Executive Summary

Recently issued rules by the Governmental Accounting Standards Board (GASB) will notably change the way state and local governments account for and report the results of their defined benefit pension plans. Some plans may see their reported funded percentages fall under the new requirements. A plan’s funded status will now be reflected on the balance sheet, increasing transparency as well as the focus on measures that plan sponsors are taking to address these shortfalls. Funded status and pension expense measures are also likely to be more volatile under the revised reporting standards.

While the new GASB rules change some important aspects of public DB plan reporting, they do not change others. In particular, they neither mandate use of a lower discount rate for calculating liabilities nor higher contribution requirements. These are changes to accounting and financial reporting, not economics. Nonetheless, they do represent a notable change to the calculation and reporting of various pension-related metrics.

Some public DB plan sponsors are already facing significant challenges, such as relatively low funded levels. In addition, given budgetary challenges, some state and local governments do not have the flexibility to increase contributions at this time. All of this is occurring in an environment where long-term expected returns across a wide variety of asset classes have been falling. The GASB changes may add yet another layer of stress, if not complexity, for some public plan sponsors.

This paper reviews the following aspects of the GASB changes:

…continue reading: A “Sea Change” in Public Pension Reporting on the Horizon

I. High Quality, Independent Auditing is Critical to Our Economic Success.

As I have learned in this job, getting the accounting right is indeed not the same thing as getting the auditing right. My sense from accountants I talk to is that auditing is receiving well-deserved attention in its own right.

Our economic success depends on the confidence of the users of capital and the providers of capital alike. Corporate managers hire internal accountants — many of you here today — to ensure they have accurate and detailed information on which to base management decisions. Managers ignore opportunities to glean trends and insights from this data at their peril.

Mistakes in this information can send a company into a business line or market that squanders resources. We now know that the true cost of financial misstatement is much greater than stock market fallout, concomitant lawsuits and insurance claims.

…continue reading: Enhancing the Relevance, Credibility and Transparency of Audits

I am here to talk about the regulatory initiatives of the Public Company Accounting Oversight Board. The PCAOB is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors.

The auditing profession has developed a highly skilled body of experts capable of analyzing accounts in a way that draws out truths and insights and sheds light on confused or misleading claims. It plays an indispensable role in making our capital markets fair and strong.

But I believe we are in a high risk period that merits more attention to the audit, not less. When companies make lay-offs, as we’ve seen recently, they often affect the internal audit and compliance staff — the first line of defense for fraud and other corporate malfeasance. This should be a concern to the legal community.

Although we have never needed it more, the audit too has, in the minds of some, become a commodity to be contained with other compliance costs.

In the United States, large audit firms’ revenues from consulting are growing 15 percent a year. Audit fees have stagnated at, basically, the inflation rate. Thus audit practices have shrunk in comparison to audit firms’ other client service lines.

This can weaken the strength of the audit practice in the firm overall. The problem is compounded when audit firms turn their talents to other endeavors that may further damage public views on the relevance and value of audit.

To be relevant, the auditor must speak to and for investors. Fair or not, that is in question today.

…continue reading: PCAOB Regulatory Initiatives

In our paper, Fair Value Accounting for Financial Instruments: Does it improve the Association between Bank Leverage and Credit Risk?, which was recently made publicly available on SSRN, we contribute to the debate on whether financial instruments should be measured at fair value in financial statements. Accounting standard setters have been deliberating the role of fair values for financial instruments for decades. A fair value is the price at which two willing parties would exchange an asset or settle a liability. Starting after the savings and loan crisis in the late 1980s, the Financial Accounting Standards Board (FASB) has increased the extent to which financial instruments are recognized at fair value (see Godwin, Petroni, and Wahlen 1998). In 2010, the FASB proposed to require that all financial instruments be recognized at fair value, with limited exceptions for receivables and payables and some companies’ own debt (FASB 2010). The proposal was controversial, with over 2,800 comment letters submitted, the vast majority of which objected to the fair value measurement of loans, deposits, and financial liabilities. The FASB is redeliberating this project and has tentatively decided that all financial instruments should be measured at fair value except certain debt financial assets and most financial liabilities (including deposits), which would be measured at amortized cost (FASB 2011).

To empirically provide insight on the controversy, we assess whether a fair value leverage ratio can explain measures of a bank’s credit risk better than a leverage ratio based on a mixture of fair values and historical costs consistent with the mixed-attribute model of US Generally Accepted Accounting Principles (GAAP) and a leverage ratio based on even fewer fair values than GAAP, which is consistent with regulatory Tier 1 capital. We focus on balance sheet leverage because it is very commonly used for assessing firm risk. We define a bank’s credit risk as the risk that the bank defaults on its obligations, and we focus on credit risk because understanding a bank’s credit risk is essential to understanding its financial condition.

…continue reading: Fair Value Accounting for Financial Instruments

The Financial Accounting Standards Board (“FASB”) voted today to remove from its agenda its outstanding project aimed at modifying the accounting standards applicable to disclosure of loss contingencies.

As noted in prior memos, in 2008 (memo) and 2010 (memo) the FASB issued “Exposure Drafts” of proposed new accounting standards for loss contingencies, including litigation contingencies.  Numerous comments were submitted in response to the exposure drafts, many of which were opposed to enhanced requirements for loss contingency disclosures (memo).

Today’s vote by the FASB to remove this project from the Board’s agenda may reflect a view by the majority of the FASB Board that current requirements under Accounting Standards Codification 450 are sufficient, but the adequacy of corporate loss contingency disclosures may continue to be a subject of compliance and enforcement interest.  For example, as we have noted, the SEC has continued efforts to encourage companies to enhance their disclosure of litigation contingencies and, in particular, to provide estimates of both exposure in excess of established accruals and “reasonably possible” losses or range of losses in actions for which accruals have not been established, or to explain why such estimates cannot be provided (memo).

The Public Company Accounting Oversight Board is proposing a new auditing standard that relates to the auditor’s evaluation of a company’s relationships and transactions with related parties, and amendments to existing auditing standards that relate to significant unusual transactions and financial relationships and transactions by a company with its executive officers (including incentive compensation arrangements). The new and amended standards are intended to focus auditors’ efforts on areas that may pose an increased risk of material misstatement to a company’s financial statements.

The PCAOB’s proposals largely build upon and enhance existing requirements in these areas, primarily by providing greater specificity around the procedures that must be employed and inquiries that must be made. While the proposals would not directly impact the non-financial-statement disclosure (such as proxy disclosure) relating to related party transactions and executive compensation under SEC rules, companies should anticipate greater auditor focus and additional audit procedures on the financial statement impact of these areas if these proposals are adopted.

Subject to SEC approval, the new and amended standards would be effective for audits of financial statements for fiscal years beginning on or after December 15, 2012. The deadline for public comment is May 15, 2012.

…continue reading: New PCAOB Auditing Standards

In our forthcoming Journal of Financial Economics paper, Stock Options and Managerial Incentives for Risk Taking, we exploit the change in the accounting treatment of stock-based compensation under FAS 123R, which was issued by the Financial Accounting Standards Board (FASB) and took effect in December 2005, to provide new evidence on the role that convexity in compensation contracts plays in providing incentives for risk taking by managers.  An additional rationale that is often stated for the dramatic rise in option-based compensation over time revolves around how stock options were treated for accounting purposes. Prior to the implementation of FAS 123R, firms were allowed to expense stock options at their intrinsic value. Because nearly all firms granted stock options at-the-money, no expenses for option-based compensation were generally reported on the income statement.

Hall and Murphy (2003) argue that, due to their favorable accounting treatment and the fact that there is no cash outlay at the time of the grant, firms act as though the perceived cost of options is lower than their true economic cost. If firms make decisions based on the perceived costs instead of the economic costs, they grant more options than they would otherwise, and options with their favorable accounting treatment are preferred to possibly better incentive plans with less favorable accounting treatment. Consistent with this view, Carter, Lynch, and Tuna (2007) provide evidence that the accounting treatment of stock options affected their use, showing that a comprehensive proxy for financial reporting concerns was positively related to the use of stock options prior to FAS 123R. The implementation of FAS 123R eliminated the ability to expense options at their intrinsic value and instead required firms to begin expensing stock-based compensation at its fair value, effectively eliminating any accounting advantages associated with stock options.

…continue reading: Stock Options and Managerial Incentives for Risk Taking

In the paper, Mandatory IFRS Adoption and the Contractual Usefulness of Accounting Information in Executive Compensation, forthcoming in the Journal of Accounting Research, we investigate the contracting implications of the transition to IFRS. Specifically, we examine how the mandatory adoption of IFRS affects the contractual usefulness of accounting information in executive compensation, as reflected in pay-for-performance sensitivity (PPS) and relative performance evaluation (RPE). These tests allow us to infer whether compensation committees of European companies view IFRS as leading to increased earnings quality and comparability.

The mandatory adoption of International Financial Reporting Standards (IFRS) on January 1, 2005, by the European Union (EU) and several other countries (e.g., Australia; South Africa) marks major progress toward a single set of high-quality, globally accepted accounting standards (Daske et al., [2008]). IFRS is primarily aimed at enhancing earnings quality and achieving a high degree of comparability of financial statements (Regulation (EC) No. 1606/2002 of the European Parliament and of the Council). The extant research, however, has provided mixed evidence on whether mandatory IFRS adoption has achieved these goals (e.g., Barth et al., [2008], Ahmed et al. [2010], DeFond et al. [2011], Lang et al. [2010]).

…continue reading: Mandatory IFRS Adoption, Accounting Information, and Executive Compensation

In our paper, The Role of Accounting in the Financial Crisis: Lessons for the Future, which was recently made publicly available on SSRN, we discuss the causes of the financial crisis, with particular focus on the debated role of the relevant U.S. accounting standards, and summarize implications for accountants and accounting regulators based on the effect of these existing rules.

The Great Recession that started in 2008 has had significant effects on the US and global economy; estimates of the amount of US wealth lost are approximately $14 trillion (Luhby 2009). Various causes of the financial crisis have been cited, including lax regulation over mortgage lending, a growing housing bubble, the rise of derivatives instruments such as collateralized debt obligations, and questionable banking practices. In addition to these and many other reasons, we explain two factors that partially contributed to the crisis: certain management incentives and fair value accounting standards.

…continue reading: The Role of Accounting in the Financial Crisis

In my paper, Managerial Investment and Changes in GAAP: An Internal Consequence of External Reporting, which was recently made publicly available on SSRN, I investigate whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. I hypothesize that the relation between changes in GAAP and investment manifests for at least two non-mutually exclusive reasons. First, I hypothesize that changes in GAAP can affect investment because the numbers reported in financial statements have a direct bearing on contractual outcomes. For example, debt contracts often contain covenants based on numbers reported in financial statements (Leftwich [1983]). Consequently, if a change in GAAP has an unfavorable (favorable) impact on current and future financial statements, and debt covenants are not adjusted to incorporate the changes, the change in GAAP will likely tighten (loosen) covenant slack. As a result, managers may alter their actions to avoid covenant violation. Specifically, since most investments have an uncertain future outcome and some positive probability that the outcome is a loss, they increase the probability of violating covenants in the future by adversely impacting future financial ratios. Consequently, managers might respond to changes in GAAP that adversely affect financial statements by cutting investment in risky assets with the goal of preserving net worth and preventing deterioration of financial ratios.

…continue reading: Managerial Investment and Changes in GAAP