrophy in ALS is critically associated with neuropsychiatric and cognitive changes. Neurology, 80(12), 1117-1123. doi:10.1212/WNL.0b013e31828869da Morgan, R. H., Srivastava, A. K. (2014). Clinical relevance of stem cell therapies in amyotrophic lateral sclerosis. Neurology India, 62(3), 239-248. doi:10.4103/0028-3886.136895 Nodera, H., Takamatsu, N., Shimatani, Y., Mori, A., Sato, K., Oda, M., Kaji, R. (2014). Thinning of cervical nerve roots and peripheral nerves in ALS as measured by sonography. Clinical Neurophysiology, 125(9), 1906-1911. doi:10.1016/j.clinph.2014.01.033 Nascimento, F., Pousinha, P. A., Correia, A. M., Gomes, R., Sebastià £o, A. M., Ribeiro, J. A. (2014). Adenosine A2A Receptors Activation Facilitates Neuromuscular Transmission in the Pre-Symptomatic Phase of the SOD1(G93A) ALS Mice, but Not in the Symptomatic Phase. Plos ONE, 9(8), 1-10. doi:10.1371/journal.pone.0104081 Raaphorst, J., Beeldman, E., Schmand, B., Berkhout, J., Linssen, W., van den Berg, L., de Haan, R. (2012). The ALS-FTD-Q: A new screening tool for behavioral disturbances in ALS. Neurology, 79(13), 1377-1383. Retrieved from: http://ezproxy.pcom.edu:2048/login?url=http://search.ebscohost.com/login.aspx?direct=truedb=jlhAN=2011697440site=eds-livescope=site Rajagopalan, V., Liu, Z., Allexandre, D., Zhang, L., Wang, X., Pioro, E. P., Yue, G. H. (2013). Brain White Matter Shape Changes in Amyotrophic Lateral Sclerosis (ALS): A Fractal Dimension Study. Plos ONE, 8(9), 1-11. doi:10.1371/journal.pone.0073614 Stommel, E. W., Cohen, J. A., Fadul, C. E., Cogbill, C. H., Graber, D. J., Kingman, L., Harris, B. T. (2009). Efficacy of thalidomide for the treatment of amyotrophic lateral sclerosis: A phase II open label clinical trial. Amyotrophic Lateral Sclerosis, 10(5/6), 393-404. doi:10.3109/17482960802709416

Audit – Solutions for Chapter 2

* Solutions for Chapter 2 * Corporate Governance Review Questions: 2-1. Corporate governance is defined as: â€Å"a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization. The owners (stockholders) elect a board of directors to provide oversight of the organization’s activities and accountability back to its stakeholders. † The key players in corporate governance are the stockholders (owners), board of directors, audit committees, management, regulatory bodies, and both internal and external auditors. -2. In the past decade, all parties failed to a certain extent. For detailed analysis, see exhibit 2. 2 in the chapter and repeated here: Corporate Governance Responsibilities and Failures Party | Overview of Responsibilities| Overview of Corporate Governance Failures| Stockholders| Broad Role: Provide effective oversight through election of Board process, approve major initiativ es, buy or sell stock. | Focused on short-term prices; failed to perform long-term growth analysis; abdicated all responsibilities to management as long as stock price increased. Board of Directors| Broad Role: the major representative of stockholders to ensure that the organization is run according to the organization charter and there is proper accountability. Specific activities include: * Selecting management. * Reviewing management performance and determining compensation. * Declaring dividends * Approving major changes, e. g. mergers * Approving corporate strategy * Overseeing accountability activities. | * Inadequate oversight of management. * Approval of management compensation plans, particularly stock options that rovided perverse incentives, including incentives to manage earnings. * Non-independent, often dominated by management. * Did not spend sufficient time or have sufficient expertise to perform duties. * Continually re-priced stock options when market price decline d. | Management| Broad Role: Operations and Accountability. Managing the organization effectively and provide accurate and timely accountability to shareholders and other stakeholders. Specific activities include: * Formulating strategy and risk appetite. * Implementing effective internal controls. * Developing financial reports. Developing other reports to meet public, stakeholder, and regulatory requirements. | * Earnings management to meet analyst expectations. * Fraudulent financial reporting. * Pushing accounting concepts to achieve reporting objective. * Viewed accounting as a tool, not a framework for accurate reporting. | Audit Committees of the Board of Directors| Broad Role: Provide oversight of the internal and external audit function and the process of preparing the annual accuracy financial statements and public reports on internal control. Specific activities include: * Selecting the external audit firm. Approving any non-audit work performed by audit firm. * Selecting and/or approving the appointment of the Chief Audit Executive (Internal Auditor), * Reviewing and approving the scope and budget of the internal audit function. * Discussing audit findings with internal auditor and external auditor and advising the Board (and management) on specific actions that should be taken. | * Similar to Board members – did not have expertise or time to provide effective oversight of audit functions. * Were not viewed by auditors as the ‘audit client’. Rather the power to hire and fire the auditors often rested with management. Self-Regulatory Organizations: AICPA, FASB| Broad Role: Setting accounting and auditing standards dictating underlying financial reporting and auditing concepts. Set the expectations of audit quality and accounting quality. Specific roles include: * Establishing accounting principles * Establishing auditing standards * Interpreting previously issued standards * Implementing quality control processes to ensure audit quality. * Educating members on audit and accounting requirements. | * AICPA: Peer reviews did not take a public perspective; rather than looked at standards that were developed and reinforced internally. AICPA: Leadership transposed the organization for a public organization to a â€Å"trade association† that looked for revenue enhancement opportunities for its members. * AICPA: Did not actively involve third parties in standard setting. * FASB: Became more rule-oriented in response to (a) complex economic transactions; and (b) an auditing profession that was more oriented to pushing the rules rather than enforcing concepts. * FASB: Pressure from Congress to develop rules that enhanced economic growth, e. g. allowing organizations to not expense stock options. Other Self-Regulatory Organizations, e. g. NYSE, NASD| Broad Role: Ensuring the efficiency of the financial markets including oversight of trading and oversight of companies that are allowed to trade on the exchange. S pecific activities include: * Establishing listing requirements – including accounting requirements, governance requirements, etc. * Overseeing trading activities,| * Pushed for improvements for better corporate governance procedures by its members, but failed to implement those same procedures for its governing board, management, and trading specialists. Regulatory Agencies: the SEC| Broad Role: Ensure the accuracy, timeliness, and fairness of public reporting of financial and other information for public companies. Specific activities include: * Reviewing all mandatory filings with the SEC, * Interacting with the FASB in setting accounting standards, * Specifying independence standards required of auditors that report on public financial statements, * Identify corporate frauds, investigate causes, and suggest remedial actions. * Identified problems but was never granted sufficient resources by Congress or the Administration to deal with the issues. | External Auditors| Broa d Role: Performing audits of company financial statements to ensure that the statements are free of material misstatements including misstatements that may be due to fraud. Specific activities include: * Audits of public company financial statements, * Audits of non-public company financial statements, * Other accounting related work such as tax or consulting. | * Pushed accounting concepts to the limit to help organizations achieve earnings objectives. Promoted personnel based on ability to sell â€Å"non-audit products†. * Replaced direct tests of accounting balances with a greater use of inquiries, risk analysis, and analytics. * Failed to uncover basic frauds in cases such as WorldCom and HealthSouth because fundamental audit procedures were not performed. | Internal Auditors| Broad Role: Perform audits of companies for compliance with company policies and laws, audits to evaluate the efficiency of operations, and audits to determine the accuracy of financial reporting pr ocesses.Specific activities include: * Reporting results and analyses to management, (including operational management), and audit committees, * Evaluating internal controls. | * Focused efforts on ‘operational audits’ and assumed that financial auditing was addressed sufficiently by the external audit function. * Reported primarily to management with little effective reporting to the audit committee. * In some instances (HealthSouth, WorldCom) did not have access to the corporate financial accounts. | 2-3.The board of directors is often at the top of the list when it comes to responsibility for corporate governance failures. Some of the problems with the board of directors included: * Inadequate oversight of management. * Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. * Non-independent, often dominated by management. * Did not spend sufficient time or have sufficient expe rtise to perform duties. * Continually re-priced stock options when market price declined. 2-4.Some of the ways the auditing profession was responsible were: * Too concerned about creating â€Å"revenue enhancement† opportunities for the firm, and less concerned about their core services or talents * Were willing to â€Å"push† accounting standards to the limit to help clients achieve earnings goals * Began to use more audit â€Å"shortcuts† such as inquiry and analytical procedures instead of direct testing of account balance. * Relied on management representations instead of testing management representations. * Were too often ‘advocates’ of management rather than protectors of users. 2-5.Cookie jar reserves are essentially liabilities or contra-assets that companies have overestimated in previous years to use when times are tougher to smooth earnings. The rationale is that the funds are then used to â€Å"smooth† earnings in the years when earnings need a boost. â€Å"Smooth† earnings typically are looked upon more favorably by the stock market. An example of a cookie jar reserve would be over-estimating an allowance account, such as allowance for doubtful accounts. The allowance account is then written down (and into the income statement) in a bad year. The result is to increase earnings in the subsequent year. 2-6.Users should expect auditors to have the expertise, independence, and professional skepticism to render an unbiased and justified opinion on the financial statements. Auditors are expected to gather sufficient applicable evidence to render an independent opinion on the financial statements. 2-7. The Sarbanes-Oxley Act was designed to â€Å"clean-up† corporate America, especially in the realms of financial reporting. The overall intent was to encourage better corporate governance; to make the audit committee the auditor’s client; encourage the independence and oversight of the board, a nd improve the independence of the external audit profession.There were certainly many factors that led to the Sarbanes-Oxley Act, but the failures at Enron and WorldCom will probably be pointed to in the future as the major factors that led to the act being passed when it was. The Congress intended to develop a new reporting process that would provide just cause for the public to again trust financial statements and the audit processes leading up to the audit opinion. 2-8. The PCAOB is mandated by Congress to set standards for audits of public companies and perform quality control inspections of CPA firms that audit public companies.In order to carry out these responsibilities, the PCAOB requires all firms that audit U. S. listed (public) companies to register with it. It performs annual inspections on all audit firms that audit more than 100 public companies each year. It performs less frequent inspections, usually once every three years, for audit firms that audit less than 100 c ompanies annually. The PCAOB issues Inspection Reports for each inspection that is performed. The first part describes problems they encountered in their reviews of audits and that part is made public.The second part describes problems that the firms have with their quality control process. The second part is not issued publicly unless the firms fail to address the problems pointed out within a reasonable time frame – usually no more than a year. 2-9. Management has always been responsible for fairness, completeness, and accuracy of financial statements, but the Sarbanes-Oxley Act goes a step further by requiring the CEO and CFO to certify the accuracy of financial statements with criminal penalties as a punishment for materially misstated statements.The CEO and CFO must make public their certifications and assume responsibility for the fairness of the financial presentations. It thereby encourages organizations to improve their financial reporting functions. 2-10. Whistle bl owing enables violations of a company’s ethical code to be reported to appropriate levels in an organization, including the audit committee. Because of its presence, potential violators know that there is a real possibility and simple avenue by which inappropriate actions may be revealed.As such, it contains a preventive component that is indirectly helpful to the audit committee in fulfilling its corporate governance role. 2-11. There are a number of provisions that are designed to increase auditor independence. First, Rule 201 of the Act prohibits any registered public accounting firm from providing many non-audit services to their public audit clients. Second, the audit committee became the â€Å"client† instead of management, and only the audit committee can hire and fire auditors. Third, audit partners are required to rotate every five years.Finally, the auditors are expected to follow fundamental principles of independence that have been enacted by the SEC (more details in Chapter 3). 2-12. Management is responsible for issued financial statements. Although other parties may be sued for what is contained in the statements, management is ultimately responsible. Ownership is important because it establishes responsibility and accountability. Management must set up and monitor financial reporting systems that help it meet its reporting obligations. It cannot delegate this responsibility to the auditors. 2-13.An audit committee is a subcommittee of the board of directors that is composed of independent, outside directors. The audit committee has oversight responsibility (on behalf of the full board of directors and its stockholders) for the outside reporting of the company (including annual financial statements); risk monitoring and control processes; and both internal and external audit functions. 2-14. An outside director is not a member of management, legal counsel, a major vendor, outside service provider, former employee, or others who may have a personal relationship with management that might impair their objectivity or independence.The audit committee is responsible for assessing the independence of the external auditor and engage only auditors it believes are independent. Auditors are now hired and fired by audit committee members, not management. The intent is to make auditor accountability more congruent with stockholder and third-party needs. 2-15. The primary point of this question is for students to understand that the audit committee’s role is one of oversight rather than direct responsibility. For example, management is responsible for the fairness of the financial statements.Auditors are responsible for their audit and independent assessment of financial reporting. The audit committee is not designed to replace the responsibility of either of these functions. The audit committee’s oversight processes are to see that the management processes for financial reporting are adequate and the audito r’s carry out their responsibilities in an independent and competent manner. 2-16. The audit committee has the ability to hire and fire both the internal auditor and the external auditor.However, in the case of the internal audit function, the audit committee has the ability to hire and fire the head of internal audit as well as set the audit plan and budget. The audit committee does not control regulatory auditors, but should meet with regulatory auditors to understand the scope of their work and to discuss audit findings with them. 2-17. The Sarbanes-Oxley Act applies only to public companies. Therefore, the Act does not require non-public companies to have audit committees. That is not to say that it does not happen or is not a good idea, however.Most stakeholders want an independent party to ensure that their interests are being considered. The AICPA recommends audit committees for smaller public companies. 2-18. The external auditor should discuss any controversial accou nting choices with the audit committee and must communicate all significant adjustments made to the financial statements during the course of the audit. In addition, the processes used in making judgments and estimates as well as any disagreements with management should be communicated.Other items that need to be communicated include: * All adjustments that were not made during the course of the audit, * Difficulties in conducting the audit, * The auditor’s assessment of the accounting principles used and overall fairness of the financial presentation, * The client’s consultation with other auditors, * Any consultation with management before accepting the audit engagement, * Significant deficiencies in internal control. 2-19. The audit committee needs to ensure that the auditor is independent with respect to the annual audit.In order to ensure that independence, the audit committee must consider all other services that might be performed by the external auditor and app rove any such services, in advance. If the audit committee approves the services, they are in essence saying that the provision of the services will not impair the auditor’s independence. 2-20. Good governance is important to the external auditor for a number of reasons, including, but not limited to the following. Good governance * usually leads to better corporate performance, reflects a commitment to a high level of ethics, integrity, and sets a strong tone for the organization’s activities, * requires a commitment to financial reporting competencies and to good internal controls, * reduces the risk that the company will have materially misstated financial statements. If a client does not have good governance, there are greater risks associated with the client. For example, their poor performance may lead to financial failure and lack of payment of the audit fee.Or their poor governance may lead to improprieties in financial reporting, which puts the auditor at risk in terms of litigation (if the improprieties go undetected by the auditor). 2-21. The auditor might utilize the following procedures in determining the actual level of governance in an organization: * observe the functioning of the audit committee by participating in the meetings, noting the quality of the audit committee questions and responses, * interactions with management regarding issues related to the audit, e. g. * providing requested information on a timely basis, quality of financial personnel in making judgments, * accounting choices that tend to ‘push the limits’ towards aggressiveness or creating additional reported net income, * the quality of internal controls within the organization. * review the minutes of the board of directors meetings to determine that they are consistent with good governance, * review internal audit reports and especially determine the actions taken by management concerning the internal auditor’s findings and recommendations , * review the compensation plan for top management, review management expense reimbursements to determine (a) completeness of documentation, (b) appropriateness of requested reimbursement, and (c) extent of such requests. * review management’s statements to the financial press to determine if they are consistent with the company’s operations. 2-22. Good corporate governance is correlated with increased corporate performance as measured by return on equity, or return on capital. Generally, good corporate governance reduces audit risk as it is less likely that the organization will suffer from problems of management integrity, or would have an environment that might allow or permit fraud.Less audit risk implies that the amount of work to render an opinion on the financial statements would also be less than that required for a company with poorer corporate governance. 2-23. The three categories of audit standards are general standards, fieldwork standards, and reporting standards. General standards cover the characteristics of the auditor – technical training and proficiency, independence, and due professional care. Fieldwork standards provide guidance concerning planning and performing the audit.Reporting standards cover the essential elements of the auditor’s communication, including the opinion, the criteria against which the assertions were tested, and an explanation of the basis for the attestor’s opinion. 2-24. Due professional care is the expectation that an audit will be conducted with the skill and care of a professional. The standard of due professional care plays a role in litigation against auditors. Plaintiffs will try to show that the auditor did not do what a reasonably prudent auditor would have done.To evaluate the standard, a third-party also decides whether someone with similar skills in a similar situation would have acted in the same way. 2-25. There are three important dimensions identified in Exhibit 2. 5 : * Scope of Information on which assurance is provided, * Nature of Organizations on which assurance is provided, * Domicile of Company being audited. These three dimensions influence the identification of applicable auditing standards as follows: * A U. S. public company filing annual reports follows PCAOB standards. A U. S. non-public company issuing financial statements, follows AICPA standards, * A foreign company filing financial statements in a different country follows International Standards or the standards of that country, * U. S. companies reporting on other than financial information follows AICPA Attestation or Assurance Standards. 2-26. For the most part, the standards issued by the IAASB are quite similar to that of the two U. S. based audit standard setters. They differ in the following major ways: The auditor must assess the appropriateness of the accounting framework against which the audit opinion will be given (U. S. standards require only that the auditor commu nicate if the accounting is not consistent with U. S. GAAP. ) * IAASB utilizes a concept of Professional Skepticism rather than independence. * The IAASB utilizes a concept of ‘reasonable assurance’ compared with the U. S. evidence on sufficiency of audit evidence and due professional care, * The IAASB standards include both audit standards and assurance standards. 2-27.The IAASB Audit Standards are quite consistent with that of the PCAOB as well as that of the AICPA. Most of the concepts are the same, but are stated differently. They are very similar in the following ways: * Requirement of independence, * Gathering and evaluation of sufficient evidence, * Documentation of audit work, * Audit designed to minimize audit risk, * Due professional care vs. reasonable assurance, * Nature of the audit report The AICPA and the IAASB have announced a plan to work towards convergence of existing and future standards. The PCAOB has not yet announced a plan for convergence. 2-28.A n audit engagement applies to the development of an opinion on an organization’s financial statements. It is planned that the financial statements will be used by third parties who do not have direct access to client data. The audit engagement is a form of ‘positive assurance’ in which an opinion must be rendered. An assurance engagement differs from an audit in a number of important dimensions: * It can apply to almost any assertion that management wants to make as long as there is agreed-upon criteria by which to test management’s assertion. It is preferable that the criteria are generally accepted. An assurance engagement generally requires a third party (although assurance can also be provided to the audit client), but it is an identified third-party as opposed to a potential user of financial statements, * Assurance can be given on individual items of a company’s financial statements, rather than the full set of statements. 2-29. Assurance enga gements are designed to provide ‘positive assurance’, i. e. the item being attested to is either properly presented, or is not properly presented. For example, one of the Big 4 firms provides assurance to the audience that the votes are properly maintained and counted for the Emmy Awards.A ‘limited assurance engagement’ does not contemplate a full audit or assurance engagement such that sufficient information (evidence) is gathered to warrant a positive statement about whether the item being assured is, or is not, properly presented. Rather, based on a more limited amount of work, the auditor either states that ‘nothing came to his or her attention – based on the limited procedures – that indicates something is not fairly presented’. This is often referred to as ‘negative assurance’. An even more limited assurance engagement is one in which the accountant expresses ‘no assurance’ whatsoever on the item be ing reported. -30. * Auditing Standards apply to the auditor’s task of developing and then communicating an opinion on financial statements and, where applicable, independent opinions on the quality of an organization’s internal control over financial statements to the board, management, and outside third parties. * Assurance Standards apply the auditor’s task of developing and communicating an opinion on financial information outside of the normal financial statements, or on non-financial information to management, the board, and outside third-parties.Assurance services are engagements in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users about the outcome of the evaluation or measurement of a subject matter against criteria. * Attestation Standards is a term used by the AICPA to describe assurance services that involve gathering evidence regarding specific assertions and communicating an opinion on th e fairness of the presentation to a third party. Compilation and Review Standards refer to AICPA Standards that apply only to non-public companies where the board or a user has requested some assurance on the fairness of presentation of financial statements. These are referred to as negative assurance standards because the auditor does not gather enough evidence to support a statement as to whether the financial statements are fairly presented. 2-31. Independence means objectivity and freedom from bias. The auditor can favor neither the client nor the third party in evaluating the fairness of the financial statements The auditor must be independent in fact and in appearance.Independence in fact means the auditor is unbiased and objective. An auditor could be independent in fact if he or she owned a few shares of common stock in an audit client, but might not appear independent to a third party. Independence in appearance means that a third party with knowledge of the auditor’ s relationship with the client would consider the auditor to be independent. Professional skepticism, as used in the standards promulgated by the IAASB, has a broader meaning in that it refers to all of the factors that would affect an auditor’s ability to exercise proper skepticism in an audit engagement.The factors to be considered vary from those associated with the individual, such as objectivity, to those associated with the structure of the firm. These are similar to the independence standards that emphasize both audit firm relationships to the client as well as objectivity. However, the IAASB emphasis on professional skepticism goes a bit further: an auditor could be objective, but not necessarily exercise professional skepticism, i. e. being open to potential explanations of events that are not consistent with the auditor’s prior experiences. Professional skepticism appears to be a broader term than independence. 2-32.PCAOB – sets audit standards for the audits of all public companies that are registered with the SEC AICPA * sets audit standards for audits of non-public companies * sets attestation standards for areas other than public company reports on internal control sets standards for assurance services that are less in scope than an audit, such as reviews and compilations IAASB – sets standards for financial statement audits on an international basis. Right now, the international standards are being increasingly accepted by all political jurisdictions, but particularly in Europe and many developing countries. Harmonization with U.S. will continue to be an objective. GAO – sets the standards for financial audits of governmental entities within the U. S. and certain other organizations that receive Federal financial assistance. Goes beyond financial statement audits and also provides standards related to program audits for economy and efficiency of operations. IASB – sets standards for the professional prac tice of internal auditing around the world. Incorporates other standards by reference where applicable. 2-33. General Standards: The audit and attestation standards both require adequate technical training, expertise, and knowledge.They also both require independence and due professional care. The attestation standards differ in that they explicitly require links between assertions and reasonable criteria and a reasonably consistent estimation process; the audit standards implicitly assume this link. Fieldwork Standards: The audit and attestation standards both require planning and sufficient evidence. The audit standards go a step further in requiring an understanding of the entity and its environment. Reporting Standards: The reporting standards are completely different. Each reflects the underlying purpose of the engagement, i. . , the audit is designed to test whether the financials adhere to GAAP, whereas the attestation is designed to test a broader and more diverse set of ass ertions. 2-34. An audit program follows good corporate governance in the following way: Good governance is critical to the development of sound controls in an organization. The stronger the controls, the less risk that the financial statements will be misstated. The development of audit programs follow the standards in determining that sufficient evidence is gathered in order to evaluate the assertions being addressed in the audit engagement.Further, the gathering and evaluation of that evidence must be done by auditors who are independent of the client – in both fact and in appearance. Finally, the work must be carried out by auditors that understand the standards and exercise due professional care in the conduct of the audit engagement. 2-35. The major planning steps are: * Meeting with the audit client * Developing an understanding of the client’s business and industry * Develop an understanding of the client’s financial reporting processes and controls * Dev elop an understanding of materiality Develop a preliminary audit program that identifies the audit objectives defined in chapter 1. 2-36. Materiality is defined as the â€Å"magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgement of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. † Materiality guidelines usually involve applying percentages to some base, such as total assets, total revenue, or pretax income and consideration of qualitative factors such as the impact on important trends or ratios.The base should be a â€Å"stable† account however, making total assets a better choice than pretax income. 2-37. The auditor would take a sample of all additions to PP&E and verify the cost through reference to vendor invoices to determine that cost is accurately recorded and that title has passed to the company. If the company was considered high risk, the auditor might choose to physically verify the existence of the asset. Multiple Choice Questions: 2-38. d. 2-39. d. this is part of the profession’s problem, but not a cause of the failure. 2-40. a. 2-41. d. 2-42. a. 2-43. . 2-44. d. 2-45. b. 2-46. a. 2-47. f. Discussion and Research Questions: 2-48. a. The auditor might use the following approaches to determine whether a corporate code of ethics is actually followed: * observe corporate behavior in tests performed during the audit, e. g. approaches the company takes to purchasing goods, promoting personnel, and so forth, * observe criteria for promoting personnel; for example does performance always take on greater importance than how things are done, * observe corporate plans to communicate the importance of ethical behavior, e. g. ebcasts, emails, and so forth to communicate the importance of ethics, * review activity on the client’s whistleblowing website, or a summary of wh istleblowing activities reported by the internal auditor, * read a sample of self-evaluations by corporate officers, the board, and the audit committee and compare with the auditor’s observations of behavior, * examine sales transactions made during the end of quarters to determine if the sales reflect ‘performance goals’ as opposed to the company’s code of ethics. b. Are auditors equipped to make subjective judgments?This should be a great discussion question because many young people are attracted to the accounting profession because there are rules and relative certainty as to how things are done. However, as the profession is evolving, more judgments are required in both auditing and accounting. Audit personnel need to be equipped to make judgments on whether the company’s governance structure operates as intended and whether there are deficiencies in internal control when it does not operate effectively. The profession believes that auditors ca n make such judgments. . Assessing the competence of the audit committee can occur in a number of ways. Fortunately, the most persuasive evidence comes from the auditor’s direct interaction with the audit committee on a regular basis. The auditor can determine the nature of questions asked, the depth of understanding shared among audit committee members, and the depth of items included in the audit committee agenda. Many audit committees have self-assessment of their activities using criteria developed by CPA firms, or by the National Association of Corporate Directors.The auditor should also review the minutes of the audit committee meetings and determine the amount of time spent on important issues. An external auditor should be very reluctant to accept an audit engagement where the audit committee is perceived to be weak. There are a number of reasons including: * The lack of good governance most likely influences the organization’s culture and is correlated with a lack of commitment to good internal control. * The auditor has less protection from the group that is designed to assist the auditor in achieving independence. The company may be less likely to be fully forthcoming in discussions with the auditor regarding activities that the auditor might question. d. Internal auditing is an integral part of good corporate governance. It contributes to corporate governance in three distinct ways: * It assists the audit committee in its oversight role by performing requested audits and reporting to the audit committee, * It assists senior management in assessing the continuing quality of its oversight over internal control throughout the organization, * It assists operational management by providing feedback on the quality of its operations and controls. -49. a. Corporate governance is defined as: â€Å"a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organiza tion. The owners (stockholders) elect a board of directors to provide oversight of the organization’s activities and its accountability to stakeholders. † The key players in corporate governance are the stockholders (owners), board of directors, audit committees, management, regulatory bodies, and auditors (both internal and external). b.In the past decade especially, all parties failed to a certain extent. For detailed analysis, see exhibit 2. 2 in the chapter and reproduced below: Corporate Governance Responsibilities and Failures Party | Overview of Responsibilities| Overview of Corporate Governance Failures| Stockholders| Broad Role: Provide effective oversight through election of Board process, approve major initiatives, buy or sell stock. | Focused on short-term prices; failed to perform long-term growth analysis; abdicated all responsibilities to management as long as stock price increased. Board of Directors| Broad Role: the major representative of stockholders to ensure that the organization is run according to the organization charter and there is proper accountability. Specific activities include: * Selecting management. * Reviewing management performance and determining compensation. * Declaring dividends * Approving major changes, e. g. mergers * Approving corporate strategy * Overseeing accountability activities. | * Inadequate oversight of management. * Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. Non-independent, often dominated by management. * Did not spend sufficient time or have sufficient expertise to perform duties. * Continually re-priced stock options when market price declined. | Management| Broad Role: Operations and Accountability. Managing the organization effectively and provide accurate and timely accountability to shareholders and other stakeholders. Specific activities include: * Formulating strategy and risk appetit e. * Implementing effective internal controls. * Developing financial reports. * Developing other reports to meet public, stakeholder, and regulatory requirements. * Earnings management to meet analyst expectations. * Fraudulent financial reporting. * Pushing accounting concepts to achieve reporting objective. * Viewed accounting as a tool, not a framework for accurate reporting. | Audit Committees of the Board of Directors| Broad Role: Provide oversight of the internal and external audit function and the process of preparing the annual accuracy financial statements and public reports on internal control. Specific activities include: * Selecting the external audit firm. * Approving any non-audit work performed by audit firm. Selecting and/or approving the appointment of the Chief Audit Executive (Internal Auditor), * Reviewing and approving the scope and budget of the internal audit function. * Discussing audit findings with internal auditor and external auditor and advising the Boa rd (and management) on specific actions that should be taken. | * Similar to Board members – did not have expertise or time to provide effective oversight of audit functions. * Were not viewed by auditors as the ‘audit client’. Rather the power to hire and fire the auditors often rested with management. Self-Regulatory Organizations: AICPA, FASB| Broad Role: Setting accounting and auditing standards dictating underlying financial reporting and auditing concepts. Set the expectations of audit quality and accounting quality. Specific roles include: * Establishing accounting principles * Establishing auditing standards * Interpreting previously issued standards * Implementing quality control processes to ensure audit quality. * Educating members on audit and accounting requirements. | * AICPA: Peer reviews did not take a public perspective; rather than looked at standards that were developed and reinforced internally. AICPA: Leadership transposed the organization fo r a public organization to a â€Å"trade association† that looked for revenue enhancement opportunities for its members. * AICPA: Did not actively involve third parties in standard setting. * FASB: Became more rule-oriented in response to (a) complex economic transactions; and (b) an auditing profession that was more oriented to pushing the rules rather than enforcing concepts. * FASB: Pressure from Congress to develop rules that enhanced economic growth, e. g. allowing organizations to not expense stock options. Other Self-Regulatory Organizations, e. g. NYSE, NASD| Broad Role: Ensuring the efficiency of the financial markets including oversight of trading and oversight of companies that are allowed to trade on the exchange. Specific activities include: * Establishing listing requirements – including accounting requirements, governance requirements, etc. * Overseeing trading activities,| * Pushed for improvements for better corporate governance procedures by its membe rs, but failed to implement those same procedures for its governing board, management, and trading specialists. Regulatory Agencies: the SEC| Broad Role: Ensure the accuracy, timeliness, and fairness of public reporting of financial and other information for public companies. Specific activities include: * Reviewing all mandatory filings with the SEC, * Interacting with the FASB in setting accounting standards, * Specifying independence standards required of auditors that report on public financial statements, * Identify corporate frauds, investigate causes, and suggest remedial actions. | * Identified problems but was never granted sufficient resources by Congress or the Administration to deal with the issues. External Auditors| Broad Role: Performing audits of company financial statements to ensure that the statements are free of material misstatements including misstatements that may be due to fraud. Specific activities include: * Audits of public company financial statements, * Audits of non-public company financial statements, * Other accounting related work such as tax or consulting. | * Pushed accounting concepts to the limit to help organizations achieve earnings objectives. * Promoted personnel based on ability to sell â€Å"non-audit products†. Replaced direct tests of accounting balances with a greater use of inquiries, risk analysis, and analytics. * Failed to uncover basic frauds in cases such as WorldCom and HealthSouth because fundamental audit procedures were not performed. | Internal Auditors| Broad Role: Perform audits of companies for compliance with company policies and laws, audits to evaluate the efficiency of operations, and audits to determine the accuracy of financial reporting processes. Specific activities include: *Reporting results and analyses to management, (including operational management), and audit committees, * Evaluating internal controls. | * Focused efforts on ‘operational audits’ and assumed that fina ncial auditing was addressed sufficiently by the external audit function. * Reported primarily to management with little effective reporting to the audit committee. * In some instances (HealthSouth, WorldCom) did not have access to the corporate financial accounts. | c. There is an inverse relationship between corporate governance and risk to the auditor i. e. he better the quality of corporate governance, the lower the risk to the auditor. This relationship occurs because lower levels of corporate governance implies two things for the auditor: * There is more likelihood that the organization will have misstatements in its financial statements because the commitment to a strong organizational structure and oversight is missing, * There is greater risk to the auditor because the governance structure is not designed to prevent/detect such misstatements, and will likely not be as forthcoming when the auditor questions potential problems. -50. Element of Poor Corporate Governance| Audit Activity to Determine if Governance is actually Poor| Risk Implication of Poor Governance| The company is in the financial services sector and has a large number of consumer loans, including mortgages, outstanding. | This is not necessarily poor governance. However, the auditor needs to determine the amount of risk that is inherent in the current loan portfolio and whether the risk could have been managed through better risk management by the organization. The lack of good risk management by the organization increases the risk that the financial statements will be misstated because of the difficulty of estimating the allowance for loan losses. The auditor will have to focus increased efforts on estimating loan losses, including a comparison of how the company is doing in relation to the other companies in the financial sector. | The CEO and CFO’s compensation is based on three components: (a) base salary, (b) bonus based on growth in assets and profits, and (c) significant s tock options. This is a rather common compensation package and, by itself, is not necessarily poor corporate governance. However, in combination with other things, the use of ‘significant stock options’ may create an incentive for management to potentially manage reported earnings in order to boost the price of the company’s stock. The auditor can determine if it is poor corporate governance by determining the extent that other safeguards are in place to protect the company. In combination with other things, the use of ‘significant stock options’ may create an incentive for management to potentially manage reported earnings in order to boost the price of the company’s stock. The auditor should carefully examine if the company’s reported earnings and stock price differs broadly from companies in the same sector. If that is the case, there is a possibility of earnings manipulation and the auditor should investigate to see if such manipula tion is occurring. The audit committee meets semi-annually. It is chaired by a retired CFO who knows the company well because she had served as the CFO of a division of the firm before retirement. The other two members are local community members – one is the President of the Chamber of Commerce and the other is a retired executive from a successful local manufacturing firm. | There is a strong indicator of poor corporate governance.If the audit committee meets only twice a year, it is unlikely that it is devoting appropriate amounts of time to its oversight function, including reports from both internal and external audit. There is another problem in that the chair of the audit committee was previously employed by the company and would not meet the definition of an independent director. Finally, the problems with the other two members is that there is no indication that either of them have sufficient financial expertise. This is an example of poor governance because (1) it s ignals that the organization has not made a commitment to independent oversight by the audit committee, (2) the lack of financial expertise means that the auditor does not have someone independent that they can discuss controversial accounting or audit issues that arise during the course of the audit. If there is a disagreement with management, the audit committee does not have the expertise to make independent judgments on whether the auditor or management has the appropriate view of he accounting or audit issues. | The company has an internal auditor who reports directly to the CFO, and makes an annual report to the audit committee. | The good news is that the organization has an internal audit activity. | The bad news is that a staff of one isn’t necessarily as large or as diverse as it needs to be to cover the major risks of the organization. The external auditor will be more limited in determining the extent that his or her work can rely on the internal auditor. The CEO is a dominating personality – not unusual in this environment. He has been on the job for 6 months and has decreed that he is streamlining the organization to reduce costs and centralize authority (most of it in him). | A dominant CEO is not especially unusual, but the centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden. The auditor should look at policy manuals, as well as interview other members of management and the board – especially the audit committee. The centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden. This increases the amount of audit risk. | The Company has a loan committee. It meets quarterly to approve, on an ex-post basis all loans that are over $300 million (top 5% for this institution). | The auditor should observe the minutes of the loan committee to verify its meetings. The auditor should also intervie w the chairman of the loan committee to understand both its policies and its attitude towards controls and risk. There are a couple of elements in this statement that carries great risk to the audit and to the organization. First, the loan committee only meets quarterly. Economic conditions change more rapidly than once a quarter, and thus the review is not timely. Second, the only loans reviewed are (a) large loans that (b) have already been made. Thus, the loan committee does not act as a control or a check on management or the organization. The risk is that many more loans than would be expected could be delinquent, and need to be written down. The previous auditor has resigned because of a dispute regarding the accounting treatment and fair value assessment of some of the loans. | The auditor should contact the previous auditor to obtain an understanding as to the factors that led the previous auditor to either resign or be fired. The auditor is also concerned with who led the c harge to get rid of the auditor. | This is a very high risk indicator. The auditor would look extremely bad if the previous auditor resigned over a valuation issue and the new auditor failed to adequately address the same issue.Second, this is a risk factor because the organization shows that it is willing to get rid of auditors with whom they do not agree. This is a problem of auditor independence and coincides with the above identification of the weakness of the audit committee. This action confirms a generally poor quality of corporate governance. | 2-51. a. External auditors are supposed to perform audits of financial statements to ensure that the statements are free of material misstatements. They work for each of the parties to a certain extent and since they are independent, they will not favor any party over the other.The auditors are an independent and objective attestor that evaluates the quality of financial reporting and conveys an opinion to all parties involved in corp orate governance. b. Some of the ways the accounting profession was responsible were: * Were too concerned about creating â€Å"revenue enhancement† opportunities, and less concerned about their core services or talents * Were willing to â€Å"push† accounting standards to the limit to help clients achieve earnings goals * Began to use more audit â€Å"shortcuts† such as inquiry and analytical procedures instead of direct testing of account balance. Relied on management representations instead of testing management representations. c. The term â€Å"public watchdog† implies that auditors will look over the business world and stop bad things from happening. In terms of financial statements, Arthur Levitt said, â€Å"We rely on auditors to put something like the good housekeeping seal of approval on the information investors receive. † The term â€Å"public watchdog† places a great deal of responsibility on the shoulders of auditors to protect the public’s interests. 2-52. b&c. Cookie jar reserves are essentially funds that companies have â€Å"stashed away† to use when times get tough. The rationale is that the reserves are then used to â€Å"smooth† earnings in the years when earnings needs a boost. â€Å"Smooth† earnings typically are looked upon more favorably by the stock market. An example of a cookie jar reserve would be over-estimating an allowance account, such as allowance for doubtful accounts. The allowance account is then written down (and into the income statement) in a bad year.Auditors may have allowed cookie jar reserves because they are known to smooth earnings, and smooth earnings are rewarded by the market. On the flip side, fluctuating earnings are penalized, and present more risk to the company of bankruptcy or other problems. The Sarbanes-Oxley Act addressed the issue by creating an oversight body, the PCAOB, but also addressed the issue in other ways. For example, Congr ess felt that creating more effective Boards would decrease the use of earnings management. Allowing improper revenue recognition is one thing that auditors may have done in their unwillingness to say â€Å"no† to clients.For example, companies shipped out goods to customers at the end of the year for deep discounts and allowed returns at the beginning of the next year. This practice is known as channel stuffing. Since the goods had a great chance of being returned, it would be improper to recognize all as revenue. Again, auditors were unwilling to say â€Å"no† to clients. Greed is probably the reason here. If companies claim more revenue, their stock would grow in the short-term, making management richer, and making management more willing to give pay raises to their auditors.With the establishment of stronger audit committees and certification of financial statements in the Sarbanes-Oxley Act, this kind of accounting trickery will certainly decrease. Creative accoun ting for M&A included the use of the â€Å"pooling† method of accounting. Pooling allowed acquiring companies to value existing assets at historical costs and did not require the recognition of goodwill for the acquisition. Because true costs (values) were not shown on the financial statements, management was often encouraged to bid up prices for acquisitions with the result that many of them were not economic.The creative accounting also shielded the income statement from charges that would have otherwise hit income including: goodwill amortization, depreciation, and depletion expenses. Greed, the same reasons as the revenue recognition issue, was most likely the motivation for this creative accounting. Discussion between an educated audit committee and auditor plus certification of financial statements required by Sarbanes-Oxley will certainly address this issue. Assisting management to meet earnings.Too often, auditors confused ‘financial engineering’ with val ue-adding. In other words, auditors often sought to add value to their clients by finding ways to push accounting to achieve earnings objectives sought by management. These earnings objectives then played a major role in escalating stock prices – all desired because of the heavy emphasis of management compensation on stock options. Incentives were misaligned. Most of management compensation came in the form of stock options.Better audit committees, increased auditor responsibility, identification of users as the client of the auditor, and management certification of statements will address the issue via requirements of the Sarbanes-Oxley Act. 2-53. a. Some ways that the impact of the Sarbanes-Oxley Act affects the external audit profession: * The creation of the PCAOB puts a watchful eye on the accounting industry. * Reporting on internal controls is required by the external auditor, adding to their workload but also strengthening their value to organizations and giving them more assurance when giving an audit opinion. Auditors can now feel more comfortable taking issues to the audit committee * Audit partners must rotate off every five years. This will create a difficult transition at every client every five years. * With the cooling off period, audit partners or managers cannot take jobs with clients as easily. b. The Sarbanes-Oxley Act encourages effective internal audit functions for all public companies. The internal audit profession has been active in assisting companies in complying with the internal control provisions of the Act. c. This could be argued either way.On one side, the legislation clearly creates a â€Å"watchdog† of the accounting industry, which decreases the power and prestige as the profession is no longer self-regulated. On the other hand, the Act and recent business press has brought a lot of attention to the accounting industry, which has educated the world about the role of accountants in the economy, and possibly incr eased their power and prestige. Now, there is a general feeling that the public accounting profession has reestablished itself as a watchdog for investors and see the audit committee as their primary client.Overall, the consensus seems to be that the profession has regained a great deal of its prestige. 2-54. a. The Sarbanes-Oxley Act changed responsibilities of management in the following ways: * Requirement that CEO and CFO certify the financial statements and disclosures * Requirement that companies provide a comprehensive report on internal controls over financial reporting * Requirement to describe whether they have implemented a Corporate Code of Conduct, including provisions for whistleblowing, and processes to ensure hat corporate actions are consistent with the Code of Conduct. b. Under The Sarbanes-Oxley Act, management is no longer the â€Å"client. † The auditor reports to the audit committee, who is independent of management. With these changes, the auditor shoul d be able to be â€Å"tougher† on management because the audit committee will be demanding it. However, the auditor still has to work with management to gain access to needed information, as well as understanding management intent as management intent drives some accounting treatments. . The CEO and CFO, as members of management, are ultimately responsible for the financial statements. The chair of the audit committee and the external auditor are then responsible to a certain extent, probably more in the minds of the public than in reality. Finally, the Director of Internal Audit is the least responsible of the group, as they are essentially employees of management and the audit committee. 2-55. a. The audit committee must be comprised of â€Å"outside† independent directors, one of whom must be a financial expert.The audit committee now has the authority to hire and fire the external auditor, and will therefore serve as the auditor’s primary contact, especially for accounting and audit related issues. In addition, the audit committee sets the scope for and hires internal auditors. They must review the work of both parties. b. The audit committee certainly takes on much more responsibility with the new standard. They will now be much more informed about the audit function and financial reporting processes within their company. The auditor must report all significant problems to the audit committee.For auditors, the reporting relationship should reinforce the need to keep the third-party users in mind in dealing with reporting choices. c. The audit committee is basically in a position of mediator, but not problem solver. One member must be a financial expert, but all members must be well versed in the field. This financial knowledge can help the audit committee to understand the disagreement. Ultimately, the auditor has to be able to give a clean audit opinion. If they believe a certain accounting treatment to be wrong, they do not have to give that clean opinion.In this way, neither the audit committee nor management can necessarily solve a dispute. d. The accounting choice is acceptable, and thus, the financial statements are fairly presented in accordance with GAAP. The fact that the auditor believes there is a better treatment should be communicated to important parties as follows: * Management – the communication should be made directly, and the rationale for the auditor’s opinion should be explained to management and documented in the working papers. The working papers should also include the client’s rationale for the chosen accounting treatment. Audit Committee – Both management’s chosen treatment and the auditor’s preferred treatment should be communicated to the audit committee. Preferably the communication would include both verbal communication and written communication. The rationale for accepting management’s accounting treatment should also be communicate d. * Users of the Financial Statement – There is no required communication to the outside users of the financial statements as long as the auditor has concluded that the financial statements are fairly presented in accordance with GAAP. 2-56. . An audit committee is a subcommittee of the board of directors; it is responsible for monitoring audit activities and serves as a surrogate for the interests of shareholders. Audit committees should preferably be composed of outside members of the board, that is, members who do not hold company management positions or are closely associated with management. b. The following information should be discussed with the audit committee: * A summary of the auditor's responsibilities under GAAS. Auditor responsibilities change over time as new standards are issued.The audit committee should always be aware of the nature of the audit function within the organization. * Initial selection or major changes in significant accounting policies that c ould have a material affect on financial statement presentation. The audit committee needs to know how the choice may affect both current reports and future financial reports as well as the rationale for the choice because it is presumed that companies select the accounting principles that best reflect the economic substance of their transactions and are thus changed only when dictated by standard-setting bodies or when the economics of the situation change. The process utilized by management to make significant estimates and other management judgments such as loan loss reserves in banks and savings and loans and insurance reserves in insurance companies. * Significant audit adjustments that may reflect on the stewardship and accountability of management, even if management agreed to make the adjustments. * The auditor's review of and responsibility for other information contained in an annual report (outside of the audited financial statements). * All major accounting disagreements with management, even if such disagreements are eventually resolved to the auditor's satisfaction. The auditor's knowledge of management's consultation with other auditors regarding accounting or auditing issues. * Any significant accounting or auditing issues discussed with management prior to the acceptance of the audit engagement – in particular, any positions taken regarding the proper accounting of controversial areas should be disclosed. * Any difficulties encountered in performing the audit, especially any activities undertaken by management that might be considered an impairment of the audit function. * Internal audit plans and reports and management’s responses to those reports. The extent to which the client has implemented a comprehensive plan of risk assessment and the organization’s plans to mitigate, share, control, or otherwise address those risks. * Any known internal control weaknesses that could significantly affect the financial reporting pro cess. The rationale for this communication is that the board of directors through

Fair Value or Cost Mode Drivers of Choice for Ias 40

European Accounting Review Vol. 19, No. 3, 461– 493, 2010 Fair Value or Cost Model? Drivers of Choice for IAS 40 in the Real Estate Industry A. QUAGLI? and F. AVALLONE ? Department of Accounting and Business Studies (DITEA), University of Genova, Genova, Italy and ? ? Department of Computer and Management Science (DISA), University of Trento, Trento, Italy (Received September 2008; accepted February 2010) ABSTRACT The IFRS mandatory adoption in European countries is an excellent context from which to assess the validity of accounting choice theory, which postulates that information asymmetry, contractual ef? iency (agency costs) and managerial opportunism reasons could drive the choice. With this aim, we test the impact of these factors to explain the adoption of fair value for investment properties (IAS 40) in the real estate industry, taking into account the ‘revaluation’ option offered by IFRS1 and using historical cost without revaluations as a baseline catego ry for comparison purposes. We select a sample of European real estate companies from Finland, France, Germany, Greece, Italy, Spain and Sweden, all ? rst-time adopters of the IFRS. Using a multinomial logistic model, we show that information asymmetry, contractual ef? iency and managerial opportunism could account for the fair value choice. Particularly, the most signi? cant ? ndings are that size as a proxy of political costs reduces the likelihood of using fair value while market-to-book ratio is negatively associated with the fair value choice. On the other hand, leverage, another typical proxy of contracting costs, seems not to in? uence the choice. This evidence con? rms the current validity of traditional accounting choice theory even if it reveals, in such a context, the irrelevance of the usual relations between accounting choice and leverage. . Introduction We analyse if the choice between cost or fair value for investment property under IAS 40 aims at (i) reducing agency costs (contractual ef? ciency Correspondence Address: A. Quagli, Department of Accounting and Business Studies (DITEA), University of Genova, Via Vivaldi 2, 16126 Genova (GE), Italy. E-mail: [email  protected] unige. it 0963-8180 Print/1468-4497 Online/10/030461–33 # 2010 European Accounting Association DOI: 10. 1080/09638180. 2010. 496547 Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA. 462 A. Quagli and F. Avallone easons), (ii) mitigating information asymmetries, as standard setters claim, or (iii) allowing managerial opportunism, typical motives de? ned by accounting choice theory (Holthausen, 1990; Fields et al. , 2001). Using a multinomial logistic regression, we test these hypotheses using 73 observations from real estate companies located in European countries (Finland, France, Germany, Greece, Italy, Spain and Sweden) which do not allow the fair value method in the pre-IFRS mandatory period in order to eliminate the in? uence of pre-exist ing fair value adoption. All these ? rms are ? sttime IFRS adopters, enabling us to compare the same accounting choice in a similar situation (? rst-time adoption). The mandatory adoption of IAS 40 (Investment properties) by European listed companies offers a unique opportunity to verify managers’ behaviour in a composite context of accounting choice. In fact, IAS 40 allows two alternative methods for appraisal of investment property assets: the cost method or the fair value method with recognition of fair value changes through pro? t and loss. Additionally, taking into account the IFRS1 ‘fair value as deemed cost’ option, the cost choice could be split into two lternatives: (i) historical cost without revaluation, (ii) historical cost with the IFRS1 option to revaluate investment property. This second option could represent a partial substitute for the fair value method, showing its effects only in equity without in? uencing pro? t and loss. 1 Thus, our model as sumes the choice of applying historical cost without revaluating it as the referent outcome category to compare (Y ? 0), and forms logits comparing the choice of using historical cost with IFRS1 revaluations of investment property (Y ? 1) and fair value choice (Y ? 2) to it. Our ? dings suggest that all the rationales described by accounting choice theory (information asymmetry, contractual ef? ciency and managerial opportunism) drive the decision to adopt fair value. Indeed, regarding contractual ef? ciency reasons in particular, we ? nd that the larger the size (proxy of political costs), the less likely fair value is to be chosen, while leverage and consequent lenders’ protection seems to be insigni? cant for the choice. Furthermore, our results show that market-to-book ratio (MTBV) (proxy of information asymmetry) is negatively related to the fair value choice. This ? nding, that con? cts with existing literature, could be accounted for in the real estate industry due to the fact that high levels of MTBV in this context reveal growth opportunities associated with a fair estimation of investment properties and therefore with a low information asymmetry. Managerial opportunism behaviour, measured by a dummy variable for earnings smoothing, seems to have an in? uence on fair value choice. While all these variables seem to have an in? uence on the fair value choice, the same variables do not explain the choice of historical cost with the IFRS1 revaluation option in preference to the cost maintenance approach.This paper offers various contributions to current literature. Firstly, to the best of our knowledge, it is one of the ? rst papers speci? cally focused on the choice Fair Value or Cost Model? 463 between cost and fair value in the IFRS context. We perform the analysis using a sample of ? rst-time IFRS adopters from several European countries adopting only the cost method in the pre-IFRS phase in order to both not limit the research to the tradition al comparison between German and UK ? rms and eliminate the risk of in? uence from past experience.Secondly, this paper introduces to the accounting choice literature a research designed to analyse the in? uence of multiple motivations (contractual ef? ciency, information asymmetry and managerial opportunism) for a multiple-choice environment (cost, cost with IFRS1 revaluation or fair value through pro? t and loss), testing through a multinomial logistic regression all the possible causes. Previous research, on the contrary, usually overlooks a comparison of multiple motivations (Fields et al. , 2001, pp. 290 – 291).In other words, compared to existing studies we conduct an analysis using an innovative multiple motivations – multiple choices approach that better captures the complexity of accounting choices in management decisions. Finally, we contribute to the current debate on fair value showing which ? rm characteristics drive the choice of this method. While inform ation asymmetries are the most discussed motives for fair value, we demonstrate the in? uence of contractual ef? ciency motivation as well as managerial opportunism, and the actual choices by ? ms demonstrate only a ‘partial enthusiasm’ towards fair value, even in a sector where liquid markets exist. The paper proceeds as follows. Section 2 concerns the literature related to our analysis. Section 3 goes on to describe the main features of IAS 40 and the preIFRS domestic GAAP of the countries sampled. Section 4 illustrates the development of our hypotheses, while Section 5 provides details on the empirical model design, variable de? nition, sample selection and data. Finally, Section 6 describes descriptive statistics, the main ? ndings and the robustness of the results. . Theory and Relation to Existing Research The choice between fair value and cost is a central topic in the current debate on accounting. Fair value is generally preferred due to the fact that ?nancial s tatements reveal a higher level of information (CFA Institute Centre, 2008),2 even if its adoption requires speci? c conditions: liquid markets, large database of available prices (Barth and Landsman, 1995; Ball, 2006), as well as new competencies in developing measurement models in the absence of liquid markets, making it possible to enhance estimate reliability (Schipper, 2005).On the other hand, the reliability of fair value estimates is the most critical point (Martin et al. , 2006; Watts, 2006; Whittington, 2008), with the potential damage brought to the stewardship function of ? nancial statements. More generally, the demand for fair value has to be evaluated in its speci? c country context. The demand for fair value and the related preference for a higher level of information vs. reliability of ? nancial statements in Common law countries is quite different from the same demand in Code law countries (see Ball et al. 2000). 464 A. Quagli and F. Avallone Alternatively, a cost m odel seems more ef? cient in a contractual perspective because it reduces agency costs generated by creditors’ protection, political visibility, taxation and litigation (Watts, 2003; Qiang, 2007). Recent studies, however, seem to ignore the importance that the analysis of the adoption of IFRS evaluation alternatives could have in providing some more explanations for managers’ accounting choices and, consequently, for the progress of accounting choice theory.Therefore, the choice between cost and fair value is a central topic in this sense. Following the framework of Francis et al. (2004), fair value and cost affect the properties of accounting numbers in a very different way. Fair value is more value relevant,3 and provides more predictable and timely earnings ? gures because it is more oriented towards future cash ? ows (derivable by the current value of some assets); on the contrary, the cost method approach supports conservatism, smoothness and the accrual quality, due to the recognition of value changes only if realized.While it is dif? cult to suppose the impact on earnings persistence, depending on the size of fair value changes, the aforementioned aspects will give rise to different accounting behaviours. The information about future cash ? ows derived by fair value will be more appreciated in ? nancial markets (analysts and equity investors), because it will contribute to mitigate information asymmetries. On the other hand, the cost method is less costly and has more utility for income smoothing and contractual ef? ciency for which conservatism is a precious support.In other words, each of these methods has, at a theoretical level, pros and cons and the actual choice will likely depend on ? rm-speci? c circumstances. The different impact of these two methods strongly implies the need of the accounting choice theory to investigate the topic. A powerful starting point for accounting choice investigation is offered by Holthausen (1990; see a lso Watts and Zimmerman, 1978; Fields et al. , 2001) who classi? ed in: (i) contractual ef? ciency (agency costs), (ii) information asymmetry and (iii) managerial opportunism, the reasons for accounting choices. i) Expectations derived from the accounting choice theory concerning the impact of fair value on contractual ef? ciency could lead to a supposed negative relationship: the choice of fair value could increase agency costs for several reasons. The greater income ? uctuations induced by fair value compared to the cost model could enhance the perceived risk by investors (European Central Bank, 2004) and, consequently, the cost of capital, as the high level of reported pro? ts could increase political costs due to higher company visibility (Hagerman and Zmijewski, 1979). Additionally, the doubtful veri? bility of fair value compared to cost measures, in some contexts (illiquid markets) could increase litigation and its related costs (Watts, 2003), as well as the fact that fair va lue through pro? t and loss could anticipate taxation costs. Furthermore, we can infer from the contractual ef? ciency reasons regarding lenders’ protection contrasting hypotheses on fair value preference. On the one hand (Watts, 2003; Qiang, 2007), lenders prefer Fair Value or Cost Model? 465 conservatism (thus the cost method) because it reduces the risk of distributing ? rm value through dividends.On the other hand, fair value represents the current value of assets and it could be more ef? cient in negotiating for debt covenants. In this sense Christensen and Nikolaev (2008), basing their research on a sample of French and German multi-industry companies, ? nd that the fair value method is preferred by companies with high leverage and they account for this through information asymmetry: the current value of ? xed assets gives more thorough information about the ? rm’s solvency capability. In this sense, IFRS1 revaluation option could be a ‘partial’ subs titute of IAS 40 fair value, that is, ? ms could use the conservative cost approach to guarantee lenders’ protection but they could opportunistically revaluate investment assets through IFRS1 to beat covenants or to give a signal about their solvency capability. In other words, while IAS 40 fair value is a ‘long-term strategy’ whose effects are uncertain (fair value could give rise to future revaluations or impairments), the IFRS1 option could be seen as a ‘short-term strategy’, the accounting consequences of which could be made available before its adoption (the revaluations ex IFRS1 option must exist at the transition date, that is, one year before the ? st exercise IFRS compliant). In this sense, this option would encourage opportunistic (and aggressive) accounting behaviour. All these propositions, however, could fail to be applied if we take into account that covenants use, on average, to exclude revaluation reserves in ? nancial ratios. (ii) Lo oking at asymmetries for market participants, measured by market-tobook ratio (MTBV), fair value could be preferred to cost method because of its higher and updated level of information divulgated to ? nancial statement users.This is the main argument supporting the fair value primacy from a current standard setters’ viewpoint (Barlev and Haddad, 2003; Ball, 2006; Danbolt and Rees, 2008; Whittington, 2008). For this hypothesis, IFRS1 option could be a partial substitute for IAS 40 fair value, because of its in? uence on equity and, consequently, on MTBV. (iii) When a ? rm is choosing between cost and fair value, the managerial opportunistic accounting behaviour, previously demonstrated by income smoothing practices (Barth et al. , 1999; He? in et al. 2002; Graham et al. , 2005) is less likely with fair value through pro? t and loss, which obliges large earnings impact due to the volatility of market prices. However, the choice of the IFRS1 option in this sense should be irrel evant (thus not competing with fair value through pro? t and loss method), because this accounting option in? uences only equity and has no impact on pro? t and loss. Our objective is to test empirically how these multiple, and in part controversial, reasons (managerial opportunism, contractual ef? iency and information asymmetries) account for the choice of either fair value or the cost model due to the recent mandatory adoption of IFRS. In the typical discussion about IFRS, in 466 A. Quagli and F. Avallone fact, the power of fair value is recognized speci? cally regarding its potential to reduce information asymmetries (Whittington, 2008). Our analysis is based on the assumption that recognition is more value relevant than simple disclosure. Since IAS 40 requires footnote disclosure of fair value investment properties for ? ms adopting cost (see Section 3), it could be assumed that the choice between cost and fair value is not relevant, because the information about fair value is available for ? nancial statement users whatever the accounting policy chosen for investment properties. Nonetheless, our paper poses disclosure not equivalent to recognition according to the prevailing literature4 (for a review see Schipper, 2007). In all probability, the reasons can be found in a different reliability of data included in the footnotes relating to the balance sheet measures (Schipper, 2007). As af? med by Cotter and Zimmer (2003), speci? cally for revaluations of ? xed assets, ‘the value relevance of recognized revaluations is not due to recognition per se, but rather to the fact that the assets being revalued are more reliably measured’ (p. 1). 3. Main Features of IAS 40 and Differences with the Domestic GAAP of Countries Sampled IAS 40 is concerned with investment property that is property (land or a building) held to earn rentals or for capital appreciation or both, rather than for use as a site in which to run a manufacturing business or as a good to sell in the ordinary course of business.The most relevant feature for our interests in IAS 40 is the evaluation method. IAS 40 permits evaluation of investment properties choosing alternatively: . fair value model, by which an investment property is measured, after an initial measurement, at fair value with changes in fair value recognized in the income statement and with no depreciation; . cost model, with the same rule as in IAS 16 (the property is to be measured after initial recognition at depreciated cost less any accumulated impairment losses).This feature makes IAS 40 unique within the IFRS because it represents the only case where the two main evaluation criteria, fair value and cost, are alternatively admitted in their ‘pure’ form; the IAS 40 fair value re? ects its changes from one period to another in the income statement and not directly in an equity reserve as established by IAS 16 or IAS 38. As a consequence, managers are conscious that the choice betwe en these accounting methods implies substantial variations in accounting results. As reported in the Basis for Conclusions, in the 2003 IAS 40 revision (par.BC 12), the IASB discussed whether to eliminate the choice between the fair value model and cost model, thus implicitly enforcing the former as the only evaluation Fair Value or Cost Model? 467 method allowed. However, it was decided to leave the choice between the two approaches for two main reasons: the ? rst was to give preparers and users time to acquire experience before using a fair value model. Obviously, with regard to the practice of fair value assessment the second was to allow time for countries with less-developed property markets and valuation professions to mature.The IASB planned to reconsider the option of using the cost model at a later date, in the light of ‘fair value supremacy’ pervading the International Accounting Standards. Nonetheless, the fair value primacy is notable for its disclosure clau se, requesting the fair value of the investment property for the entities that choose the cost model, this means that an entity is obliged to assess fair value in all cases, which is a logical premise to permitting an easier transition to the fair value method at a later date.Additionally, the entity has to declare in notes whether it applies the fair value model or the cost model and the methods and signi? cant assumptions applied in determining the fair value, including a statement whether the determination of fair value was supported by market evidence or was more heavily based on other factors (which the entity should disclose) relating to the nature of the property and the lack of comparable market data. The fair value method benchmarked by IAS 40 is a novelty for several European countries.Our sample looks at domestic accounting rules; it is made up of companies from countries which allow only the cost method for investment property: Germany (Deloitte & Touche, 2001), Finland (KPMG, 2003a), France (KPMG, 2003b), Greece (Tsalavoutas and Evans, 2009), Italy (PWC, 2005), Spain (Perramon and Amat, 2007), Sweden (KPMG, 2005). More speci? cally, in Spain and Italy an asset revaluation credited to equity is permitted only if a special law allows it. In France a revaluation to equity is permitted only if it embraces all ? ed assets and the long-term ? nancial assets. In Greece, it is possible to revaluate ? xed assets to equity every four years following a revaluation index established by the Government. In Germany no revaluations are allowed. Finnish and Swedish GAAP permit a revaluation of properties credited to equity if their fair value exceeds cost in a permanent, signi? cant and reliable way. The choice of countries using only the cost model in the pre-IFRS mandatory phase allows us to eliminate the in? uence of any pre-existing in? ence of fair value adoption. 4. Hypothesis Development Following Section 2, we develop our hypotheses concerning: (i) ef? cie ncy reasons, in terms of both the reduction of political costs and the lenders’ protection, (ii) information asymmetry and (iii) managerial opportunism. 468 A. Quagli and F. Avallone (1) Contractual Ef? ciency Following the hypothesis that conservatism accounting should reduce agency costs through a greater lenders’ protection (Watts, 2003; Qiang, 2007), we suppose a negative correlation between leverage and fair value method.We do not conjecture the opposite assumption (Holthausen and Leftwich, 1983) that in order to beat covenants, higher leverage could induce earnings increasing policies (like, in our speci? c context, the choice of fair value through pro? t and loss) because covenants usually do not take into account fair value revaluations (Citron, 1992; Christensen and Nikolaev, 2008). Thus, H1: The probability of choosing fair value decreases if company has a high leverage ratio level before IFRS adoption.We do not posit any assumption on the relationship betwee n leverage and the choice of historical cost with the IFRS1 option for the aforementioned exclusion of revaluation reserves in ? nancial ratios used by covenants. As already described in the part of Section 2 that looks at political costs, we can suppose from the literature that conservative accounting reduces political costs because the high level of reported pro? ts could affect them due to higher company visibility (Hagerman and Zmijewski, 1979; Watts, 2003). In order to verify the impact of political cost on fair value choice, we adopt the ? m size as an independent variable. The size per se has been mentioned speci? cally as a criterion for actions against corporations since several studies document that the magnitude of political costs is highly dependent on the size of corporation (Watts and Zimmerman, 1978). Thus, we conjecture that the political costs increase according to the company size; the larger it is the higher are the political costs and the lower is the probability that is advantageous to choose a fair value approach. Accordingly, our research proposition is: H2: The probability of choosing fair value decreases with the size of the ? m. Even in this case, we do not suppose any relationship between political costs and the choice of historical cost with the IFRS1 option, because this option has no impact on pro? t and loss. (2) Information Asymmetry If information asymmetry exists in the speci? c context investigated, managers could choose fair value in order to clearly inform the market about the ‘true’ value of the ? rm. So, under the assumption that disclosure is not equivalent to recognition (Schipper, 2007), a positive association between the choice of the fair value method and information asymmetry is assumed.Fair Value or Cost Model? 469 Many studies (Smith and Watts, 1992; Amir and Lev, 1996) use market-tobook ratio (MTBV) as a proxy for information asymmetry, starting from the intuition that while market value captures the present value of growth opportunities, the book value approximates the value of assets in place. As a result, we posit that MTBV is positively related to information asymmetry and, consequently, positively related to fair value choice. Therefore, we assume: H3a: The probability of choosing fair value increases the more marked is the difference between market value and the book value of equity.We could also develop a concurrent hypothesis to H3a, on the basis that, in this case, the choice of historical cost with IFRS1 option, in? uencing equity, could be a ‘partial’ substitute of fair value through pro? t and loss. Thus, we expect a positive association between the choice of historical cost with IFRS1 option and information asymmetry, as measured by MTBV ratio. H3b: The probability of choosing historical cost with IFRS1 option increases the more marked is the difference between market value and book value of equity. (3) Managerial OpportunismFrom the theory we derive t hat managerial opportunistic accounting behaviour is demonstrated by income smoothing practices (Barth et al. , 1999; He? in et al. , 2002; Graham et al. , 2005) and we thus suppose that fair value through pro? t and loss with its volatile changes contrasts smoothing policies. So, a negative association between fair value choice and pre-IFRS earnings smoothing is expected. Hence: H4: The probability of choosing fair value decreases if managers reduce the variability of reported earnings using accruals.We do not suppose any relationship between managerial opportunism estimated by earnings smoothing and the choice of historical cost with IFRS1 revaluation, because this option has no impact on pro? t and loss. 5. Research Design Empirical Model and Variable De? nitions Two statistical procedures are used in our analysis: (i) the non-parametric Mann – Whitney two-sample rank-sum test is used to analyse the difference in explanatory variables between the group of ? rms that have a dopted the fair value model or cost model with the IFRS1 revaluation and the group that have chosen the cost 470A. Quagli and F. Avallone model (the cost group has been taken as a referent category). Additionally, (ii) we use a multinomial logistic regression model (MNL) to test the relationship between the ? rm accounting choice for investment properties and the hypothesized explanatory variables. Under the multinomial logistic model with three outcome categories (0, 1 and 2), p covariates and a constant term (b) denoted by the vector x, two logit functions are described as follows (Hosmer and Lemeshow, 2000): g1 (x) = ln[P(Y = 1| x)/P(Y = 0| x)] = b10 + b11 X1 + b12 X2 + . . . + b1p Xp (1) and 2 (x) = ln[P(Y = 2| x)/P(Y = 0| x)] = b20 + b21 X1 + b22 X2 + . . . + b2p Xp . (2) It follows that the conditional probabilities of each outcome category given the covariate vector are: P(Y = 0| x) = 1/1 + eg1 (x) + eg2 (x) P(Y = 1| x) = eg1 (x) /1 + eg1 (x) + eg2 (x) (3) P(Y = 2| x) = eg2 ( x) /1 + eg1 (x) + eg2 (x) . Our model assumes the choice to use historical cost without revaluating as the referent or baseline outcome category to compare (Y ? 0), and forms logits comparing the choice to use historical cost with the IFRS1 revaluation of investment properties (Y ? 1) and fair value choice (Y ? 2) to it.Furthermore, the model assumes the following relation between the proposed explanatory variables and the fair value accounting choice: ln[P(Y = FV| x)/P(Y = COST| x)] = b0 + b1 LEV + b2 SIZE + b3 MTBV + b4 SM + b5 CNT + b6 EPRA + b7 ACT + 1 (4) where b ? CHOICEi ? bFV; dependent variable equal to 2 if the ? rm i adopts fair value model under IAS 40 in ? rst-time adoption (FTA), 1 if ? rm i adopts the historical cost and uses IFRS1 to revalue investment properties and 0 if the ? rm i adopts the historical cost without revaluating; Fair Value or Cost Model? LEVi ? SIZEi MTBVi ? ? SMij ? CNTi ? EPRA ? ACT ? 471 he average debt to asset ratio for ? rm i, measured over tw o years before FTA; log of the average total asset over the two years before FTA; market-to-book value of ? rm i calculated over the last month of the FTA year since the market is in? uenced by the IFRS immediately after the FTA year; dummy variable coded 1 if ? rm i has an earnings smoothing index . the average index of earnings smoothing in country j (? rm’s country of domicile) and 0 otherwise; dummy variable coded 1 if ? rm i has an external market capitalization on GNP . the average external market capitalization on GNP for his legal country of origin (from La Porta et al. 1997) and 0 otherwise; dummy variable coded 1 if ? rm i is a member of the European Public Real Estate Association (EPRA) and 0 otherwise; ratio between total rents and total operating income estimated over the ? scal year preceding the IFRS mandatory adoption. Following Leuz et al. (2003) and Burgstahler et al. (2006) our proxy to capture earnings smoothing policies in the pre-IFRS period is computed as the ratio of the standard deviation of operating income divided by the standard deviation of cash ? ow from the operation, both measures being computed over the four years before IFRS mandatory adoption.The ratio is then multiplied by 2 1 so that higher values are associated with higher earnings smoothing policies. Moreover, in order to capture the real signi? cance of the smoothing ratio (only values around zero denote strong earnings smoothing activities but the more the values decrease the more the smoothing signi? cance disappears), in our analysis for each ? rm we only measure the distance from the average value of the same ratio for the country of origin as measured in Burgstahler et al. (2006). So, the resulting dummy variable is equal to 1 if the ? m has an earnings smoothing index higher than the average index estimated for the country of origin and 0 otherwise. This procedure enables us to capture the peculiarity of each country due to the different local GAAP adopted b efore IFRS (Leuz et al. , 2003; Burgstahler et al. , 2006). We control for three variables we conjecture to affect the fair value choice by including them as independent variables in the model. Controlling for both the country of origin and the EPRA (European Public Real Estate Association) membership allows us to include two exogenous factors that could affect the fair value choice.The former factor is considered because the differences in the nature of ? nancial systems around Europe are innate factors for international divergences in accounting (Nobes, 1998), thus in? uencing the fair value choice as well. The 472 A. Quagli and F. Avallone latter factor is considered because the EPRA’s Best Practices Committee encouraged the members to adopt fair value accounting to enhance uniformity, comparability and transparency of ? nancial reporting by real estate companies (EPRA, 2006). Additionally, it makes sense to control for the ? m activity since the business segments within t he real estate industry could be considerably different (long-term investments, trading activity, development or services). With reference to the country (CNT), we do not use the distinction between Code Law Countries and Common Law Countries (Ball et al. , 2000), because our sample is entirely made up of Code Law Countries. Since accounting practices usually adhere to ? nancing systems (systems based on banks are generally more conservative than systems based on markets), we decided to capture the country effect with the level of ? ancial market development. So, following Nobes (1998), we theoretically classify countries included in our sample in two groups: countries where the role of ? nancial markets is more developed (capital market-based systems) and countries where ? nancial markets are less developed (credit-based systems). We can assume that the adoption of the fair value method should be easier in capital market based systems, where the indirect cost of information product ion should be lower and the more developed market could better appreciate the informative content of fair value estimates. In order to summarize ? ancial market development, we use the same variable and values as in La Porta et al. (1997). Speci? cally, we ? rstly computed the ratio of stock market capitalization held by minorities to gross national product. Hence, the higher ratio value is associated with highly diffused equity and, as a consequence, with more ? nancially developed markets. Therefore, we adopt a dummy variable coded 1 if the ? rm has an external market capitalization on GNP higher than the average external market capitalization on GNP for its legal country of origin (from La Porta et al. , 1997) and 0 otherwise.The stock market capitalization held by minorities is computed as the product of the aggregate stock market capitalization and the average percentage of common shares not owned by the top three shareholders in the 10 largest non-? nancial, privately owned do mestic ? rms in a given country. The lack of availability of certain data forced us to use the same values estimated by La Porta et al. With reference to the EPRA membership, we only use a dummy variable (EPRA) that takes a value of 1 for ? rms that are EPRA members and 0 otherwise. Lastly, we control for ? rm activity (ACT).Particularly, since real estate companies could operate in many businesses (renting out investment properties, services, trading of investment properties and development), we use a variable to discriminate the ? rms which generally rent out investment properties from ? rms that operate in trading, services and development. Thus, we use the ratio between total rents and total operating income as a proxy of ? rm activity. So, the high values of the ratio suggest that the renting activity may be considered the company’s core business while low values of the ratio express the opposite.Both rents and total operating income are hand-collected from ? nancial sta tements for the ? scal year preceding the IFRS mandatory adoption and the latter Fair Value or Cost Model? 473 has been computed as the sum of rents, services, realized gains/losses on investment property sales and other operating revenues. In terms of empirical predictions, we conjecture a positive relationship between the fair value choice (CHOICE) and both ? nancial market development (CNT) and EPRA membership (EPRA). The present work makes no prediction with respect to the other control variable (ACT).Table 1, Panel A presents the proxies used for independent variables and the predicted sign of each relation between covariates and fair value choice for investment properties under IAS 40. Moreover, Table 1, Panel B only shows the relations between independent variables and the choice to use historical cost with IFRS1 revaluation, if theoretically signi? cant. Sample and Data Our study focuses on a sample of real estate ? rms from countries where a systematic use of fair value mod el was not allowed for investment property assets by pre-IFRS domestic GAAP.A sample of 76 companies was selected from a population of 216 European real estate companies listed in their own country of origin in December 2007 in the following stock markets: Finland, France, Germany, Greece, Italy, Spain and Sweden. In December 2007, the Datastream International database revealed 216 real estate ? rms from the countries that were analysed (235 items, of which 19 were paid rights, preferred share, etc. ). This sample was then screened against a set of conditions: (i) the availability of the full version of the ? rst ? ancial statement complying with IFRS, obtained from the corporate website or via a speci? c request to Investor Relators, (ii) investment property assets on the balance sheet (as de? ned by IAS 40) not equal to zero, and (iii) the full data availability in the Datastream International database. Of the original 216 ? rms, 40 had neither website nor IR contact, 26 had ? nan cial statements not complying with IFRS in the period of analysis (2005– 2007), 7 had no investment properties, 27 failed to respond and 40 ? rms did not have complete availability of data in ? nancial statements or in the Datastream database.Thus, only 76 ? rms had suf? cient information for the above-mentioned explanatory variables to be included in the sample. Table 2, Panel A shows the sample selection procedure. The described procedure clearly illustrates that our sample consists of the maximum number of companies for which it is possible to obtain suf? cient information for the analysis, starting from the initial number of companies identi? ed in the database (N ? 216). Nevertheless, our analysis could have introduced a selection bias if an association between ? rms’ disclosure policies (e. g. assuring the availability of the full ? ancial statement on the corporate website or replying to a speci? c request) and the accounting choice had existed. In order to remo ve any doubts, we test whether there is a difference in drivers of choice used in our analysis between ? rms that provide an annual report or disclose it 474 A. Quagli and F. Avallone Table 1. Proxies and predicted signs for explanatory variables. The variables are grouped according to the main hypotheses for fair value choice and for the choice to use historical cost with IFRS1 revaluation Hypotheses Predicted sign Proxies Explanatory variables Panel A: explanatory variables and fair value choice 1) Contractual ef? ciency The probability of choosing (H1) 2 Debt/asset LEV fair value model decreases (leverage) with higher leverage The probability of choosing (H2) 2 Log of total asset SIZE fair value model decreases with the size (2) Information asymmetry The probability of choosing (H3a) + Market-to-book MTBV the fair value model value increases the higher is information asymmetry (3) Managerial opportunism The probability of choosing (H4) 2 Earning SM the fair value model Smoothing decreases with the extent to Index (dummy which corporate insiders variable) reduce the variability of eported earnings (earnings smoothing) (4) Control variables Firm’s country of origin + External cap/ CNT (? nancial markets GNP (dummy development) variable) EPRA members (European + Yes/no (dummy EPRA Public Real Estate variable) Association) Firm activity ? Total rents/total ACT operating income Panel B: explanatory variables and historical cost with the IFRS1 option (2) Information asymmetry The probability of choosing (H3b) + Market-to-book MTBV the historical cost with value IFRS1 option increases the higher is the information asymmetry after request (the sample) and those that do not.Of course, we could only test the difference between the variables we collected from the Datastream database because we do not have access to the ? nancial statements of non-disclosing ? rm. Thus, we do not control if a difference exists in ? rm activity (ACT) between sampled and non-sampl ed ? rms. Fair Value or Cost Model? 475 Table 2 . Sample selection procedure and breakdown by country Number Panel A: sample selection procedure European Real Estate Firms listed in their own country of origin in December 2007 in the following stock markets (source: Datastream): Finland, France,Germany, Greece, Italy, Spain and Sweden (countries where systematic revaluation of investment properties was not allowed before the IFRS adoption) Excluding the ? rms: – not reporting under IAS/IFRS in the period of analysis (2005– 2007) – with no investment property assets (or with investment properties equal to zero) – with neither website nor IR contact – failing to respond – with insuf? cient data to estimate equation (3) (in ?nancial statements or in Datastream database) Per cent 216 100% 2 26 12% 27 3% 2 40 2 27 2 40 18. 5% 13% 18. 5% Final sample 76 35% Panel B: breakdown of sampled ? ms by country and the number (percentage) of companies sele cting fair value, cost with the IFRS1 revaluation or cost method Country No. of sampled Weight Fair value Cost with the Cost (%) companies (%) (%) IFRS1 (%) Finland France Germany Greece Italy Spain Sweden Total 4 26 22 4 8 4 8 76 5 34 29 5 11 5 11 100 4 (100) 11 (42) 12 (55) 3 (75) 2 (25) 0 (0) 8 (100) 0 (0) 4 (16) 4 (18) 1 (25) 1 (12) 3 (75) 0 (0) 0 (0) 11 (42) 6 (27) 0 (0) 5 (63) 1 (25) 0 (0) Panel B shows the breakdown by country of the sample and the proportion of companies that select fair value, cost with IFRS1 revaluation or cost method without revaluating in each country.We considered companies listed in: Helsinki (Finland), Paris (France), Frankfurt and Munich (Germany), Athens (Greece), Milan (Italy), Madrid (Spain) and Stockholm (Sweden). Of the original 67 non-disclosing ? rms (which have neither website nor IR contact or failed to respond), 34 ? rms did not have complete data availability on the Datastream database. Thus, only 33 ? rms had suf? cient information to be included in the test. For non-disclosing ? rms, we collected data using the same rules as applied in the sample and considering 2005 as a reference date unless companies were still not listed.In that case the reference date has been considered as the listing year. The results show that disclosing ? rms (the sample) are not statistically different from the non-disclosing ? rms in terms of the explanatory variables we selected except for the size ( p-value of 0. 000). 476 A. Quagli and F. Avallone This result is consistent with the literature that shows disclosure levels are usually positively correlated with ? rm size because of the decrease in the cost of disclosure (Lang and Lundholm, 1993). However, we keep the variable in the analysis for two reasons. Firstly, the ? m size (our proxy for political costs) could have both a possible negative relationship with fair value choice and a positive relationship with earnings smoothing (Watts and Zimmerman, 1978). If we do not include the ? rm size in the analysis, a signi? cant negative relation between earnings smoothing and fair value choice could be observed even if the size were the true explanatory variable. Secondly, even if a difference between sampled ? rms and non-disclosing ? rms exists in terms of size, summary statistics show a deviation in size within the sample that does not affect the results of the analysis.With reference to the control variables, among the non-sampled ? rms only one company is an EPRA member. This is an expected result because the EPRA’s objective is to establish best practices in reporting and to provide high-quality information to investors. The result, however, does not introduce a selection bias in the analysis because the sample is made of both EPRA’s members (34 ? rms, around 45% of the sample) and companies that are not (42 companies, 55% of the sample). For these reasons, the results validate our sample and suggest that the sample selection did not introduce a bias into the analysis.We relied on two sources for obtaining data for tests: (i) the ? rst ? nancial statement compliant with IFRS and (ii) the Datastream database. The former source enables us to verify the ? rms’ fair value or cost method choice for investment properties (IAS 40), the choice of ‘fair value as deemed cost’ under IFRS1 and to hand-collect from notes the portion of revenue that is a result of rental activities. The latter source provides all the accounting and non-accounting data we need to de? ne the other explanatory and control variables.Non-accounting data includes market-to-book ratio while the accounting data consists of leverage (debt to asset ratio), total asset, operating income and cash ? ow from the operation (the last two accounting numbers have been used to estimate the earnings smoothing ratio) and the revenues that come from rents. Since the aim of this study is to ? nd out why fair value might be preferred to cost under IAS 40, we have commonly used data which is not in? uenced by the choice. In order to make sense of this key assumption, we referred to different periods for market records and information collected from ? ancial statements when collecting data. Market data refers to the end of the FTA year because the market is in? uenced by IFRS immediately after the FTA year. In other words, immediately after the FTA ? nancial data under IFRS is actually disclosed in ? nancial statements (which explains why the market-to-book value is collected during the last month of the ? rst-time adoption ? scal year). Financial data was collected over the two ? scal years before the FTA. Two years of ? nancial data rather than one year is considered to be more representative of a ? rm’s general characteristics and, in particular, able to reduce the effectsFair Value or Cost Model? 477 that might occur from any unusual or abnormal data from a single year. Only the earnings smoothing ratio required a longer perio d of time; we used a four-year time period before the FTA for both operating income and cash ? ow from operation in order to estimate the related standard deviations. These two values were then compared to detect any earnings smoothing propensity. Financial information about the Swedish ? rms is converted into euros on the date of download from Datastream. Market data was automatically converted by the Datastream database. 6. Analysis of Results Summary StatisticsTable 2, Panel B shows the sample by country breakdown and displays both the number and the proportion of companies that select fair value, fair value with IFRS1 or cost model, respectively, in each country. At ? rst glance, Table 2, Panel B seems to reveal some national patterns in explaining the selection between fair value, historical cost with IFRS1 and cost model without revaluating investment properties. Despite the relatively small number of companies selected in some countries, it has still been possible to observe that companies from Finland, Greece and Sweden are extremely prone to adopting the fair value method.Conversely, Italian companies seem to prefer historical cost without revaluating, Spanish companies have a preference for historical cost with the IFRS1 choice to revalue investment properties, while companies from France and Germany, the main countries in our study in terms of number of companies examined, do not show an a priori preference. Thus, the results justify our choice to control for a country variable through the multivariate analysis. Table 3 presents summary statistics for the full sample of 76 ? rms.It should be noted that the two variables, market-to-book value (MTBV) and leverage (LEV), give rise to outlying observations implied by the values in the minimum and maximum columns of the table. One ? rm in particular had problematic values of both MTBV (value below zero) and LEV (value above one), due to a negative book value and this observation was removed from the anal ysis. Additionally, we isolate the outlying observations by means of the three sigma (standard deviation) rule (Barnett and Lewis, 1994), thus separating companies which have x ? m(x) ? 3s(x) (5) where s(x) is the standard deviation of the variable (x).To remove the possible effects of the outliers on the results, we present both the nonparametric analysis and the multinomial logistic regression excluding these values (N ? 73). 478 Variable Explanatory variables: LEV SIZE MTBV SM Control variables: CNT EPRA ACT Mean Std. dev. Minimum Q1 Median Q3 Maximum 0. 5881 12. 7876 1. 4739 0. 3684 0. 2802 1. 6774 1. 1350 0. 4855 0 8. 2765 2 0. 17 0 0. 4829 11. 9451 0. 965 0 0. 6015 12. 9058 1. 3 0 0. 7235 13. 9800 1. 615 1 2. 07 16. 6882 8. 94 1 0. 4736 0. 4473 0. 4999 0. 5026 0. 5005 0. 3492 0 0 0. 1834 0 0 0. 4551 1 1 0. 7778 0 0 0 1 1 1 LEV ? leverage; SIZE ? og of total asset; MTBV ? market-to-book value; SM ? earnings smoothing (dummy); CNT ? ?nancial market development (dummy); EPRA ? EP RA member (dummy); ACT ? ?rm activity. A. Quagli and F. Avallone Table 3. Summary statistics of explanatory variables for sampled ? rms (n ? 76) Fair Value or Cost Model? 479 Nonparametric Mann – Whitney Test To begin by analysing the characteristics of the ? rms that adopt the fair value method or the historical cost with the IFRS1 revaluation in comparison to those that adopt the historical cost without revaluation, we use a Mann–Whitney twosample rank-sum test.In view of the small size of the three groups, a nonparametric alternative to a conventional t-test is justi? ed because of the less challenging assumptions it requires, although this test has some limitations of its own, including being somewhat less powerful than the t-test. Table 4 shows evident differences across our independent variables, some of which appear statistically signi? cant. Consistent with the information asymmetry hypothesis (H3a), the output shows that there is a statistically signi? cant di fference in MTBV between real estate ? ms that choose the fair value method and real estate ? rms that adopt historical cost without revaluation (difference signi? cant at 0. 000 level). The analysis of both means and median for fair value and cost groups makes the direction of the difference clear (for the fair value group, a mean of 1. 203 and a median of 1. 11 against 1. 775 and 1. 49 for the cost group). The output exhibits a negative relation between the MTBV and the fair value choice, contrary to the prediction derived by the traditional meaning of MTBV as proxy for information asymmetry.In fact, the usual interpretation of high MTBV ratios as a signal of information asymmetry is based on the existence of growth options well known by managers, not revealed by accounting rules and, consequently, not identi? ed by investors. In theory, more growth options for high-tech ? rms in particular, are supposed as a consequence of a large bulk of intangibles whose recognition in ? nancia l statements is not allowed, even though investors can estimate their importance (Smith and Watts, 1992; Amir and Lev, 1996).However, in the real estate industry the relevance of intangibles seems less important than in high-tech ? rms. The main assets are investment properties, whose fair value could be easily estimated by ? nancial analysts. In this context, the meaning of high MTBV ratios might be in direct con? ict with the original intuition. In the cost accounting systems before IFRS adoption, higher values of MTBV ratios revealed growth opportunities associated with a fair estimation of investment properties and therefore with a lower information asymmetry. Conversely, lower MTBV ratios for real estate ? ms adopting the cost method could feasibly be the effect of information asymmetries on investment properties value and managers could prefer to use fair value method to reduce these asymmetries. In more precise terms, under the assumption that disclosure is not equivalent to recognition (Schipper, 2007), lower MTBV ratios estimated before the IFRS adoption for real estate ? rms adopting historical cost should be the result of information asymmetries on investment properties value. Thus, lower MTBV ratios could justify the managers’ preference to the fair value method in order to reduce the asymmetries.This reasoning makes it possible to demonstrate the validity of the hypothesis (H3a), even if the sign of the variable is opposite to the traditional interpretation of the relationship between MTBV and information asymmetry. 480 A. Quagli and F. Avallone Table 4. Mann– Whitney two-sample rank-sum test. Fair Value Group vs. Cost Group (NFV ? 38; NCOST ? 16) and Cost with IFRS1 revaluation vs. Cost Group (NIFRS1 ? 19; NCOST ? 16) Group Explanatory variables: LEV SIZE MTBV SM Control variables: CNT EPRA ACT Z-Statistics Pr . |Z| FV vs. COST IFRS_1 vs. COST FV vs. COST IFRS_1 vs. COST FV vs. COST IFRS_1 vs. COST FV vs. COSTIFRS_1 vs. COST 2 0. 11 4 1. 192 0. 682 0. 762 3. 543 1. 258 0. 814 2 1. 185 0. 909 0. 233 0. 495 0. 446 0. 000 0. 208 0. 415 0. 235 FV vs. COST IFRS_1 vs. COST FV vs. COST IFRS_1 vs. COST FV vs. COST IFRS_1 vs. COST 2 2. 018 2 1. 931 2 1. 007 0. 040 2 3. 523 2 0. 364 0. 043 0. 053? 0. 314 0. 968 0. 000 0. 715 This table presents the Mann–Whitney two-sample rank-sum test for both explanatory and control variables. ? , and indicate statistical signi? cance at less than 10%, 5% and 1% level, respectively. The sample (excluding the outliers) comprises 73 companies from seven countries, split into three groups: ? ms that adopt the fair value model (NFV ? 38), ? rms that choose the historical cost and use the IFRS1 option to revalue investment properties (NIFRS1 ? 19) and ? rms that adopt the cost model without revaluating (NCOST ? 16) for investment properties under IAS 40. LEV ? leverage; SIZE ? log of total asset; MTBV ? market-to-book value; SM ? earnings smoothing (dummy); CNT ? ?nancial market de velopment (dummy); EPRA ? EPRA member (dummy); ACT ? ?rm activity. Furthermore, both the ? nancial market development (CNT) and the ? rm activity (ACT) appear statistically signi? ant as well, with a difference signi? cant at 0. 043 and 0. 000 levels, respectively. The analysis of the means and median for CNT (mean of 0. 5526 and median of 1 for the fair value group against a mean of 0. 25 and median of 0 for the cost group) also shows a direction for the difference consistent with our assumption. Particularly, more developed ? nancial markets (estimated as in La Porta et al. , 1997) with the ratio of stock market capitalization held by minorities to GNP) seem to facilitate the adoption of fair value. Hence, the companies from countries where the role of ? ancial markets is more developed (capital market based systems) appear to view the fair value method more favourably than companies from countries where the markets are less developed (credit-based systems). With respect to the ? rm activity (ACT), we made no prediction of the sign. Both the output and the analysis of the mean and the median (mean of 0. 6558 and median of 0. 7507 for the fair value group against a mean of 0. 3005 and median of 0. 2756 for the cost group) show a positive direction of the difference. The result suggests that the predominant activity of the ? rms that choose the fairFair Value or Cost Model? 481 value model seems to be investment properties’ rental instead of other activities such as development and trading. Renting out properties implies a longer time period than other activities like development or trading, where assets would typically be sold in a shorter time. Thus, we could interpret the relation with fair value choice as the ? rms need to show the market value of their properties on the balance sheet when their realization will be in a longer time (rental activity). This would reduce the information asymmetry otherwise existing if properties were evaluated at cost. Conversely, when the business is more concentrated on development and trading, the need for fair value recognition is less strong, due to a shorter time horizon for the realization of these assets. Further explanatory variables, such as leverage (LEV), dimension (SIZE) and earnings smoothing (SM), appear not to be signi? cant in the univariate analysis. However, even if not signi? cant it seems interesting to highlight that for both the size (SIZE) and the earnings smoothing (SM) the analysis of the mean and median reveals differences coherent with our research proposition, hence larger size and earnings smoothing for ? ms adopting historical cost (for size, mean of 12. 781 and median of 12. 905 for the fair value group against mean of 13. 167 and median of 12. 932 for the cost group; for earnings smoothing, mean of 0. 263 and median of 0 for the fair value group against mean of 0. 375 and median of 0 for the cost group). Except for the ? nancial market development (CNT), neither ex planatory nor control variables seem to explain the managers’ choice to adopt the historical cost with the IFRS1 option to revalue investment properties rather than opting for historical cost without revaluation.As for fair value choice, the analysis of the means and median for CNT (mean of 0. 578 and median of 1 for the IFRS1 group against a mean of 0. 25 and median of 0 for the cost group) shows a direction for the difference consistent with the idea that in countries where the role of ? nancial markets is more developed (capital market based systems), companies seem to view the revaluation of investment properties allowed by IFRS1 more favourably than in countries where the markets are less developed (creditbased systems). Multivariate AnalysisBefore presenting the results of the multinomial logistic regression, we report the Spearman (rank) correlation coef? cients for the variables (Table 5). Considering the following multinomial logistic regression analysis, the depende nt variable has been split into three variables: (i) CHOICE, equal to 0 if companies adopt the historical cost, 1 if companies adopt the historical cost with the IFRS1 revaluation and 2 if ? rms embrace the fair value; (ii) FV vs. COST that only regards as fair value choice (Y ? 1) and historical cost (Y ? 0) and (iii) IFRS1 vs.COST that only takes into account the choice to adopt historical cost with the IFRS1 revaluation (Y ? 1) and the historical cost (Y ? 0). With reference to the dependent variable, Table 5 con? rms the previous univariate 482 Variables CHOICE FV vs. COST IFRS1 vs. COST LEV SIZE MTBV SM CNT EPRA ACT CHOICE – – – 0. 0552 2 0. 0620 2 0. 4343 2 0. 1728 0. 1890 0. 1462 0. 4707 FV vs. COST IFRS1 vs. COST – – 0. 0122 2 0. 0978 2 0. 4745 2 0. 0983 0. 2499? 0. 1356 0. 472 – 2 0. 2045 2 0. 1306 2 0. 2131 0. 2033 0. 3311? 2 0. 0068 0. 0625 LEV SIZE – 0. 1780 0. 1657 2 0. 1818 2 0. 312 0. 0895 2 0. 1136 – 0. 0915 0. 0781 0. 2874 0. 3638 0. 0239 MTBV SM CNT EPRA ACT – 0. 0633 – 2 0. 0826 0. 2091? – 0. 1176 0. 2734 0. 0400 – 2 0. 2627 2 0. 0525 0. 4447 0. 1659 – This table provides Spearman (rank) correlation matrix for both explanatory and dependent variables. Considering the following multinomial logistic regression analysis, dependent variable has been split into three variables: CHOICE, equal to 0 if companies adopt historical cost, 1 if companies adopt historical cost with the IFRS1 revaluation and 2 if ? rms adopt the fair value; FV vs.COST that only regards the fair value choice (1) and the historical cost (0) and IFRS1 vs. COST that only takes into account the choice to adopt the historical cost with IFRS1 revaluation (1) and the historical cost (0). Values indicated in bold show statistically signi? cant relationship between variables. ? , and indicate statistical signi? cance at less than 10%, 5% and 1% levels, respectively (two-tailed). Pearson corr elation shows similar results. LEV ? leverage; SIZE ? log of total asset; MTBV ? market-to-book value; SM ? earnings smoothing (dummy); CNT ? ?nancial market development (dummy); EPRA ?EPRA member (dummy); ACT ? ?rm activity. A. Quagli and F. Avallone Table 5. Spearman (rank) correlation matrix Table 6. Multinomial logistic regression results Panel A: model summary – goodness of ? t Number of obs. ? 73 LR chi2 (14) ? 41. 81 Prob . chi2 ? 0. 0001 Pseudo-R2 ? 0. 2799 Log-likelihood ? 2 53. 766523 Panel B: estimated coef? cients Variable Hypothesis 1 LEV SIZE MTBV SM CNT EPRA ACT Constant LEV SIZE MTBV SM CNT EPRA ACT Constant – – (H3b) – – – – 2 (H1) (H2) (H3a) (H4) Predicted sign + 2 2 + 2 + + ? Coeff. 2 0. 6117228 2 0. 4409383 2 0. 6115429 0. 2741504 1. 900273 0. 8488012 2 0. 708886 6. 279216 1. 734055 2 0. 6789767 2 1. 662586 2 1. 692808 1. 510263 2. 449269 2. 263975 8. 836272 Std. err. 1. 681102 0. 2748586 0. 5957133 0. 8804852 0. 9 408805 1. 124734 1. 421061 3. 866769 1. 715306 0. 289514 0. 6609104 0. 9636362 0. 949826 1. 124299 1. 353768 3. 969725 z 2 0. 36 2 1. 60 2 1. 03 0. 31 2. 02 0. 75 2 0. 68 1. 62 1. 01 2 2. 35 2 2. 52 2 1. 76 1. 59 2. 18 1. 67 2. 23 P . |z| 0. 716 0. 109 0. 305 0. 756 0. 043 0. 450 0. 494 0. 104 0. 312 0. 019 0. 012 0. 079? 0. 112 0. 029 0. 094? 0. 026 95% conf. interval 2 3. 906621 2 0. 9796511 2 1. 779119 2 1. 451569 0. 0561811 1. 355637 2 3. 756117 2 1. 299512 2 1. 627883 2 1. 246414 2 2. 957947 2 3. 5815 2 0. 3513614 0. 2456834 2 0. 3893613 1. 055755 2. 683176 0. 0977746 0. 5560336 1. 99987 3. 744365 3. 053239 1. 81434 13. 85794 5. 095992 2 0. 1115397 2 0. 3672257 0. 1958842 3. 371888 4. 652855 4. 91731 16. 61679 483 (Continued ) Fair Value or Cost Model? LOGIT 484 Panel C: estimated odds ratios LOGIT Variable Odds ratio 1 LEV SIZE MTBV SM CNT EPRA ACT LEV SIZE MTBV SM CNT EPRA ACT 0. 5424156 0. 6434324 0. 5425132 1. 315413 6. 68772 2. 336844 0. 3787464 5. 663571 0. 5071357 0. 189 6479 0. 1840021 4. 527923 11. 57988 . 621254 2 Std. err. 0. 9118557 0. 1768529 0. 3231823 1. 158201 6. 292345 2. 628327 0. 5382217 9. 714756 0. 1468229 0. 1253403 0. 1773111 4. 300739 13. 01925 13. 02494 z 2 0. 36 2 1. 60 2 1. 03 0. 31 2. 02 0. 75 2 0. 68 1. 01 2 2. 35 2 2. 52 2 1. 76 1. 59 2. 18 1. 67 P . |z| 0. 716 0. 109 0. 305 0. 756 0. 043 0. 450 0. 494 0. 312 0. 019 0. 012 0. 079? 0. 112 0. 029 0. 094? 95% conf. interval 0. 0201083 0. 3754421 0. 1687867 0. 2342026 1. 057789 0. 2577831 0. 0233743 0. 1963449 0. 2875341 0. 0519254 0. 0278339 0. 7037294 1. 278495 0. 6774894 14. 63149 1. 102714 1. 743742 7. 388093 42. 8214 21. 18385 6. 137025 163. 3658 0. 8944559 0. 6926533 1. 216386 29. 13348 104. 884 136. 6346 Choice ? 0 (historical cost) is the base outcome. This table presents coef? cients/odds ratios from multinomial logistic regression (MLN). Our model assumes the choice to use the historical cost without revaluating as the baseline outcome category to compare (Y ? 0), and fo rms logits comparing the choice to use the historical cost with the IFRS1 revaluation of investment properties (Y ? 1) and their fair value choice (Y ? 2) to it. We present Wald statistics, log-likelihood and McFadden pseudo-R2. , and indicate signi? cance at less than 10%, 5% and 1% level, respectively. LEV ? leverage; SIZE ? log of total asset; MTBV ? market-to-book value; SM ? earnings smoothing (dummy); CNT ? ?nancial market development (dummy); EPRA ? EPRA member (dummy); ACT ? ?rm activity. A. Quagli and F. Avallone Table 6. Continued Fair Value or Cost Model? 485 analysis results. Our proxy for information asymmetry, the market-to book ratio (MTBV), has a strong negative association with fair value choice, thus discriminating the fair value model group from the cost model group.The result con? rms the above-mentioned interpretation of this sign. Furthermore, both the ? nancial market development (CNT) and the ? rm main business (ACT) condition the choice as well. Conversely , the choice to adopt the historical cost with IFRS1 revaluation is not accounted for by the explanatory variables except for the ? nancial market development (CNT). With reference to independent variables, Table 5 shows that some statistically signi? cant