Katherine Schipper's Presidential Lecture

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  • I appreciate this opportunity to speak with you this morning and I am honored that AAA President Jane Mutchler chose me to be a presidential lecturer. My topic this morning is disclosures. This is a topic that I have considered for many years, as a teacher, a researcher and most recently a standard setter. Disclaimer
  • Financial reports communicate measurements of financial statement items such as assets and liabilities, revenues and expenses, and other information as well. Some communication fits the C/F definition of recognition—depiction in numbers with captions on the face of the statements. Other does not. This other communication is not specifically defined in the C/F. It occurs in notes, supporting schedules and supplementary information. We call those disclosures. Disclosures are in my view very important to financial reporting. It’s not possible to imagine effective financial reports without extensive disclosures because there are items that convey information that will help investors make decisions that cannot be recognized because those items cannot be expressed in currency units. For example, descriptions of accounting policies, summaries of inputs to calculated numbers, sensitivity analyses. A theory of disclosure would have to consider these items as well as items that can be recognized so that either disclosure or recognition is a feasible reporting requirement. They are also increasing in number and complexity and given the nature of projects currently on the FASB’s agenda, I expect this trend to continue. However, disclosures not very well understood. We lack a comprehensive theory of mandatory disclosures; the C/F is largely silent on the purpose of disclosures and we do not fully understand how preparers, auditors and users view disclosures, particularly in contrast to recognized items.
  • Theories of voluntary disclosure face a choice made at the firm level, so an objective function is clearer and perhaps easier to agree on (e.g., maximize firm value or maximize manager utility). Mandated disclosures are policy choices made at the economy level so they affect multiple firms each with its own circumstances and its own multiple contracting parties. Accounting research has been reluctant to posit a social welfare function that should be maximized by the policy maker who sets requirements for disclosures. In addition, theories characterize information signals in terms of their relations to some economic construct , like the terminal value of a firm. The characterizations focus on things like bias, variance, covariance of the signal with something else. This way of characterizing items does not match up well with the standard setter’s task of distinguishing between disclosed and recognized information. More on this distinction later.
  • The FASB has declined on at least one occasion to undertake a formal project on disclosures (1996). There have been several documents issued, for example, ITC in 1980, which noted in very general terms that disclosures must meet decision usefulness and cost benefit tests. Another example was 1995 Prospectus on Disclosure effectiveness which was in part a response to Jenkins Committee recommendation that FASB seek out and eliminate less relevant disclosures. Also Ray Groves May/June 1994 Financial Executive, “ Important information is getting lost in a disclosure forest, because our present system does not distinguish between information that’s critical for decision-making and nonessential data” See also WSJ August 4, 1994, op ed. AICPA Committee on Generally Accepted Accounting Principles for Smaller and/or Closely Held Businesses, 1976 Understand availability of assets for use in the business, payment requirements of liabilities and legal characteristics of equity Accounting principles used, including changes Commitments and contingencies Subsequent events Unusual or infrequent events and transactions Related party transactions
  • General observation about disaggregation to improve prediction is that should group items that behave the same way over time and separate unlike items. However, that is not a practical guideline for standard setter because too general and not operational Behave same way over time => generated by same time series process but this is highly firm specific Also, other disaggregations may be based on persistence (not the same as predictability) and/or risk
  • Original reasoning for +/- 1% change disclosure was that health care cost information was unfamiliar to readers of financial statements (SFAS 106, para 355) Although the original reason has disappeared, the disclosure remains. But the FASB has been reluctant to extend this type of analysis, although it appears in SFAS 140 in the context of retained interests in securitized financial assets (hypothetical effect on fair value of the interests of 2 or more unfavorable variations from the expected levels for key assumptions) para.17g3
  • With regard to pensions, see Basis, para 102 and 104. The Board acknowledged that delayed recognition excludes the most current and relevant information, but the information is included in the disclosures. Para 107 discusses recognition of net pension A or L as difference between PBO and plan assets. “too great a change from past practice to be adopted at this time.” Para 219, reconciliation of B/S sheet amount to funded stated of PBO is essential and amount recognized does not reflect the funded status
  • SFAS 105 seems to be the closest thing to conceptual guidance As a practical matter, recognition and measurement decisions seem to cause disclosure decisions. Decisions about disclosure requirements seem to be made case by case. Recognition and measurement get most of the attention and effort in deliberations.
  • Comments about this: Franco Wong’s paper illustrates the shortcomings of disclosures that existed at the time for determining risk exposures. Subsequent work on SEC requirements shows that those disclosures appear to be sufficient or at least workable My own observation is that this is how the FASB tends to proceed. Most recent example is ED on Business Combinations which lays out context specific objective for disclosures. Problem is, they are tied to the case at hand. Not possible to generalize. And disclosures will grow without limit. Objectives in ED: enable users of financial statements to evaluate (1) the nature and financial effect of business combinations; (2) financial effects of adjustments to accounts made in this period because of business combinations in current or previous period—this would include for example changes in contingent items and deferred tax assets; (3) evaluate changes in carrying amount of goodwill
  • These are just some examples. In all cases, the research design involves choosing an outcome indicator that would change because of the disclosure if the disclosure is effective. This of course requires that the researcher infer or posit the purpose.
  • With regard to changes in organizational structures because of disclosures, lack of data makes systematic investigation difficult Transaction structuring is widely believed to occur in response to any accounting standard that offers an accounting subsidy for certain arrangements (recall the lengths to which ATT went to structure the NCR acquisition as a pooling; see Lys and Vincent 1995). In the case of SFAS 13, the subsidy takes the form of off balance sheet financing with only disclosure of information about the obligation Some researchers believe that contracting uses of accounting information are key, and should affect disclosure versus recognition decisions, specifically, by excluding from recognition relatively less reliable items. For example, Espahbodi et al 2002 argue that the positive share price response to a 12/94 decision by the FASB to permit disclosure only of the fair value of share based payments to employees was due at least in part to alleviating contracting costs. Those researchers argue that requiring recognition would involve no new information so the only effects on security prices would be through contracting and possibly political costs.
  • Although reliability as a concept is not directly part of my topic this morning, I do note, in the observations, that there seems to be disagreement about what exactly this concept means. The FASB’s discussions with constituents make this clear, as do comment letters. Revisiting the whole notion is part of the C/F project. For our purposes, I will simply note that opinions vary as to what exactly is meant, empirically, by reliability. Some believe it is verifiability, meaning able to be confirmed or vouched to an external archival source. Others believe it is verifiability in the C/F sense, meaning the item is characterized by consensus among independent measurers. Still others appear to believe it is precision, or a good estimate of an ultimate settlement amount. With regard to Cotter and Zimmer, use Australian data. Australian accounting standards require disclosure of periodic real estate revaluations. Australian Concepts Statement 4 allows assets to be recognized only when they can be measured reliably. Management characterizations of reliability of disclosures are rare. However, Frederickson et al. report that some pro forma disclosures of share based payments per SFAS 123 are accompanied by a management disavowal of the reliability of the disclosed items. Frederickson et al. 2005 report that users (business school alumni) attend to these disavowals in making judgments based on the pro forma information provided.
  • Return to the first 2 items later; that is revisit the assumption that investors process disclosed and recognized information the same say. Revisit the question of whether there might be differences in reliability among various types disclosures Boone AR 2002 revisits low value relevance of SFAS 69 supplementary disclosures about oil and gas values. Others have said that the values have a lot of measurement error because reserves are hard to estimate and SFAS 69 imposes questionable assumptions (e.g., must use 10% discount rate and current oil price) so clearly not fair values. However he finds that low value relevance due in part, maybe large part, to model misspecification.
  • AU Section 9312 A, Audit Risk and Materiality in Conducting an Audit: Auditing Interpretations of Section 312A. Para 1.02 “In the absence of materiality considerations, a misstatement causes the financial statements not to be in accordance with generally accepted accounting principles. A misstatement may consist of any of the following: A difference between the amount, classification or presentation of a reported financial statement element, account or item and the amount, classification or presentation that would have been reported under generally accepted accounting principles The omission of a financial statement element, account or item A financial statement disclosure that is not presented in accordance with generally accepted accounting principles The omission of information required to be disclosed in accordance with generally accepted accounting principles Special rules for segments (AU Section 9326, Evidential Matter: Auditing Interpretations of Section 326). Para describes segment disclosures. 4.25 says,” …the auditor is not required to apply procedures as extensive as would be necessary to express an opinion on the segment information taken by itself” [consider in context of the entire financial statements] Special rules for related parties (AU Section 334, Related Parties Special rules for required supplementary information e.g. SFAS 69 With respect to materiality judgments, Staff Accounting Bulleting (SAB) 99 issued by SEC in 1999 provides guidance for these judgments. Based on qualitative criteria
  • Materiality standards might distinguish between recognized and disclosed amounts SEC Staff Accounting Bulletin 99—Materiality (August 1999) Materiality implies that the magnitude of the item is such that the judgment of a reasonable person….would have been changed or influenced. But magnitude, by itself, is not sufficient. Both the nature of the item and the circumstances surrounding the materiality judgment matter Item that is capable of precise measurement versus an estimate Item that masks a change in earnings or other trends Item that masks a failure to meet analysts forecasts Item that changes a loss to income or vice versa Item that concerns a segment (or other portion of the business) that plays a significant role in operations or profitability Item that affects compliance with regulatory requirements, with loan covenants or with other contracts Item that affects management’s compensation Item that conceals an unlawful transaction Volatility of returns in response to disclosures Management intent (an amount that is just under a numerical threshold) Location in the statements (example is in small versus large operating segment)
  • Issue is whether the requirement to disclose the “impact” is tantamount to a requirement to disclose an item that will be subsequently recognized and whether, so early in the process of adoption, the measurement’s reliability is lower than when adoption is complete. Davis-Friday et al. note that a number of the SAB 74 disclosures were ranges not point estimates and that ranges appeared to have lower valuation wts than point estimates. My own discussions with practicing professional auditors suggest that SAB 74 disclosures are often vague and state that the impact has not yet been determined.
  • Costs mean having to develop another presentation not just list out items that were aggregated to get the recognized number. In the face of these costs, would management adopt short cuts and practical expedients that have the effect of reducing reliability? Could be most acute when an entire pro forma presentation is required and the information is not used for any internal purpose.
  • In this approach, disclosed items receive lower weight from users because the users don’t understand the disclosures. Barth et al. do not assume that the more salient (easier to process) information is always better quality in the sense of revealing more about intrinsic values. Rather , they consider how varying the relative and incremental quality of the easy-to-use and hard-to-use signals provides insights about how the two signals should be displayed. This consideration is carried out in a strictly disaggregation setting. So, for example, if the hard-to-understand item has high quality, the solution is to show it separately, as a line item, along with the easy-to-understand item.
  • Lambert’s discussion questions this approach, including the requirement that investors who ignore disclosed information also do not use price as a piece of information. He also notes that the necessity of specifying the form of inattention to disclosed information plus the sensitivity of results to the relations between disclosed and recognized behavior reduce the generalizability of the results. If models exist that posit different types of investors who process information differently depending on its placement, and if some archival empirical work either assumes the differences don’t exist or if they do exist, the differences don’t matter, the next logical question is: what do we know about how investors use or don’t use disclosed versus recognized items.
  • The no difference view implies that reliability differences if they exist are not significant, or are adjusted for. View 2 seems to underlie some archival studies, as just discussed View 3 is most easily investigated using experimental studies.
  • Dearman and Shields. Began with 113 students. 25 eliminated because did not or could not understand the task. Of 81 subjects, 24 were judged low on all 3 attributes. Of total subjects used, 63 did not do the necessary analysis to adjust the costs. Of those that did (16), 13 were judged high on all 3 attributes. Two that did an analysis to adjust, but incorrectly, were high on effort and problem solving ability but low on knowledge. In their sample the 3 characteristics were correlated about .20 to .30. Cannot assume that any one is a good proxy for the others. Authors recommend and I concur, a positive focus on characteristics of those who use information in a full information way, not documentation that most (median or average) do not. However, research requires a large number of observations per subject. Dearman and Shields subjects made 32 pricing decisions apiece under each of 2 costing systems. Hirst and Hopkins blatant manipulation. One page display of CI; 2 page display of CI with OCI in OE; information in notes. See App B. May be possible to infer something about expertise/effort/problem solving ability by studying individual responses in other studies as well. For example, Hirst and Hopkins 1998 asked subjects what is growth in NI (easily calculated over 3 years); asked subjects if firm reported CI (it did) and about 50% were able to discern this when OCI shown in OE. When had to derive information from notes, 2 of 15 analysts used that information in explanations of judgments. When had explicit statement, 8 of 17 did and when had OE, 2 of 14 did.
  • Katherine Schipper's Presidential Lecture

    1. 1. American Accounting Association August 2005 Katherine Schipper Financial Accounting Standards Board The views expressed in this presentation are my own and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation. Required Disclosures in Financial Reports Required Disclosures in Financial Reports
    2. 2. <ul><li>Starting point: financial reports are communications </li></ul><ul><li>Purpose of disclosures </li></ul><ul><ul><li>Theory </li></ul></ul><ul><ul><li>Concepts Statement 5 </li></ul></ul><ul><ul><li>Inferences from analyses of specific standards—examples from SFAS 132R, Employers Disclosures about Pensions and Other Post-Retirement Benefits </li></ul></ul><ul><li>Do disclosures achieve their intended purpose? </li></ul><ul><li>Differences between disclosure and recognition </li></ul><ul><ul><li>Are disclosed items less reliable? </li></ul></ul><ul><ul><ul><li>Standard setter perspective </li></ul></ul></ul><ul><ul><ul><li>Auditor/preparer perspective </li></ul></ul></ul><ul><ul><li>Analytical distinctions between disclosure and recognition </li></ul></ul><ul><ul><li>Are disclosed items processed (used) differently? </li></ul></ul>Overview Required Disclosures in Financial Reports
    3. 3. <ul><li>No generally accepted theory of required disclosures </li></ul><ul><ul><li>No agreed-upon objective function for required disclosures </li></ul></ul><ul><ul><li>Logical focus of theory would be providing decision useful information </li></ul></ul><ul><ul><ul><li>Consistent with the FASB’s conceptual framework but too general to provide much guidance </li></ul></ul></ul><ul><ul><ul><li>Example: Required disclosures might reduce information asymmetries </li></ul></ul></ul><ul><ul><ul><ul><li>Between investors and managers </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Among investors </li></ul></ul></ul></ul><ul><ul><ul><li>Example: Required disclosures might require the collection and dissemination of new information </li></ul></ul></ul>Theories of Disclosure Purposes Required Disclosures in Financial Reports Key issue for standard setting : It is difficult to distinguish, analytically, between disclosed information and recognized information.
    4. 4. <ul><li>SFAC 5 describes recognized items explicitly ( but not disclosed items) </li></ul><ul><ul><li>Recognized items meet several criteria, subject to cost-benefit and materiality considerations, and have the best combination of relevance and reliability </li></ul></ul><ul><li>Inference: Disclosure and recognition are not alternatives </li></ul><ul><ul><li>They do not serve the same purpose </li></ul></ul><ul><ul><li>Items that meet the definitions of financial statement elements but fail one or more of the recognition criteria should be disclosed </li></ul></ul>Purpose of Disclosures in the Conceptual Framework Required Disclosures in Financial Reports <ul><li>Observations : </li></ul><ul><li>Seems implausible that standard setters would not require recognition of highly reliable items unless those items utterly lacked relevance. </li></ul><ul><li>Some research presumes that a purpose of disclosures is to report relevant items that are less reliably measured. This inference is consistent with (for example) standards that require disclosure but not recognition of fair values as an interim step. </li></ul>
    5. 5. <ul><li>Describe recognized and unrecognized items </li></ul><ul><li>Provide a useful measure of unrecognized items </li></ul><ul><li>Provide alternative measures of recognized items </li></ul><ul><li>Provide information useful for assessing risks and potentials of recognized and unrecognized items </li></ul><ul><li>Provide interim information while other issues are studied </li></ul><ul><ul><li>Examples: SFAS 36 (Pensions), SFAS 47 (Long term obligations) </li></ul></ul><ul><ul><ul><li>SFAS 81 (Post retirement benefits) </li></ul></ul></ul>Purpose of Disclosures as Stated in SFAS 105 Required Disclosures in Financial Reports <ul><li>Observations : </li></ul><ul><li>SFAS 105 discussion of disclosure purposes is at least partly consistent with inference, from SFAC 5, that disclosure is reserved for less reliable information. </li></ul><ul><li>Examination of specific standards reveals other apparent purposes of disclosures, such as providing information on a required future cash payment (Barth and Murphy, 1994). </li></ul>
    6. 6. <ul><li>Changes in benefit obligations and plan assets </li></ul><ul><li>Long term rate of return assumption for plan assets </li></ul><ul><li>Reconciliation of funded status with recognized amounts </li></ul><ul><li>Components of periodic pension cost </li></ul>Purpose of Disclosures Inferred from Specific Examples: SFAS 132 and SFAS 132R Required Disclosures in Financial Reports Prediction <ul><li>Observations: </li></ul><ul><li>SFAS 132R explicitly mentions assessing earnings quality and predicting earnings. </li></ul><ul><li>Prediction, as a purpose of disclosure, implies disaggregation . </li></ul><ul><li>Some disaggregation disclosures might also have as a goal displaying management’s assumptions. </li></ul>
    7. 7. <ul><li>Observations: </li></ul><ul><li>This type of disclosure would seem to be pertinent to any significant input to a material measurement, although it is not often observed. </li></ul><ul><ul><li>Example : Change in revenues for a 1% change in volume, holding all else constant. </li></ul></ul><ul><ul><li>However, effects of changing one input may be nonlinear and interactive. </li></ul></ul><ul><li>The FASB is also considering ways to show relative measurement uncertainty </li></ul><ul><ul><li>Example: Proposed disclosure, in the FASB’s Fair Value Measurement Statement, to show fair values of disclosed and recognized items by category: </li></ul></ul><ul><ul><ul><li>Observed prices versus measurement techniques and models </li></ul></ul></ul><ul><ul><ul><li>Recurring (e.g., marketable securities) versus intermittent remeasurements (e.g., impaired nonfinancial assets) </li></ul></ul></ul>Purpose of Disclosures Inferred from Specific Examples: SFAS 132 and SFAS 132R Required Disclosures in Financial Reports Display Management Estimates and Assumptions; Measurement Uncertainty <ul><li>Sensitivity of the OPEB obligation and current period costs to a 1% increase and decrease in the health care cost trend rate </li></ul>
    8. 8. <ul><li>Changes in defined benefit pension obligations and plan assets, including unrecognized gains and losses </li></ul><ul><ul><li>Basis for conclusions of SFAS 87 states that a preferable accounting treatment would recognize the net pension asset or liability measured as difference between the plan’s assets and the projected benefit obligation, with immediate recognition of changes in that net asset or liability </li></ul></ul>Purpose of Disclosures Inferred from Specific Examples: SFAS 132 and SFAS 132R Required Disclosures in Financial Reports Alternative Accounting Treatment Implication: Some disclosures are intended to compensate for a recognition/measurement standard that requires (or permits) a less preferred accounting treatment Question to consider : Are these disclosures effective?
    9. 9. <ul><li>Sparse guidance in the Conceptual Framework </li></ul><ul><li>Analysis of disclosure requirements in existing standards </li></ul><ul><ul><li>Inference, from SFAC 5, that disclosures are used to present relevant but less reliably measured items, seems incomplete </li></ul></ul><ul><ul><li>More apparent purposes than are listed in SFAS 105 </li></ul></ul><ul><ul><ul><li>Alleviate noncomparability </li></ul></ul></ul><ul><ul><ul><li>Inputs into measured amounts </li></ul></ul></ul><ul><ul><ul><li>Alternative presentation, because a recognition/measurement standard does not adopt the preferred alternative </li></ul></ul></ul>Inferences about the Purpose of Disclosures, from a Standard Setting Perspective Required Disclosures in Financial Reports <ul><li>Observations: </li></ul><ul><li>Standard setting tension between communicating a conceptually grounded measurement (i.e., recognition) and communicating information that can be used as inputs to measurement. </li></ul><ul><li>Example: Separately measure and recognize components of compound instruments such as convertible debt versus provide detailed disclosures to support user inferences about components. </li></ul>
    10. 10. <ul><li>Identify a specific judgment or decision that could not be made (or could not be made effectively) using recognized items only </li></ul><ul><li>Analyze extant disclosures to determine if they are adequate for that judgment or decision. If not, require disclosures that are sufficient. </li></ul><ul><li>Example: Determining risk exposures to interest rates, foreign currency fluctuations and commodity prices </li></ul><ul><ul><li>SFAS 107, SFAS 119 disclosures are not sufficient (Wong, 2000) </li></ul></ul><ul><ul><li>FRR 48 disclosures are sufficient (Thornton and Welker, 2004 and Linsmeier et al., 2002) </li></ul></ul>A Pragmatic Approach to Disclosures, Based on Assumptions about Specific Judgments/Decisions Required Disclosures in Financial Reports <ul><li>Observations: </li></ul><ul><li>The number of possible specific judgments/decisions is sufficiently large and variable (across users and over time) that this approach would lead to proliferating disclosures – they could grow (almost) without limit. </li></ul><ul><li>This approach appears to be consistent with how standard setters actually establish disclosure requirements. </li></ul>
    11. 11. <ul><ul><li>Identify the purpose and choose an outcome indicator </li></ul></ul><ul><ul><ul><li>Increase ability to predict earnings or another recognized item </li></ul></ul></ul><ul><ul><ul><ul><li>Disaggregating revenues to identify same store sales increases ability to predict revenues and earnings (Cole and Jones, 2004) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>VAR (Value at Risk) disclosures predict variability of trading revenues for banks (Jorion, 2002) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Numerous analyses of segment reporting show that segment disclosures improve earnings predictions (both statistical models and analysts forecasts) </li></ul></ul></ul></ul><ul><ul><ul><li>Provide information to undo noncomparable reporting or create an alternative accounting approach </li></ul></ul></ul><ul><ul><ul><ul><li>Constructive capitalization of operating leases (Imhoff et al., 1991, 1993) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Numerous analyses of LIFO versus FIFO inventory accounting </li></ul></ul></ul></ul><ul><ul><ul><li>Reduce uncertainty </li></ul></ul></ul><ul><ul><ul><ul><li>FRR 48 risk disclosures reduce uncertainty/diversity of opinion about the implications for equity values of changes in certain market interest rates, foreign exchange rates and commodity prices (Linsmeier et al., 2002) </li></ul></ul></ul></ul>Do Disclosures Achieve their Intended Purpose? Required Disclosures in Financial Reports
    12. 12. Do Disclosures Achieve their Intended Purpose? Required Disclosures in Financial Reports An aside on other possible consequences of disclosures <ul><li>Organizational consequences </li></ul><ul><ul><li>Speculation about possible changes in organizational structures because of SFAS 131 segment reporting requirements (Piotroski, 2003) </li></ul></ul><ul><li>Commercial arrangements </li></ul><ul><ul><li>Rearrange leases so as to qualify for operating lease treatment (disclosure only) after SFAS 13 (Imhoff et al, 1988) </li></ul></ul><ul><li>Disclosed items not typically included in contracts </li></ul><ul><ul><li>Disclosing (instead of recognizing) less reliable items facilitates contracting uses of accounting numbers, if efficient contracting requires highly reliable items (Espahbodi et al., 2002) </li></ul></ul><ul><li>Disclosed items not always included in machine-readable commercial databases (but recognized items are) </li></ul>
    13. 13. <ul><li>Management perspective </li></ul><ul><ul><li>If management can choose either to recognize or disclose, does management recognize more reliably measured items? </li></ul></ul><ul><ul><ul><li>Example: Given a choice, managers recognize revaluations for assets that are more reliably measured (e.g., land as opposed to buildings) and disclose other revaluations (Cotter and Zimmer, 2003) </li></ul></ul></ul><ul><ul><ul><li>Example: SFAS 148 transition to voluntary adoption of fair value measurement of share based payments permits disclosure and recognition of similar items in the same period (Balsam et al., 2005) </li></ul></ul></ul>Are Disclosed Items Less Reliable? Archival Evidence Required Disclosures in Financial Reports <ul><li>Observations: </li></ul><ul><li>Requires an ex ante specification of reliability of items. </li></ul><ul><li>Not always clear there is agreement about what is meant by reliability. </li></ul><ul><li>Free choice between disclosure and recognition is rare, and when it exists, the outcome is confounded by self-selection (incentives and other factors unrelated to reliability). </li></ul><ul><ul><li>Questions have been raised about standard approaches used in accounting to deal with self-selection (Larcker and Rusticus, 2005). </li></ul></ul>
    14. 14. <ul><li>Investor perspective: Regress a market variable on disclosed and recognized items </li></ul><ul><ul><li>Smaller valuation weights on disclosed versus recognized items interpreted as evidence of less reliability </li></ul></ul><ul><ul><ul><li>Same firm, disclosure followed by recognition </li></ul></ul></ul><ul><ul><ul><ul><li>Lower valuation weights on OPEB amounts disclosed (per SAB 74) versus recognized (per SFAS 106) (Davis-Friday et al., 1999) </li></ul></ul></ul></ul><ul><ul><ul><li>Same firm, both disclosure and recognition for the same item </li></ul></ul></ul><ul><ul><ul><ul><li>Prior to SFAS 133, only derivatives in certain arrangements were recognized; others were disclosed. Within firms, lower valuation weights on disclosed versus recognized derivatives (Ahmed et al., 2005) </li></ul></ul></ul></ul><ul><li>Investor perspective: Direct estimation of measurement error </li></ul><ul><ul><li>Example: Investors perceive disclosed OPEB liabilities as measured with greater error than recognized OPEB or pension liabilities (Davis-Friday et al., 2004, extending techniques from Barth, 1991 and Choi et al., 1997) </li></ul></ul>Are Disclosed Items Less Reliable? Archival Evidence Required Disclosures in Financial Reports
    15. 15. Observations about archival analyses of investor perceptions Are Disclosed Items Less Reliable? Archival Evidence Required Disclosures in Financial Reports <ul><li>Analyses based on share prices and returns require assumptions about both investors and information items </li></ul><ul><ul><li>Common assumption : Investors process disclosed and recognized items the same way, so that differences in valuation weights (or any other differences) are due to reliability differences </li></ul></ul><ul><li>Drawing inferences about disclosure reliability in general requires assumptions about whether there is differential reliability among various types of disclosures </li></ul><ul><li>Results can be difficult to interpret </li></ul><ul><ul><li>Sensitive to specification (e.g., Boone, 2002) </li></ul></ul><ul><ul><li>Coefficients on recognized items often differ from their theoretical values </li></ul></ul><ul><ul><li>Reasonable confidence intervals for coefficients on disclosed items can encompass both zero and the coefficients on recognized items </li></ul></ul>
    16. 16. <ul><li>Auditor perspective </li></ul><ul><ul><li>Auditors may permit more misstatement in a disclosed item than in a recognized item (Libby et al., 2005) </li></ul></ul><ul><ul><li>Possible reasons </li></ul></ul><ul><ul><ul><li>Auditing standards distinguish between misstatements in notes and on the face of financial statements </li></ul></ul></ul><ul><ul><ul><ul><li>My reading of these standards, plus extensive discussions with auditors, does not support this view </li></ul></ul></ul></ul><ul><ul><ul><li>Auditors applying SAB 99 might make different materiality judgments about recognized versus disclosed items </li></ul></ul></ul>Required Disclosures in Financial Reports Are Disclosed Items Less Reliable? Experimental Evidence Observation: From the auditor’s perspective, management has already developed the item (and thereby affected its properties). Evidence on whether preparers tolerate greater misstatements in disclosed versus recognized items is anecdotal and circumstantial.
    17. 17. <ul><li>SAB 99 does not formally distinguish between recognized items and disclosed items </li></ul><ul><ul><li>Basic principle in SAB 99 defines materiality as affecting the judgment of a reasonable person </li></ul></ul><ul><ul><ul><li>Auditors may believe that judgments of users of financial reports are intrinsically less sensitive to disclosures (because of user characteristics) </li></ul></ul></ul><ul><ul><li>Four key materiality criteria could not affect disclosures because they pertain only to recognized amounts (e.g., an item that converts a loss to income) </li></ul></ul>Required Disclosures in Financial Reports Are Disclosed Items Less Reliable? Materiality Observation : There is a possible circularity. Users rely less on disclosures because they believe disclosures are prepared less rigorously. Preparers and auditors use less rigor in preparing disclosures because they believe users rely less on them.
    18. 18. <ul><li>Longstanding required disclosure, with no immediate expectation of recognition </li></ul><ul><ul><li>SFAS 105, 107, 119: fair values of financial instruments </li></ul></ul><ul><ul><li>Unrealized inventory holding gain for LIFO users </li></ul></ul><ul><li>SAB 74 disclosures, before a new standard is adopted </li></ul><ul><ul><li>Recognition of the disclosed amount is imminent; SAB 74 requirements are very general and disclosures tend to be qualitative </li></ul></ul><ul><ul><ul><li>Discuss the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made. </li></ul></ul></ul><ul><ul><li>Have been used to compare recognition and disclosure, e.g., SAB 74 disclosures versus recognized SFAS 106 amounts analyzed by Davis-Friday et al., 1999. </li></ul></ul>Could Required Disclosures Differ in Reliability? Required Disclosures in Financial Reports Temporary versus (near) permanent disclosure
    19. 19. <ul><li>Disaggregation (details) of a recognized amount </li></ul><ul><ul><li>To the extent there are no new measurements or allocations, preparers (almost surely) incur few or no additional costs </li></ul></ul><ul><ul><ul><li>Examples: List of long term debt instruments, with terms; Inventory components </li></ul></ul></ul><ul><li>Disaggregated presentation based on measurements and allocations that differ from those in recognized amounts </li></ul><ul><ul><li>Cost to prepare varies with the nature of the presentation </li></ul></ul><ul><ul><ul><li>Reconciliations of defined benefit plan assets and obligations </li></ul></ul></ul><ul><ul><ul><li>Revenues, assets and income by segment </li></ul></ul></ul>Could Required Disclosures Differ in Reliability? Required Disclosures in Financial Reports Disaggregations of recognized amounts Question to consider : Under what circumstances would the cost to prepare a disclosure affect its reliability?
    20. 20. <ul><li>Mandated measurement, with disclosure of an alternative </li></ul><ul><ul><li>Bank loans recognized at cost, with impairment and fair values disclosed </li></ul></ul><ul><li>Free choice of measurement, with disclosure of an alternative </li></ul><ul><ul><li>For LIFO users, the FIFO cost of ending inventories </li></ul></ul>Could Required Disclosures Differ in Reliability? Required Disclosures in Financial Reports Alternative measurement attribute <ul><li>Observation: </li></ul><ul><li>This type of disclosure may become more common, because of the FASB’s proposals to permit (but not require) fair value for more measurements. </li></ul><ul><li>Questions to consider: </li></ul><ul><li>With regard to the properties of the disclosed measurement, does it matter whether the recognized measurement is a free choice? </li></ul><ul><li>Research on LIFO users suggests they differ systematically from other firms. Is this result generalizable and if so are there implications for disclosed measurements? </li></ul>
    21. 21. <ul><li>Specify information properties of the item </li></ul><ul><ul><li>Intrinsic and exogenously specified qualities (e.g., bias, variance) </li></ul></ul><ul><ul><li>Differentially affected by management and/or auditor interventions </li></ul></ul><ul><ul><li>Degree to which the item is an imperfect indicator of realized cash flow. The more imperfect the indicator, the more likely the item will be required to be disclosed, not recognized </li></ul></ul><ul><ul><li>Model disclosure versus recognition as two signals </li></ul></ul><ul><ul><ul><li>Recognition: Signal 1 is received by all and interpreted the same way by all </li></ul></ul></ul><ul><ul><ul><li>Disclosure: Signal 2 is private to each investor (like something that is interpreted differently by different investors) </li></ul></ul></ul>Can Differences between Recognized and Disclosed Items be Modeled Analytically? Required Disclosures in Financial Reports <ul><li>Observations: </li></ul><ul><li>This approach seems to be roughly consistent with SFAC 5’s implicit distinction between recognized and disclosed items, based on characteristics of the information. </li></ul><ul><li>If the model treats investors as rational agents who fully understand the properties of the information, placement of the information, per se , will not matter. </li></ul>
    22. 22. <ul><li>Relax assumptions that investors are identical, fully rational and not subject to constraints on ability to process information </li></ul><ul><ul><li>Focus on investor characteristics : Separate disclosure from recognition by characterizing disclosures as harder to understand and process (Barth et al., 2003) </li></ul></ul><ul><ul><ul><li>Two pieces of information are provided, one of which is costless to use </li></ul></ul></ul><ul><ul><ul><li>Investors must incur a cost to gain the expertise necessary to understand the other piece of information, and not all choose to do so </li></ul></ul></ul><ul><ul><ul><li>However, it is still necessary to characterize the information with respect to its informativeness about the attribute of interest to investors </li></ul></ul></ul>Can Differences between Recognized and Disclosed Items be Modeled Analytically? Required Disclosures in Financial Reports Question to consider: If the hard-to-understand information is intrinsically informative about the attribute of interest, should the standard setter try to make that information easier to understand and use and if so, how can this be done? Observation : Required tabular reconciliations of items (e.g., warranties, estimated restructuring costs) are intended to make the information easier to use.
    23. 23. <ul><li>Disclosure differences based on investor characteristics </li></ul><ul><ul><li>Some investors use only salient (i.e., recognized) items and ignore both other (disclosed) items and price (Hirshleifer and Teoh, 2003; see also discussion by Lambert, 2003) </li></ul></ul><ul><ul><li>Pricing outcomes determined by the information processing rule investors use and the relation between the salient and the ignored information </li></ul></ul><ul><ul><ul><li>Example : Predict earnings using the firm’s growth rate ignoring differential growth rates provided by segment disclosures. Pricing determined by relations among recognized and disclosed items, so no general result is possible. </li></ul></ul></ul>Can Differences between Recognized and Disclosed Items be Modeled Analytically? Required Disclosures in Financial Reports <ul><li>Observations : </li></ul><ul><li>Standard setters do not appear to include differential expertise among users in the decision rule for separating recognition from disclosure. </li></ul><ul><li>It is unclear whether commercial databases that do not capture certain disclosures affect overall use of disclosed information. </li></ul>
    24. 24. <ul><li>View 1: No difference </li></ul><ul><ul><li>Once an item has entered the financial reports, location and presentation (face of the financial statements versus notes) have no implications </li></ul></ul><ul><li>View 2: Rational differences </li></ul><ul><ul><li>Location (that is, disclosure in the notes versus recognition on the face of the statements) has implications because the location reveals something about the decision usefulness of the item </li></ul></ul><ul><li>View 3: Differences due to user characteristics and not to intrinsic differences in recognized versus disclosed items </li></ul><ul><ul><li>Users ignore, underweight or process disclosed items differently, perhaps because they lack some combination of problem solving ability, knowledge, and ability and willingness to process disclosed items thoroughly, or perhaps for other reasons </li></ul></ul>Do Users of Financial Statements Process Recognized and Disclosed Items Differently? Required Disclosures in Financial Reports
    25. 25. <ul><li>Research design issues </li></ul><ul><ul><li>What user group should be studied? </li></ul></ul><ul><ul><ul><li>Investors, whose judgments and decisions are aggregated in share prices </li></ul></ul></ul><ul><ul><ul><li>Financial intermediaries (sell-side analysts, buy-side analysts, credit analysts) </li></ul></ul></ul><ul><ul><ul><li>Creditors, whose judgments and decisions are aggregated in lending decisions or the terms of those decisions or their lending contracts </li></ul></ul></ul><ul><ul><ul><li>Internal decision makers (e.g., boards of directors) </li></ul></ul></ul><ul><ul><ul><ul><li>Imhoff, et al., 1995, provide evidence that the determination of CEO compensation appears to disregard operating lease disclosures </li></ul></ul></ul></ul><ul><ul><li>Examples of users in accounting research </li></ul></ul><ul><ul><ul><li>Alumni of a well known business school (Frederickson et al., 2005) </li></ul></ul></ul><ul><ul><ul><li>MBA students with business and investing experience (Maines and McDaniel, 2000; Koonce et al., 2005) </li></ul></ul></ul><ul><ul><ul><li>Nonspecialist buy-side analysts (Hirst and Hopkins, 1998) </li></ul></ul></ul><ul><ul><ul><li>Buy-side analysts with specific expertise in the disclosure being examined (Hirst et al., 2004) </li></ul></ul></ul>Do Users of Financial Statements Treat Recognized Items Differently from Disclosed Items? Required Disclosures in Financial Reports
    26. 26. <ul><li>Yes, based on results of experiments, users appear to underweight (or ignore altogether) disclosures </li></ul><ul><ul><li>Other Comprehensive Income, not shown on a single statement with earnings </li></ul></ul><ul><ul><ul><li>Maines and McDaniel, 2000, focus on nonprofessional investors </li></ul></ul></ul><ul><ul><ul><li>Hirst and Hopkins, 1998, focus on buy-side analysts </li></ul></ul></ul><ul><ul><li>Explicit display of information that can be inferred from a knowledgeable analysis of information that is provided </li></ul></ul><ul><ul><ul><li>Dietrich et al., 2001, focus on students (the information pertains to oil and gas reserves). Reliability considerations do not enter. </li></ul></ul></ul><ul><ul><ul><li>Hirst et al., 2004, focus on bank analysts (the information pertains to fair values that are either shown on the balance sheet and income statement, or can be inferred from recognized information and disclosed information). </li></ul></ul></ul>Do Users of Financial Statements Treat Recognized Items Differently from Disclosed Items? Required Disclosures in Financial Reports
    27. 27. <ul><li>Those with high levels of three attributes (motivation, subject matter knowledge and problem-solving ability) were able to adjust product costing information to take account of bias introduced by using a volume based system (Dearman and Shields, 2005) </li></ul><ul><ul><li>Research design requirements are considerable </li></ul></ul><ul><ul><ul><li>Many observations per subject; may not be feasible in many settings </li></ul></ul></ul><ul><ul><ul><li>Psychometric testing of subjects to determine knowledge, problem solving ability and intrinsic motivation </li></ul></ul></ul><ul><ul><li>Those who lacked a high level of any one of the three attributes did not make the adjustment </li></ul></ul><ul><li>Users rely on salient, readily available information and simple heuristics. They do not make complex calculations that require more knowledge (Imhoff, et al., 1995, Dietrich et al., 2001, Hirst et al., 2004) </li></ul>Why Do Users Treat Disclosed Items Differently? Required Disclosures in Financial Reports Is it competence?
    28. 28. <ul><li>Factors other than knowledge, effort and ability </li></ul><ul><ul><li>Judgments about risk of financial items are a function of both decision theory (probabilities and outcomes) and certain emotional or affective factors (dread and uncertainty) (Koonce et al., 2005) </li></ul></ul><ul><ul><ul><li>Dread includes worry, newness and immediacy </li></ul></ul></ul><ul><ul><ul><li>A key link is amount of potential loss (the loss outcome) which both affects dread and affects risk directly </li></ul></ul></ul>Why Do Users Treat Disclosed Items Differently? Required Disclosures in Financial Reports <ul><li>Observations : </li></ul><ul><li>Certain biases in information processing (e.g., anchoring) appear to be “hard wired.” Incentives (e.g., Kachelmeier and Hobson, 2005) knowledge and ability do not seem to overcome these biases. </li></ul><ul><li>Using certain search-facilitating technology aids (e.g., XBRL) increases the likelihood that disclosed information will be acquired and used (e.g., Hodge et al., 2004). </li></ul>Is it something other than competence?
    29. 29. <ul><li>Existing disclosure requirements are not guided by a general theory or broad conceptual guidance </li></ul><ul><ul><li>Conceptual Framework may imply that disclosed items are distinguishable from recognized items by lower reliability </li></ul></ul><ul><ul><ul><li>Analysis of standards suggests some purposes appear to be derived from assumptions about specific judgments and decisions </li></ul></ul></ul><ul><ul><ul><li>No systematic evidence that standard setters act as if they believe that users cannot understand and use disclosures as easily as they understand and use recognized items </li></ul></ul></ul><ul><li>Research suggests users of financial reports process disclosed information differently from recognized information </li></ul><ul><ul><li>Unclear what causes this difference, and how much it matters for pricing outcomes </li></ul></ul><ul><ul><li>Differences that arise because investors use heuristics, or have hard-wired biases, are difficult to model </li></ul></ul>Concluding Observations Required Disclosures in Financial Reports

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