Template for Bachelor thesis in International Business
Higher Earnings & Cash Flows Volatility
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Fair Value Accounting US GAAP VS IFRS
Higher Earnings & Cash Flows VolatilityInvestors, analysts, and the market require future earnings and cash flow growth rates to value the assets and make better informed economic decisions to move scarce resources within adjusted portfolios (Georgiou and Jack, 2011; Hitz, 2007). Though, as investigated by Hitz (2007) & Schildbach (2011), earnings per share (EPS) weightage in estimating the value of an asset is much less compared to future cash flows, which occupy a significant role in assessing market value. Nevertheless, earnings play an important role in predicting the future profitability of the assets because there can be no growth in cash flows without the increase in profitability (Leslie D. Hodder et al., 2006). Many investors' return metrics such as dividend payout ratios, earnings per share and retention ratio, ROE, and ROA depend on net profitability. Under the historical cost accounting, the P&L statement is driven by operational activities – which mirrors the historical and current profitability of the firm. Un- distorted historical and current profitability performance enables investors to figure out where the firm is heading and how future strategic, business, micro, and macro environment will affect its profitability. Under fair value accounting, the earnings have become more balance sheet centric (Hitz, 2007) which creates distortion and noise in fair value revaluations for PP&E, fair value unrealized gains, and losses for investment properties and financial instruments. According to (Leslie D. Hodder et al., 2006), earnings volatility is five times more under fair value measurement than the historical method due to fair value remeasurements and subsequent revaluation charges. This makes earnings more balance sheet-centric instead of operational-centric (Laux and Leuz, 2009), as shown in fig.9. The impact is negligible for non-financial firms, while the effects of fair value adjustments and revaluations are much more in financial institutions and real estate investment trusts. This is because financial institutions' assets are mainly financial assets, including securities under FVTPL, FVOCI (Trading securities, AFS under fair value measurement in US GAAP), including loans as assets. Real Estate Investment Trusts operate portfolio of investment properties for rental income, which under fair value measurement are reported at fair value on the balance sheet. The change in valuation is reported directly on the income statement. Figure 7 Historical Cost Accounting
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