You are on page 1of 190

Volume 5, Number 2

ISSN 1096-3685

ACADEMY OF ACCOUNTING AND FINANCIAL STUDIES JOURNAL

An official Journal of the Allied Academies, Inc.

Phil Little, Western Carolina University Accounting Editor Denise Woodbury, Weber State University Finance Editor Academy Information is published on the Allied Academies web page www.alliedacademies.org

The Academy of Accounting and Financial Studies is a subsidiary of the Allied Academies, Inc., a non-profit association of scholars, whose purpose is to support and encourage research and the sharing and exchange of ideas and insights throughout the world.

Printed by Whitney Press, Inc. PO Box 1064, Cullowhee, NC 28723 www.whitneypress.com

hitney Press, Inc.

Authors retain copyright for their manuscripts and provide the Academy with a publication permission agreement. Allied Academies is not responsible for the content of the individual manuscripts. Any omissions or errors are the sole responsibility of the individual authors. The Editorial Board is responsible for the selection of manuscripts for publication from among those submitted for consideration. The Publishers accept final manuscripts on diskette and make adjustments solely for the purposes of pagination and organization.

The Academy of Accounting and Financial Studies Journal is owned and published by the Allied Academies, Inc., PO Box 2689, 145 Travis Road, Cullowhee, NC 28723, (828) 293-9151, FAX (828) 293-9407. Those interested in subscribing to the Journal, advertising in the Journal, submitting manuscripts to the Journal, or otherwise communicating with the Journal, should contact the Executive Director at www.alliedacademies.org.

Copyright 2001 by the Allied Academies, Inc., Cullowhee, NC

iii

ACADEMY OF ACCOUNTING AND FINANCIAL STUDIES JOURNAL

CONTENTS
LETTER FROM THE EDITORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v CLASSIFICATION OF FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH DEBT AND EQUITY: EVIDENCE CONCERNING CONVERTIBLE REDEEMABLE PREFERRED STOCK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Mark G. McCarthy, East Carolina University Douglas K. Schneider. East Carolina University AUDITOR CONCENTRATION WITHIN CLIENT INDUSTRIES . . . . . . . . . . . . . . . . . . . . . 15 James H. Scheiner, Northern Michigan University Clark M. Wheatley, Florida International University THE USEFULNESS OF ACCOUNTING INFORMATION IN ASSESSING SYSTEMATIC RISK: A RE-EXAMINATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Ronald J. Woan, Indiana University of Pennsylvania COMPENSATION OF INVESTMENT COMPANY ADVISORS: AN EMPIRICAL INVESTIGATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Denise Woodbury, Weber State University Kyle Mattson, Weber State University EARNINGS MANAGEMENT USING PENSION RATE ESTIMATES AND THE TIMING OF ADOPTION OF SFAS 87 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Marianne L. James, California State University, Los Angeles

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

iv

EARNINGS RESPONSE TO AUDITOR SWITCHES USING A MULTI-TIERED AUDITOR CLASSIFICATION . . . . . . . . . . . . . . . . . . . . 85 Ronald A. Stunda, Birmingham-Southern College David H. Sinason, Northern Illinois University ACCOUNTING FOR ACQUISITIONS AND FIRM VALUE . . . . . . . . . . . . . . . . . . . . . . . . . 99 Oliver Schnusenberg, St. Joseph's University W. Richard Sherman, St. Joseph's University LEASE FINANCIAL STATEMENT ACCOUNTING PRACTICES TYPES AND NUMBERS FOR HONG KONG . . . . . . . . . . . . . . . . . . . 117 Gary A. Miller, Texas A&M International University COMPREHENSIVE INCOME REPORTING CONCERNS . . . . . . . . . . . . . . . . . . . . . . . . . . 133 R. David Mautz, Jr., North Carolina A&T State University Ida Robinson-Backmon, University of Baltimore THE UK INVESTOR AND INTERNATIONAL DIVERSIFICATION . . . . . . . . . . . . . . . . . 143 Michael E. Hanna, University of Houston-Clear Lake Joseph P. McCormack, University of Houston-Clear Lake Grady Perdue, University of Houston-Clear Lake A NEW STOCK OPTION PLAN AND ITS VALUATION . . . . . . . . . . . . . . . . . . . . . . . . . . 155 Anthony Yanxiang Gu, State University of New York, Geneseo THE IMPACT OF THE AMERITRADE ONLINE INVESTOR INDEX ON THE AUTOCORRELATIONS AND CROSS-CORRELATIONS OF MARKET RETURNS . . . . . . . . . . . . . . . . . . . 165 Thomas Willey, Grand Valley State University LOAN PRICING: A PRICING APPROACH BASED ON RISK . . . . . . . . . . . . . . . . . . . . . . 175 James B. Bexley, Sam Houston State University Leroy W. Ashorn, Sam Houston State University Joe F. James, Sam Houston State University

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

LETTER FROM THE EDITORS


Welcome to the Academy of Accounting and Financial Studies Journal. The Academy of Accounting and Financial Studies is an affiliate of the Allied Academies, Inc., a non profit association of scholars whose purpose is to encourage and support the advancement and exchange of knowledge, understanding and teaching throughout the world. The AAFSJ is a principal vehicle for achieving the objectives of the organization. The editorial mission of this journal is to publish empirical and theoretical manuscripts which advance the discipline. Dr. Philip Little, Western Carolina University, is the Accountancy Editor and Dr. Denise Woodbury, Weber State University is the Finance Editor. Their joint mission is to make the AAFSJ better known and more widely read. As has been the case with the previous issues of the AAFSJ, the articles contained in this volume have been double blind refereed. The acceptance rate for manuscripts in this issue, 25%, conforms to our editorial policies. The established mission of fostering a supportive, mentoring effort on the part of the referees which will result in encouraging and supporting writers. Phil and Denise will continue to welcome different viewpoints because in differences we find learning; in differences we develop understanding; in differences we gain knowledge and in differences we develop the discipline into a more comprehensive, less esoteric, and dynamic metier. Information about the Allied Academies, parent organization of the AAFS, the AAFSJ, and the other journals published by the Academy, as well as calls for conferences, are published on our web site. In addition, we keep the web site updated with the latest activities of the organization. Please visit our site and know that we welcome hearing from you at any time. Phil Little, Western Carolina University Denise Woodbury, Weber State University www.alliedacademies.org

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

vi

MANUSCRIPTS

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

CLASSIFICATION OF FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH DEBT AND EQUITY: EVIDENCE CONCERNING CONVERTIBLE REDEEMABLE PREFERRED STOCK
Mark G. McCarthy, East Carolina University Douglas K. Schneider. East Carolina University
ABSTRACT This study examines the market perception of a compound financial instrument, convertible redeemable preferred stock (CRPS). CRPS has the form of preferred stock, but also possesses a redemption feature and a conversion feature. Accounting for such instruments is the subject of a pending exposure draft by the Financial Accounting Standards Board. Current accounting rules for CRPS require that it be excluded from equity, but not classified as debt. A sample of firms reporting CRPS for fiscal years 1991 through 1995 is examined using a levels approach. The findings suggest that the market perceives CRPS as debt in two out of the five years under study. In the other three years the evidence is less convincing, raising the question as to whether current accounting rules classify CRPS according to how it is perceived by investors. The results would appear to support the FASB's decision to consider a new accounting standard for instruments with characteristics of both debt and equity. This study is timely and sheds light on an issue under deliberation by accounting standard setters. INTRODUCTION Compound financial instruments are securities that have characteristics of both debt and equity. This study addresses one type of compound financial instrument called convertible redeemable preferred stock (CRPS). Specifically, investor perception of CRPS is examined and based on the findings, implications are discussed in regard to accounting for CRPS. CRPS is a type of preferred stock that contains a debt-like redemption feature requiring the issuer to pay the holder the par value for the preferred stock at a specified redemption date. The redemption feature is similar to the maturity value and date of a debt instrument. In addition, CRPS possesses a conversion feature that allows the holder the option to convert CRPS into common stock, similar to the conversion feature available on convertible debt instruments. In spite of the substance of CRPS, it has the form of "preferred stock" and is accounted for in the U.S. according to current accounting rules for redeemable stock. Examples of recent issuances of CRPS include a $15 million issuance by Frontline Communications Corporation and Mpower Communications Corporation's $207 million issuance, both in February 2000. In the United States (U.S.), redeemable preferred stock is currently accounted for as 'temporary equity'. According to the Securities and Exchange Commission's (SEC) Accounting Series Release No. 268, "Presentation in Financial Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

2 Statements of Redeemable Preferred Stocks" (Securities and Exchange Commission 1979), redeemable preferred stock should be reported below debt but above stockholders' equity on the balance sheet. Since redeemable preferred stock is not considered debt, the distributions related to redeemable preferred stock are treated as dividends and are not reported on the income statement. Research investigating CRPS is both timely and relevant. In the U.S., accounting for compound financial instruments, such as CRPS, is under deliberation by standard setters. A decade ago the Financial Accounting Standards Board (FASB), the U.S. body that issues accounting standards, issued a Discussion Memorandum entitled "Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both." It discussed alternatives from current reporting standards for compound financial instruments (FASB, 1990). In 1997 the FASB formally added redeemable preferred stock and convertible debt instruments to its active agenda (FASB 1997). More recently, March 2000, the FASB announced its tentative decisions on how to approach accounting for compound instruments (FASB 2000). As it relates to CRPS, the FASB would classify it as a liability because, in the absence of the holder exercising a right to convert the security, the issuer is required to settle the obligation by transferring assets, e.g., cash. In essence, the FASB considers CRPS to be a debt instrument. If CRPS is in substance a debt instrument, as stated in the previous sentence, then taking in to account its conversion feature, CRPS should be considered a convertible debt instrument. The FASB also announced in March 2000 that it would require the proceeds from a convertible debt issuance to be segmented into separate debt and equity components. The equity component represents the value of a call option giving the right of a holder to exchange convertible debt for shares of the issuing firm's stock. The tentative decision by the FASB mentioned in the preceding paragraph (FASB 2000) for a new accounting standard applicable to CRPS is in contrast to the current standard that requires CRPS to be excluded from both debt or equity and reside in 'temporary equity' (Securities and Exchange Commission 1979). In so far as that CRPS is in substance a convertible debt instrument (as the FASB's tentative proposal would suggest), the current accounting rule requires that convertible debt be classified as entirely debt, without any separation of the instrument into debt and equity components. The FASB issued an exposure draft for new accounting standards for compound instruments applicable to CRPS in October 2000, with the expectation that the new standard would be effective for fiscal years beginning after June 15, 2002. Due to the anticipated issuance of an exposure draft and the deliberations in response to the exposure draft, it would appear that research addressing the market perception of a compound financial instrument would be of significant interest to the financial reporting community. This study empirically examines the market perception of CRPS for fiscal years 1991 through 1995 by employing a levels approach research design. The findings of this study suggest that CRPS is perceived as debt for sample firms, consistent with the FASB's tentative approach to such financial instruments. The results of this study provide insights into investor perception of a compound financial instrument and challenge current accounting rules for CRPS. Such insights should be pertinent to the FASB's deliberation on a new accounting standard for financial instruments.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

3 RESEARCH DESIGN AND MODEL DEVELOPMENT The objective of this study is to provide evidence concerning the market perception of CRPS to the equity value of a firm using a levels approach. Landsman (1986) uses balance sheet elements to explain the variation in the market value of stockholders' equity. The market value of stockholders' equity, ME, is given by: ME = B 1 MA + B 2 ML + u (1)

where MA equals the market value of a firm's assets and ML represents the market value of a firm's liabilities. Landsman uses the model in equation (1) with book values for assets and liabilities to test the market's perception of firms' pension assets and liabilities. Ayers (1998) uses the same model with assets and liabilities to test the value relevance of firms' net deferred tax liabilities, net pension liabilities, and post-retirement benefits. Regressions similar to equation (1) above have been used in other studies to examine the relationship between stock market valuation and the accounting treatment for various balance sheet items and disclosures. Barth (1991) and Gopalakrishnan and Sugrue (1993) estimate regressions to examine the accounting treatment for pension fund assets and liabilities. In other studies employing different versions of the model, Harris and Ohlson (1987) investigate the accounting treatment for oil and gas properties, Shevlin (1991) examines accounting treatment for research and development limited partnerships and Barth (1994) examines the accounting treatment for holding gains and losses on investment securities held by banks. Barth, Beaver and Landsman (1996) examine the value relevance of fair value disclosure of banks under Statement of Financial Accounting Standard (SFAS) No. 107 and Amir (1996) examines the value relevance of financial disclosures under SFAS No. 106. Hughes (2000) a explored non-financial measure, air pollution, in the electric utility industry and its association with the market value of the firm. Ohlson (1995), however, models the value of a firm with the inclusion of an income variable in addition to the balance sheet. This is based on Ohlson's conclusion that the market value of a firm is a function of both the balance sheet and income statement. In this study, the hypothesis testing examines the relationship between stock prices and CRPS as a separate independent variable. The following regression equation is estimated to test how the market perceives CRPS: ME i = B 0 + B 1 ASSET i + B 2 LIAB i + B 3 CRPS i + B 4 NI i + u where: ME ASSET LIAB CRPS NI = = = = = (2)

market value of common stock at fiscal year-end, book value of assets, book value of liabilities, book value of convertible redeemable preferred stock net income before extraordinary items 1

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

4 ADDITIONAL PROCEDURES Several econometric problems may be encountered with regression equations employing the levels approach used in this study. Two of these potential problems are addressed here: heteroscedasticity and multicollinearity. Heterocedasticity occurs since large firms tend to have large errors and small firms usually have small errors. The result produces the understatement of standard errors resulting in t-statistics that are overstated. T-statistics which are greater than their true values can lead to concluding that a variable is significant in explaining the variation of the dependent variable when in fact it is not significant. There are methods to mitigate the effects of heteroscedasticity. One common technique is deflation. For each firm observation in the sample this involves adjusting all variables in the regression model by a deflator. In this study, each variable is deflated through division of the number of common shares outstanding. The estimates of regression coefficients are unbiased in the presence of multicollinearity. However, there are several potential problems including the imprecision of estimation (high sampling variances) and a high degree of sensitivity of the estimates of the coefficients to particular sets of sample data. The existence of multicollinearity may create the potential for drawing misleading inferences from the t-statistics. Specifically, even though the t-statistics are unbiased (given there are no other econometric problems), it is hard to determine if the sampling variances are large because of multicollinearity, or whether the variance of the true population is large. In the model employed in this study, CRPS, the variable of primary interest, is not suspected of multicollinearity. It is expected that ASSET and LIAB will be highly correlated. Therefore, the model is also estimated in a net form where assets and liabilities are combined to form a single variable, "net assets". Multicollinearity should be mitigated by use of the reduced model where assets and liabilities are combined. SAMPLE SELECTION To address the research issue in this study a sample is constructed of firms reporting CRPS for the fiscal years 1991 through 1995. The Compustat data base provides all the necessary data. Compustat does not report a specific data item for CRPS. However, it reports a data item for convertible preferred stock (without regard to whether it is redeemable) and a separate data item for redeemable preferred stock (without regard to whether it is convertible). Amounts of preferred stock that are both convertible and redeemable are determined by identifying firms where all of the firms' preferred stock is both redeemable and convertible. Thus, firms are identified that report the same dollar amounts for the Compustat data items for preferred stock (data item A130), redeemable preferred stock (data item A175) and convertible preferred stock (data item A214). The integrity of the study would be compromised if observations of convertible preferred stock included non-redeemable preferred. To further confirm that all the convertible preferred stock is redeemable, another Compustat data item, nonredeemable preferred stock (data item A209), is collected. Nonredeemable preferred stock is found to equal zero for each firm in the sample, thus confirming that all convertible preferred stock is also redeemable preferred stock.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

5 Thus, firms included in this study are those reporting a positive net income before extraordinary items and equal dollar amounts for preferred stock (data item A130), redeemable preferred stock (data item A175) and convertible preferred stock (data item A214). One other screening criterion is that each firm must report at least $1,000 of market value. (Market value is the Compustat 'concept' MKVALF, consisting of data item A199 multiplied by data item A25). Market value is the dependent variable in this study. This screening process generated the number of firms used in the regression models in this study as described in the following table. The results of the model are discussed in the next section.
Year 1991 1992 1993 1994 1995 Total Number of Firms 41 45 42 50 53 231

RESULTS Table 1 presents summary statistics for all of the deflated variables, dependent and independent, used in the regression model for the years 1991-1995. CRPS, the variable of primary interest, ranges from $0.01 per share to $17.64 per share across all five years. The mean of CRPS ranges from $1.14 per share in 1992 to $2.25 per share 1994, while the median of CRPS ranges from $0.55 per share to $0.95 per share. Table 2 presents summary statistics for the sample of firms related to the mean and median percentage of CRPS to total liabilities and to total assets. Both percentages increase from the first year, 1991, to the last year, 1995. The mean CRPS/LIAB ratio percentages range from 10.1% in 1992 to 16.4% in 1995. The lowest mean CRPS/ASSET ratio percentage is 6.3% in 1992 and reaches a maximum of 10.5% in 1995. The median CRPS/LIAB ranges from 5.6% in 1992 to 10.5% in 1995. The median CRPS/ASSET ranges from 3.6% in 1992 to 5.4% in 1995. In each year the mean is greater than the median. Since multicollinearity is a potential problem with the regression model, several diagnostics are used to check for its presence. The Pearson correlation coefficients are presented in Table 3. As expected, the correlation between ASSET and LIAB is greater than 0.97 in all of the years examined suggesting a high degree of multicollinearity among these variables. The correlation between the variable of interest, CRPS, and the other independent variables varies over the five-year sample period. The year with the highest correlations is 1993 where the correlation between CRPS and the independent variables AT and LT are .7159 and .6854 respectively. In 1995 the correlation between CRPS and the other balance sheet variables is not significant. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

TABLE 1 DESCRIPTIVE STATISTICS FOR VARIABLES USED IN ESTIMATING THE REGRESSION MODEL (Deflated - $ Per Share) YEA R 1991 N=41 VARIABLE ME ASSET LIAB CRPS NI ME ASSET LIAB CRPS NI ME ASSET LIAB CRPS NI ME ASSET LIAB CRPS NI ME ASSET LIAB CRPS NI MEAN 11.09 19.77 13.15 1.37 0.67 11.72 24.21 16.88 1.14 0.69 13.21 24.85 17.73 1.63 0.93 13.60 37.60 29.60 2.25 1.08 15.55 36.09 27.95 1.65 0.97 MEDIAN 8.26 13.72 7.38 0.62 0.51 10.37 16.46 12.35 0.55 0.49 10.40 14.87 12.83 0.60 0.49 11.81 29.69 16.17 0.79 0.75 12.00 18.03 11.37 0.95 0.72 MINIMUM 0.46 0.77 0.20 0.01 0.01 0.31 0.57 0.20 0.01 0.01 1.53 1.45 0.25 0.01 0.01 1.62 0.92 0.39 0.01 0.01 0.04 0.69 0.27 0.01 0.01 MAXIMUM 38.37 93.15 70.19 9.73 4.31 37.60 136.39 107.64 9.21 2.99 57.70 118.52 101.06 12.80 4.21 55.25 181.76 170.37 17.64 4.59 65.37 460.54 426.11 16.41 4.84

1992 N=45

1993 N=42

1994 N=50

1995 N=53

ME: Market Value of Common Stockholders' Equity ASSET: Book Value of Total Assets LIAB: Book Value of Total Liabilities CRPS: Convertible Redeemable Preferred Stock NI: Net Income or Loss Before Extraordinary Items

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

7
TABLE 2: CONVERTIBLE REDEEMABLE PREFERRED STOCK AS A PERCENTAGE OF LIABILITIES AND ASSETS YEA R 1991 N=41 1992 N=45 1993 N=42 1994 N=50 1995 N=53 RATIO CRPS/LIAB CRPS/ASSET CRPS/LIAB CRPS/ASSET CRPS/LIAB CRPS/ASSET CRPS/LIAB CRPS/ASSET CRPS/LIAB CRPS/ASSET MEAN 11.9% 7.6% 10.1% 6.3% 12.9% 7.0% 12.5% 9.1% 16.4% 10.5% MEDIAN 6.7% 4.6% 5.6% 3.6% 7.3% 4.3% 5.7% 4.1% 10.5% 5.4% LIAB: Book Value of Total Liabilities STD DEV 13.5 8.1 14.2 8.3 15.3 7.8 17.9 15.9 20.1 14.6

ASSET: Book Value of Total Assets CRPS: Convertible Redeemable Preferred Stock

TABLE 3: PEARSON CORRELATION COEFFICIENTS FISCAL YEARS 1991 - 1995 1991 MKVALF AT LT PSTKC NI 1992 MKVALF AT LT PSTKC NI 1993 MKVALF AT LT PSTKC NI ME 1.0000 AT 0.5044* 1.0000 LT 0.4053* 0.9789* 1.0000 CRPS 0.1902 0.7159* 0.6854* 1.0000 ME 1.0000 AT 0.5550* 1.0000 LT 0.5267* 0.9874* 1.0000 CRPS 0.1645 0.3183* 0.2855 1.0000 ME 1.0000 AT 0.6018* 1.0000 LT 0.5475* 0.9772* 1.0000 CRPS 0.2132 0.5342* 0.5402* 1.0000 NI 0.4594* 0.2725 0.2399 0.6202* 1.0000 NI 0.6158* 0.2136 0.2027 0.2778 1.0000 NI 0.7698* 0.7419* 0.7011* 0.5256* 1.0000

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

8
TABLE 3: PEARSON CORRELATION COEFFICIENTS FISCAL YEARS 1991 - 1995 1994 MKVALF AT LT PSTKC NI 1995 MKVALF AT LT PSTKC NI * Significant at the 0.05 level ME 1.0000 AT 0.3169* 1.0000 LT 0.2472 0.9944* 1.0000 CRPS 0.0375 0.0124 -0.0035 1.0000 ME 1.0000 AT 0.4001* 1.0000 LT 0.3147* 0.9820* 1.0000 CRPS 0.0430 0.3084* 0.3066* 1.0000 NI 0.6725* 0.5424* 0.4859* 0.2196 1.0000 NI 0.6591* 0.4724* 0.4126* 0.0980 1.0000

Variance Inflation Factors (VIFs) and Condition Indices (CI) are also examined and discussed below, but are not shown in a table for purposes of brevity. As expected, the VIFs for ASSET and LIAB range from 23 to 155 suggesting a high degree of multicollinearity (Neter, Wasserman and Kutner, 1985). The Condition Index values range from 17 to 34 suggesting moderate dependencies (Belsley, Kuh and Welsch, 1980). However, for the variable of interest, CRPS, the greatest VIF is 2.2 in 1991 suggesting that multicollinearity may not be a problem with this variable. The results of the initial regressions estimated for each year are presented in Table 4. The regression models are significant in every year with the adjusted R-square ranging from 0.4955 in 1994 to .7654 in 1993. The estimated coefficients for the variables representing total assets (ASSET) and total liabilities (LIAB) are in their expected direction in every year, but not significant in all years. The income variable is significant in all five years and has a positive coefficient as expected. The variable of interest, CRPS, has a negative coefficient in all five years and is significant in two of them, 1991 and 1993. In the years where CRPS is not significant, 1992, 1994, and 1995, the p-values are 0.1293, 0.2876 and 0.4797. With CRPS being negative in all years and significant in two of them, there is some evidence to suggest that the market perceives the nature of these instruments as consisting largely of debt, but perhaps not exclusively as debt. As discussed previously, there is a problem with multicollinearity between the ASSET and LIAB variables. The model was estimated again with these two variables netted together to form a NET variable. In these regressions the highest VIF was 2.01 and the largest CI was less than 5. These statistics suggest that multicollinearity is not an issue with this model that uses a single combined variable to represent ASSET and LIAB. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

TABLE 4 REGRESSION MODEL RESULTS ME i = B 0 + B 1 ASSET i + B 2 LIAB i + B 3 CRPS i + B 4 NI i + u i Year 1991 Variable INTERCEPT ASSET LIAB CRPS NI INTERCEPT ASSET LIAB CRPS NI INTERCEPT ASSET LIAB CRPS NI INTERCEPT ASSET LIAB CRPS NI INTERCEPT ASSET LIAB CRPS NI Coef. 3.7586 0.4361 -0.2042 -2.1874 6.8059 3.4924 0.4400 -0.3734 -0.8503 7.0103 3.1320 0.8422 -0.9255 -1.4998 8.5794 5.0170 0.4325 -0.4538 -0.3588 6.0319 5.8019 0.8960 -0.9446 -0.3261 4.4853 Error 1.3826 0.2060 0.2967 0.6483 1.5475 1.4195 0.2118 0.2758 0.5491 1.3327 1.2641 0.1783 0.1948 0.4099 1.2723 1.7563 0.1627 0.1764 0.3334 1.3696 1.8707 0.2294 0.2412 0.4578 1.8152 t Stat 2.719 2.116 -0.688 -3.374 4.204 2.460 2.077 -1.354 -1.549 5.260 2.478 4.723 -4.751 -3.659 6.743 2.857 2.657 -2.572 -1.076 4.404 3.101 3.905 -3.916 -0.712 2.471 p Value* 0.0100 0.0413 0.4957 0.0018 0.0002 0.0183 0.0443 0.1833 0.1293 0.0001 0.0179 0.0001 0.0001 0.0008 0.0001 0.0065 0.0109 0.0135 0.2876 0.0001 0.0032 0.0003 0.0003 0.4797 0.0171 R 2 (N) .5610 (41)

1992

.5630 (45)

1993

.7654 (42)

1994

.4955 (50)

1995

.5364 (53)

ASSET: Book Value of Total Assets CRPS: Convertible Redeemable Preferred Stock *p-value is a two-tailed statistic

LIAB: Book Value of Total Liabilities NI: Net Income Before Extraordinary Items

The results for these regressions are presented in Table 5. Consistent with the previous results, CRPS was negative and significant in 1991 and 1993. The other three years were again insignificant but did have negative coefficients. These results tend to confirm the findings in the first regression model of some evidence that the market perceives CRPS to be primarily a liability. However, the lack of significance of the coefficient for CRPS in three of the five years leaves open the possibility that investors may regard CRPS as having a component other than debt, which logically would be an equity component. If one subscribes to this interpretation of the results, then the results would appear to lend support to the FASB's March 2000 proposal to consider an Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

10 instrument such as CRPS as primarily a convertible debt instrument that should be broken up into separate debt and equity components.
TABLE 5 REGRESSION MODEL RESULTS ASSETS AND LIABILITIES NETTED INTO ONE VARIABLE ME i = B 0 + B 1 NET i + B 2 CRPS i + B 3 NI i + u i Year 1991 Variable INTERCEPT NET CRPS NI INTERCEPT NET CRPS NI INTERCEPT NET CRPS NI INTERCEPT NET CRPS NI INTERCEPT NET CRPS NI Coef. 4.4271 0.7610 -1.6209 5.6987 3.4926 0.5904 -0.8699 7.0742 2.9458 0.8216 -1.7508 7.7947 4.9073 0.4101 -0.4001 5.8032 5.9568 0.6953 -0.2444 4.4686 Error 1.4079 0.1438 0.6176 1.5688 1.4157 0.1263 0.5472 1.3272 1.2673 0.1792 0.3647 1.1297 1.7317 0.1564 0.3224 1.2952 1.9246 0.2122 0.4695 1.8691 t Stat 3.144 5.292 -2.624 3.633 2.467 4.672 -1.590 5.330 2.325 4.585 -4.800 6.899 2.834 2.622 -1.241 4.480 3.095 3.277 -0.521 2.391 p Value* 0.0033 0.0001 0.0125 0.0008 0.0179 0.0001 0.1196 0.0001 0.0255 0.0001 0.0001 0.0001 0.0068 0.0118 0.2209 0.0001 0.0032 0.0019 0.6049 0.0207 R 2 (N) .5197 (41)

1992

.5653 (45)

1993

.7612 (42)

1994

.5031 (50)

1995

.5084 (53)

NET: Book value of assets less liabilities NI: Net Income before extraordinary items

CRPS: Convertible Redeemable Preferred Stock *p-value is a two-tailed statistic

To investigate the market perception further, all the years were pooled into one sample and the full model was estimated again. The results from this regression are presented in Table 6. Caution must be exercised with these results since some of the same firms appear in the pooled sample more than once creating a lack of independence. The pooled results in Table 6 show that ASSET, LIAB, and NI are significant and in the expected direction. The variable of interest, CRPS, is negative and significant, suggesting that the market perceives these instruments as liabilities. However, the entirely-debt conclusion based on a significant coefficient for CRPS is supported only by the pooled results and not the results for individual years. Finally, there may be some firms that have more liabilities than assets, i.e., a negative book value, so there may be some question as to whether the model holds for these type firms. Therefore, Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

11 the full model and reduced model with net assets were estimated again where firms with a negative book value or stockholders' equity were deleted. For the years 1991 through 1995 there were 2, 1, 0, 3, and 4 firms deleted respectively. These results were consistent with the previous findings in Table 4. In two of the five years, 1991 and 1993, the variable of interest CRPS was negative and significant. For 1994 the CRPS variable was closer to being significant at the .05 level with p-values of 0.0633 for the full model and 0.0566 for the reduced model. In 1992 and 1995 the CRPS variable was not significant. These results also suggest that the market perceives these instruments primarily as liabilities, but perhaps with some other component (equity) present.
TABLE 6 REGRESSION MODEL RESULTS: POOLED SAMPLE OF FIRMS FOR FISCAL YEARS 1991 - 1995 ME i = B 0 + B 1 ASSET i + B 2 LIAB i + B 3 CRPS i + B 4 NI i + u i Year 1991-1995 Variable INTERCEPT ASSET LIAB CRPS NI Coef. 4.6893 0.6511 -0.6825 -0.6541 6.0537 Error 0.7045 0.0781 0.0856 0.1848 0.6204 t Stat 6.655 8.337 -7.974 -3.538 9.758 p Value* 0.0001 0.0001 0.0001 0.0005 0.0001 R 2 (N) .5676 (231)

ASSET: Book Value of Total Assets CRPS: Convertible Redeemable Preferred Stock *p-value is a two-tailed statistic

LIAB: Book Value of Total Liabilities NI: Net Income Before Extraordinary Items

IMPLICATIONS Current U.S. accounting rules for CRPS place it in 'temporary equity,' excluded from stockholders' equity and not required to be included in debt. One could argue that CRPS should be equity since it has the form of, or is at least called, 'preferred stock' and is also reported in an pseudo-equity category, albeit temporary equity. Following this reasoning, all of the CRPS issues should be perceived by investors as equity, i.e., a positive and significant coefficient. Yet, that is not what the results of this study found. A counter-argument could be made that one should not expect CRPS to be perceived as equity because it has the substance of debt, particularly in regard to the redemption feature of CRPS. If it were argued that CRPS is actually debt, then the conversion feature of CRPS would suggest that CRPS is in substance a form of convertible debt. However, if this argument is accepted, current U.S. rules for convertible debt, Accounting Principles Board Opinion No. 14 (APBO 14) (AICPA 1969), require that all issues of convertible debt be classified as entirely debt until conversion. APBO 14 does not allow a convertible debt issue to be classified as equity prior to conversion, regardless of the conversion features. Nor does it allow a portion of the proceeds at issuance to be allocated to equity, a proposal contained in the most recent FASB decision on how to account for convertible debt. Accordingly, even if one argues that CRPS is in substance convertible debt, an ex ante expectation conforming to APBO 14 is that all issues of CRPS should be perceived as debt. Our Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

12 findings do show some support for CRPS being primarily debt. However, the lack of significance in three of the five years raises the questions of whether an equity component may be present, at least in the years that the CRPS coefficient was not significant. Regardless of whether CRPS is presumed to be debt, or consisting of separate debt and equity components, current U.S. accounting rules do not appear to adequately account for CRPS, at least based on investors' perception. CONCLUSIONS In summary, this study can be said to provide at least some evidence that current accounting rules for CRPS are at variance with investor perception of CRPS. The importance of these findings to financial reporting is the suggestion that new standards are needed for at least one compound instrument, CRPS. Perhaps a future area of research would be to repeat the tests and design presented in Table 5 for other compound instruments. If other such studies' results present findings similar to these findings, then additional evidence would exist to support the need for changes in reporting standards for compound instruments. ENDNOTES
1 Only those firms that reported a positive net income before extraordinary items are included in the sample. Barth, Beaver and Landsman (1992) examined the market valuation of pension cost components using a levels approach. They only included items on the income statement as independent variables in trying to explain the market value of a firm. Barth et al. included only those firms that reported a positive net income. The equation model is not expected to hold for firms reporting a net loss. Firms reporting losses were also eliminated from the sample in Barth, Beaver and Stinson (1991) and Barth, Beaver, and Wolfson (1990).

REFERENCES American Institute of Certified Public Accountants (1969). Accounting for convertible debt and debt issued with stock purchase warrants. APB Opinion No. 14. New York, NY: AICPA. Amir, E. (1996). The effect of accounting aggregation on the value-relevance of financial disclosures: The case of SFAS No. 106. The Accounting Review (October), 573-90. Ayers, B.C. (1998). Deferred tax accounting under SFAS No. 109: An Empirical Investigation of its Incremental Value-Relevance Relative to APB No. 11. The Accounting Review (April), 195-212. Barth, M.E. (1991). Relative measurement errors among alternative pension asset and liability measures. The Accounting Review (July), 433-63.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

13 Barth, M.E. (1994). Fair value accounting: evidence from investment securities and the market valuation of banks. The Accounting Review (January), 1-25. Barth, M.E., W.H. Beaver, & W.R. Landsman (1992). The market valuation implications of net periodic pension cost components. Journal of Accounting and Economics (Vol. 15), 27-62. Barth, M.E., W.H. Beaver, & W.R. Landsman (1996). Value-relevance of banks' fair value disclosure under SFAS No. 107. The Accounting Review (October), 513-37. Barth, M.E., W.H. Beaver, & C.H. Stinson (1991). Supplemental data and the structure of thrift share prices. The Accounting Review (Vol. 66), 56-66. Barth, M.E., W.H. Beaver, and M.A. Wolfson. 1990. Components of Bank Earnings and the Structure of Bank Share Prices. Financial Analysts Journal (May/June), 53-60. Belsley, D.A. E. Kuh, & R.E. Welsh (1980). Regression diagnostics: Identifying influential data and sources of collinearity. (John Wiley & Sons). Financial Accounting Standards Board (1990). Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both. Discussion Memorandum. Stamford, CT: FASB (August). Financial Accounting Standards Board (1997). Financial Accounting Series, No. 172-A, Status Report, No. 287 (April 22). Financial Accounting Standards Board (2000). Project Updates: Board Agenda Projects; Liabilities and Equity (April 28). http://www.rutgers.edu/Accounting/raw/fasb/tech/index.html. Gopalakrishnan, V.& T.F. Sugrue (1993). An empirical investigation of stock market valuation of corporate projected pension liabilities. Journal of Business Finance & Accounting (September), 711-24. Harris, T.S. & J.A. Ohlson (1987). Accounting disclosures and the market's valuation of oil and gas properties. The Accounting Review (October), 651-70. Hughes, K.E., II (2000). The value relevance of nonfinancial measures of air pollution in the electric utility industry. The Accounting Review (April), 209-28. Landsman, W. (1986). An empirical investigation of pension fund property rights. The Accounting Review (October), 662-91.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

14 Neter, J., W. Wasserman & M.H. Kutner (1985). Applied Linear Statistical Models, Second Edition (Richard D. Irwin). Ohlson, J.A. (1995). Earnings, book values, and dividends in security valuation. Contemporary Accounting Research (Spring), 648-76. Securities and Exchange Commission, Accounting Series Release No. 268: "Presentation in Financial Statements of Redeemable Preferred Stocks," SEC Docket, August, 1979, 1411-19. Shevlin, T. (1991). The valuation of R&D firms with R&D limited partnerships. The Accounting Review (January), 1-21.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

15

AUDITOR CONCENTRATION WITHIN CLIENT INDUSTRIES


James H. Scheiner, Northern Michigan University Clark M. Wheatley, Florida International University
ABSTRACT Auditors have increasingly emphasized industry specialization in their audit, management advisory, tax, and litigation services as a tool for obtaining new clients and serving existing ones. This research explores auditor concentration within industries over a twenty-year period. We find that increases in concentration came at the expense of non Big-6 auditors. In contrast to previous studies, however, our results demonstrate that firms with the largest market share in a particular industry at the beginning of the period, did not necessarily maintain or increase that market share through the end of the period. Furthermore, this study indicates that auditor concentration research, which relies solely upon metrics such as the "four-firm concentration ratio," may provide biased or misleading results. INTRODUCTION Mergers, acquisitions and bankruptcies in the recent past have significantly altered the composition of business in the United States. This time period has witnessed similar changes in the accounting profession as well. In essence, these changes have left fewer client firms with a long financial history, contracting with fewer accounting firms. To increase share in an industry, an auditor must obtain new clients from new businesses, from established businesses or by being on the "winning side" in a merger. Whether this decline in the population of potential auditors is good or bad for the business community depends in part on the level of competition in the accounting industry. Increasingly, auditors have emphasized industry specialization in their audit, management advisory, tax, and litigation services as a tool for obtaining new clients and serving existing ones. Specialization by auditors is promoted as leading to greater efficiency and hence lower audit fees for client companies. As regards management advisory services, specialization may enhance the service firm's competence thus increasing the value of its services. Similar benefits may be realized in both tax and litigation services. Specialization may, however, result in fewer firms providing services to any one particular industry. Such increases in auditor concentration might therefore have anti-competitive consequences - especially as regards consulting services (Minyard and Tabor, 1991). The impact of this potential problem is compounded in specific industries by mergers and bankruptcies which have reduced the number of industry firms. A good example of this is the oil and gas industry. In such industries, client firms that desire to engage both specialists and different

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

16 auditors/consultants than those engaged by their competitors, must balance any benefits accruing from auditor specialization with the potential detriments of increased concentration. The only scenarios in which this complication would not result, would be those where either (1) no audit firms are specialists, or (2) all audit firms are specialists. Assuming that specialization is not costless, competition between auditors would induce specialization (eliminating the first alternative), until only those accounting firms able to operate with some competitive advantage within an industry would remain (eliminating the second alternative). The result of specialization therefore, is that client firms would be forced to choose from a smaller pool of "efficient" audit/consulting providers. This article examines changes in auditor concentration for publicly held entities by industry and year, from 1977 through 1996. We look at three traditional measures of concentration, propose a new measure of concentration and assess the competitiveness of the audit profession in various industries. PRIOR RESEARCH Auditor specialization or concentration has been examined in a number of papers. Eichenseher and Danos (1981) using 1977 data for 4,900 firms, found significant concentration within industry groupings. Danos and Eichenseher (1982) examined changes in auditor concentration during the 1970s and found that gains in market share occurred in regulated industries while declines occurred in nonregulated industries. Kwon (1966) presented evidence that in concentrated industries, clients will demand audit firms different from competitors' auditors. Hogan and Jeter (1997) examined changes in concentration and market share from 1976 to 1993 and found that concentration levels have increased over time. They also found that firms classified as market leaders increased market share over time at the expense of firms with a smaller market share. We extend these investigations, by exploring auditor concentration within the professed specialization areas of the Big-6 accounting firms, and suggest an alternative approach for gauging industry concentration. METHODOLOGY AND SAMPLE SELECTION Auditor concentration has been measured in prior studies (Scheiner and Wheatley (1998), Hogan and Jeter (1997) and Danos and Eichenseher (1982)): following three metrics (1) number of firms in an industry audited by a public accounting firm, (2) the square root of total assets of firms in an industry audited by a public accounting firm, and (3) the square root of net sales of firms in an industry audited by a public accounting firm. The second measure is based on Simunic's (1980) conclusion that audit fees vary linearly with the square root of a client's total assets. The first measure (N), which uses the number of firms audited by a single public accounting firm, is computed using equation 1. N i = n i / SUM i ( n i ) (1)

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

17 where n i is the number of industry firms audited by auditor i. The second measure (TA), which uses the square root of the total assets of clients audited by a single public accounting firm, is computed using equation 2. TA i = SUM j ( Square Root ( A i j ) ) / SUM i j ( SUM ( Square Root ( A i j ) ) ) (2)

where A i j is the total assets of client firm j for auditor i. The third measure (NS), which uses the square root of the net sales of clients audited by a single public accounting firm, is computed using equation 3. NS i = SUM j ( Square Root ( S i j ) ) / SUM i j ( SUM ( Square Root ( S i j ) ) ) (3)

where S i j is the net sales of client firm j for auditor i. Consistent with prior research, we measure concentration using three and four firm concentration ratios by summing the largest values for each measure for each year. Note however, that when an accounting firm audits one very large client, measures (2) and (3) may skew the results. Since the time period covered by our study predates the merger of Price Waterhouse with Coopers & Lybrand, those firms are evaluated as separate entities. Auditors are thus classified as one of the individual Big-6 firms or as Non Big-6. Hence there are seven possible classifications. (Firms audited by Deloitte, Haskins and Sells and Touche Ross were combined during the entire time period as were firms audited by Ernst & Whinney and Arthur Young). Data for this study was gathered from the Standard and Poor's Compustat PC-Plus Database published in 1997. Compustat company data "is derived from publicly traded companies, specifically those trading on the New York Stock Exchange, American Stock Exchange, NASDAQ, Over-the Counter, Toronto Stock Exchange, Quebec Stock Exchange, Montreal Stock Exchange, and wholly-owned subsidiaries of companies that are required to file with the SEC." Sample firms were identified by searching the Active database for those firms with auditor data for the period 1977 through 1996. Hence firms that were taken over, have gone out of business or been delisted are not included in this sample. This method of sample selection may lead to a survivorship bias. We chose however, to examine survivor firms because obtaining or having clients that are either bought-out or fail is, in the long term, an inappropriate expenditure of effort by the auditor. In addition, since survivor auditors are used in this and previous studies to represent the supply side of the audit market, it is consistent to use survivor firms to represent the demand side. Indeed, it is just this "survivorship" approach that Danos and Eichenseher (1982) assume implies a competitive advantage. This reduces the number of firms in the earlier years as compared to the later years examined. The requirements for data on assets, auditor, industry and sales resulted in a sample of 85,574 firm-year observations for the 20-year period analyzed. The number of sample observations available was lowest for 1977 (1700) and greatest for 1995 (8555). The data available given the requirements for auditor, sales and total asset information is summarized by year in Table 1. Firms were classified into industry groups by standard industrial classification code. Eight industry groupings were created using the following schedule: agricultural and natural resources (0 Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

18 - 1499); manufacturing (1500-3999); transportation and public utilities (4000-4799 & 4900-4999); communications (4800-4899); wholesale trade (5000-5199); retail trade (5200-5999); finance, insurance and real estate (6000-6799); and services (7000-9999).
Table 1 Firm-Year Sample Observations Year 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Total Auditor 1714 1903 1967 2099 2210 2594 2825 3027 3425 3834 4140 4363 4599 4955 5406 6032 6741 7572 8611 8901 Net Sales 1711 1901 1964 2096 2206 2591 2824 3027 3424 3832 4136 4361 4596 4951 5406 6031 6739 7568 8606 8901 Total Assets 1700 1878 1962 2088 2195 2585 2816 3018 3417 3816 4118 4335 4565 4923 5361 5985 6685 7518 8555 8054 85,574

We chose this broad based method of classification, rather than classification based on two-digit SIC codes (as in Hogan and Jeter, 1997), because the various Big-6 firms themselves use these broad classifications in describing their areas of specialization. Hogan and Jeter, by matching areas of claimed specialization to two-digit SIC codes, found that the Big-6 specialized in only 57% of the possible industry classifications, and that within that 57% there was considerable overlap. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

19 Since this result is counterintuitive to the basic precepts of business competition, and since we could find no evidence that the Big-6 define their areas of specialization in such a narrow fashion, we employ the broader classification groupings used in Warren (1980) and Rose-Green, et al (1998).Table 2 depicts the specialization areas claimed by the various Big-6 firms, and the corresponding industry groupings. Four of the Big-6 claimed specialization in all eight industry groups. Ernst & Young claimed specialization in six of the groups, while Price Waterhouse claimed specialization in seven of the eight.
Table 2 Areas of Specialization Industry Areas (per firms) Communications and Entertainment Consumer Products Energy Financial Services Government Healthcare Manufacturing Real Estate Transportation SIC Code 4 2,5,6 1 7 NA 8 2 7 3 AA X X X X X X X X X CL X X X X X X X X X X X EY X X X X DT X X X X X X X X X KPMG X X X X X X X X X X X X PW X X X X

Notes: An "X" indicates that the firm reports a specialization in that industry AA = Arthur Andersen CL = Coopers & Lybrand EY = Ernst & Young DT = Deloitte & Touche KPMG = KPMG Peat Marwick PW = Price Waterhouse

RESULTS Table 3 presents the change in non Big-6 firms between 1977 and 1996. In all eight industry groups there is a decline in the percentage of audits by non Big-6 firms. In only the communications industry using total assets and net sales is there an increase for non Big-6 firms. Table 4 presents the four firm (and three firm) concentration ratios by industry by year. While there is some variability among years, the concentration ratios based on number of clients exhibit very little change over the period. The TA and NS measures show a slightly greater amount of variation however, particularly in respect to industry 4 (communications and entertainment).

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

20
Table 3: Percentage of Industry Audits by Non Big-Six Firms
Panel A: Number (N) of Client Firms Industry 1 2 3 4 5 6 7 8 All Firms Industry 1 2 3 4 5 6 7 8 All Firms Industry 1 2 3 4 5 6 7 8 All Firms 1977 0.353 0.195 0.096 0.132 0.273 0.256 0.217 0.308 0.215 1977 0.147 0.110 0.044 0.019 0.130 0.119 0.079 0.143 0.099 1977 0.120 0.108 0.044 0.017 0.137 0.126 0.128 0.131 0.105 1996 0.186 0.151 0.069 0.112 0.226 0.108 0.145 0.191 0.154 1996 0.046 0.043 0.010 0.038 0.091 0.030 0.031 0.061 0.039 1996 0.038 0.044 0.012 0.037 0.092 0.028 0.033 0.060 0.042 Average 0.284 0.178 0.064 0.142 0.225 0.174 0.235 0.270 0.193 Average 0.115 0.079 0.021 0.025 0.096 0.068 0.070 0.110 0.070 Average 0.097 0.078 0.025 0.023 0.096 0.071 0.073 0.101 0.071 Change 1997 to 1996 -0.17 -0.04 -0.03 -0.02 -0.05 -0.15 -0.07 -0.12 -0.06 Change 1997 to 1996 -0.10 -0.07 -0.03 0.02 -0.04 -0.09 -0.05 -0.08 -0.06 Change 1997 to 1996 -0.08 -0.06 -0.03 0.02 -0.04 -0.10 -0.09 -0.07 -0.06

Panel B: Total Assets (TA) of Client Firms

Panel C: Net Sales (NS) of Client Firms

Notes: 1 = Agricultural & Natural Resources, 2 = Manufacturing, 3 = Transportation and Public Utilities, 4 = Communications, 5 = Wholesale Trade, 6 = Retail Trade, 7 = Finance, Insurance and Real Estate, 8 = Services

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

21
Table 4
Industry Year 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Average 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1 0.51 0.48 0.50 0.53 0.53 0.51 0.51 0.53 0.52 0.52 0.56 0.55 0.60 0.60 0.59 0.59 0.60 0.60 0.60 0.62 0.55 0.70 0.68 0.68 0.68 0.68 0.68 0.67 0.65 0.66 0.68 0.72 0.66 0.72 2 0.59 0.59 0.60 0.60 0.60 0.61 0.61 0.60 0.60 0.59 0.61 0.61 0.61 0.62 0.62 0.61 0.60 0.60 0.60 0.61 0.60 0.66 0.66 0.68 0.68 0.68 0.67 0.67 0.67 0.66 0.66 0.65 0.66 0.67 3 0.75 0.74 0.77 0.81 0.81 0.75 0.75 0.75 0.76 0.77 0.77 0.78 0.77 0.76 0.75 0.74 0.73 0.73 0.72 0.73 0.76 0.77 0.78 0.79 0.84 0.82 0.81 0.80 0.80 0.78 0.78 0.77 0.79 0.79 4 0.72 0.71 0.71 0.69 0.70 0.72 0.74 0.75 0.76 0.73 0.71 0.72 0.70 0.68 0.67 0.68 0.70 0.69 0.70 0.73 0.71 0.90 0.91 0.89 0.89 0.88 0.88 0.87 0.89 0.89 0.85 0.83 0.83 0.81 5 0.57 0.61 0.61 0.59 0.60 0.62 0.60 0.58 0.57 0.58 0.61 0.62 0.62 0.63 0.62 0.61 0.61 0.58 0.57 0.57 0.60 0.73 0.74 0.75 0.77 0.76 0.77 0.76 0.74 0.74 0.75 0.74 0.75 0.76 6 0.59 0.60 0.61 0.61 0.60 0.61 0.61 0.61 0.61 0.63 0.65 0.67 0.66 0.69 0.70 0.69 0.67 0.64 0.66 0.69 0.64 0.69 0.69 0.71 0.70 0.70 0.71 0.71 0.71 0.71 0.72 0.74 0.75 0.74 7 0.65 0.64 0.62 0.61 0.60 0.60 0.58 0.59 0.59 0.62 0.62 0.62 0.60 0.61 0.61 0.61 0.61 0.64 0.64 0.66 0.62 0.81 0.83 0.83 0.83 0.84 0.84 0.82 0.80 0.80 0.80 0.79 0.80 0.77 8 0.55 0.51 0.51 0.52 0.52 0.52 0.49 0.50 0.55 0.57 0.61 0.60 0.59 0.62 0.61 0.58 0.58 0.58 0.58 0.62 0.56 0.70 0.65 0.66 0.68 0.68 0.66 0.65 0.65 0.64 0.69 0.72 0.73 0.72 Panel A: Four-Firm Concentration Ratio (Number of Clients) by Industry and Year

Panel B: Four-Firm Concentration Ratio (Total Assets) by Industry and Year

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

22
Table 4
Industry Year 1990 1991 1992 1993 1994 1995 1996 Average 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Average 1977 1978 1979 1980 1981 1 0.70 0.69 0.70 0.72 0.71 0.68 0.70 0.69 0.70 0.72 0.68 0.68 0.69 0.69 0.68 0.67 0.68 0.71 0.74 0.70 0.74 0.73 0.71 0.71 0.73 0.73 0.69 0.71 0.71 0.40 0.38 0.41 0.43 0.43 2 0.67 0.68 0.68 0.68 0.68 0.68 0.69 0.67 0.66 0.67 0.68 0.68 0.69 0.67 0.67 0.67 0.67 0.66 0.65 0.66 0.67 0.67 0.68 0.68 0.68 0.68 0.67 0.68 0.67 0.46 0.46 0.47 0.47 0.47 3 0.77 0.77 0.77 0.77 0.75 0.74 0.77 0.78 0.80 0.80 0.82 0.86 0.84 0.79 0.78 0.78 0.78 0.77 0.78 0.79 0.78 0.77 0.77 0.77 0.77 0.77 0.76 0.77 0.79 0.60 0.59 0.62 0.63 0.65 4 0.79 0.80 0.80 0.78 0.78 0.74 0.79 0.84 0.91 0.91 0.90 0.89 0.89 0.88 0.87 0.89 0.89 0.87 0.85 0.84 0.83 0.81 0.81 0.81 0.80 0.80 0.78 0.81 0.85 0.65 0.63 0.63 0.62 0.62 5 0.76 0.77 0.77 0.76 0.72 0.73 0.72 0.75 0.71 0.75 0.77 0.77 0.77 0.77 0.76 0.75 0.75 0.76 0.75 0.74 0.76 0.75 0.76 0.76 0.75 0.72 0.73 0.72 0.75 0.44 0.50 0.50 0.47 0.50 6 0.77 0.77 0.76 0.75 0.74 0.75 0.75 0.73 0.68 0.68 0.68 0.68 0.69 0.71 0.69 0.70 0.70 0.71 0.73 0.74 0.73 0.75 0.76 0.75 0.75 0.74 0.74 0.75 0.72 0.49 0.49 0.52 0.50 0.50 7 0.76 0.76 0.76 0.75 0.77 0.77 0.77 0.80 0.76 0.82 0.82 0.83 0.84 0.83 0.81 0.80 0.79 0.80 0.79 0.79 0.75 0.75 0.75 0.74 0.75 0.77 0.77 0.78 0.79 0.52 0.51 0.50 0.47 0.47 8 0.74 0.73 0.72 0.71 0.71 0.71 0.72 0.69 0.71 0.66 0.68 0.70 0.70 0.66 0.65 0.66 0.65 0.70 0.73 0.73 0.73 0.75 0.75 0.73 0.73 0.71 0.71 0.72 0.70 0.45 0.41 0.41 0.42 0.42

Panel C: Four-Firm Concentration Ratio (Net Sales) by Industry and Year

Panel D: Three-Firm Concentration Ratio (Number of Clients) by Industry and Year

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

23
Table 4
Industry Year 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Average 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1 0.41 0.41 0.43 0.42 0.41 0.43 0.42 0.48 0.48 0.48 0.47 0.47 0.48 0.49 0.50 0.44 0.59 0.57 0.57 0.56 0.57 0.57 0.58 0.55 0.55 0.56 0.58 0.55 0.59 0.57 0.56 0.56 0.58 0.57 0.53 2 0.48 0.49 0.48 0.48 0.48 0.48 0.48 0.48 0.49 0.49 0.48 0.47 0.47 0.48 0.49 0.48 0.53 0.53 0.54 0.54 0.55 0.54 0.54 0.54 0.53 0.53 0.52 0.52 0.53 0.53 0.54 0.53 0.53 0.53 0.53 3 0.64 0.65 0.64 0.64 0.64 0.64 0.65 0.64 0.62 0.62 0.61 0.60 0.60 0.58 0.60 0.62 0.61 0.62 0.63 0.66 0.67 0.69 0.67 0.67 0.66 0.66 0.66 0.67 0.68 0.65 0.65 0.65 0.64 0.62 0.61 4 0.65 0.65 0.57 0.65 0.63 0.59 0.59 0.58 0.56 0.56 0.56 0.58 0.57 0.57 0.59 0.61 0.85 0.85 0.83 0.83 0.82 0.81 0.79 0.82 0.80 0.75 0.73 0.71 0.70 0.69 0.70 0.70 0.65 0.65 0.61 5 0.52 0.50 0.49 0.46 0.47 0.49 0.50 0.49 0.49 0.47 0.46 0.46 0.44 0.44 0.44 0.48 0.59 0.61 0.62 0.64 0.66 0.66 0.65 0.64 0.64 0.64 0.63 0.64 0.64 0.61 0.62 0.64 0.62 0.58 0.57 6 0.51 0.51 0.49 0.48 0.51 0.53 0.55 0.55 0.56 0.55 0.54 0.52 0.50 0.51 0.54 0.52 0.58 0.56 0.58 0.58 0.58 0.59 0.59 0.58 0.57 0.58 0.60 0.61 0.63 0.63 0.64 0.63 0.61 0.60 0.59 7 0.48 0.46 0.48 0.47 0.50 0.50 0.48 0.47 0.49 0.48 0.48 0.48 0.50 0.51 0.53 0.49 0.73 0.75 0.74 0.74 0.75 0.73 0.72 0.70 0.67 0.66 0.65 0.65 0.62 0.63 0.63 0.61 0.60 0.61 0.61 8 0.41 0.38 0.39 0.44 0.45 0.47 0.47 0.47 0.49 0.49 0.46 0.47 0.47 0.48 0.50 0.45 0.55 0.51 0.51 0.52 0.53 0.51 0.51 0.52 0.53 0.58 0.60 0.60 0.59 0.62 0.62 0.60 0.60 0.59 0.58

Panel E: Three-Firm Concentration Ratio (Total Assets) by Industry and Year

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

24
Table 4
Industry Year 1996 Average 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Average Notes: 1 0.56 0.57 0.59 0.60 0.56 0.57 0.60 0.58 0.57 0.55 0.56 0.57 0.60 0.58 0.60 0.58 0.58 0.57 0.59 0.58 0.54 0.56 0.58 2 0.54 0.53 0.52 0.53 0.54 0.55 0.55 0.54 0.54 0.54 0.53 0.53 0.52 0.52 0.53 0.53 0.53 0.53 0.53 0.53 0.52 0.53 0.53 3 0.63 0.65 0.65 0.66 0.68 0.68 0.71 0.68 0.67 0.66 0.67 0.65 0.66 0.68 0.68 0.65 0.65 0.64 0.64 0.63 0.62 0.64 0.66 4 0.67 0.75 0.83 0.83 0.82 0.82 0.81 0.80 0.79 0.82 0.81 0.78 0.76 0.74 0.73 0.71 0.72 0.71 0.67 0.68 0.65 0.71 0.76 5 0.56 0.62 0.57 0.64 0.65 0.65 0.69 0.67 0.67 0.65 0.64 0.64 0.64 0.63 0.63 0.61 0.62 0.63 0.62 0.59 0.57 0.56 0.63 6 0.59 0.60 0.57 0.56 0.56 0.56 0.57 0.58 0.57 0.58 0.57 0.58 0.59 0.61 0.62 0.62 0.63 0.61 0.60 0.59 0.59 0.59 0.59 7 0.62 0.67 0.63 0.69 0.69 0.69 0.69 0.70 0.68 0.67 0.64 0.65 0.64 0.64 0.61 0.60 0.61 0.60 0.58 0.60 0.61 0.62 0.64 8 0.60 0.56 0.57 0.53 0.54 0.55 0.55 0.53 0.52 0.52 0.53 0.58 0.60 0.61 0.61 0.63 0.63 0.62 0.61 0.60 0.58 0.60 0.58

Panel F: Three-Firm Concentration Ratio (Net Sales) by Industry and Year

1 = Agricultural & Natural Resources, 2 = Manufacturing, 3 = Transportation and Public Utilities, 4 = Communications, 5 = Wholesale Trade, 6 = Retail Trade, 7 = Finance, Insurance and Real Estate, 8 = Services

Table 5 summarizes the changes in the concentration ratios between 1977 and 1996. For number of clients [N], Transportation and Public Utilities was the only industry to have a decrease in its four firm concentration ratio. For total assets [TA], Communications had the largest decrease (12.2%) followed by Finance, Insurance and Real Estate (4.9%) and Wholesale Trade with (1.4%). Two industries had no change. For net sales [NS], Communications (11%) and Transportation and Public Utilities (3.8%) had decreases. Hence while the number of clients increased, their size as measured by assets or sales did not increase proportionally. This is consistent with auditors obtaining more and smaller client firms.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

25
Table 5: Four Firm Concentration Ratios 1977 and 1996 1977 Number of Clients Agriculture & Natural Resources Manufacturing Transportation & Public Utilities Communications Wholesale Trade Retail Trade Finance, Insurance & Real Estate Services Total Assets Agriculture & Natural Resources Manufacturing Transportation & Public Utilities Communications Wholesale Trade Retail Trade Finance, Insurance & Real Estate Services Net Sales Agriculture & Natural Resources Manufacturing Transportation & Public Utilities Communications Wholesale Trade Retail Trade Finance, Insurance & Real Estate Services 70.0% 66.0% 80.0% 91.0% 71.0% 68.0% 76.0% 71.0% 71.0% 68.0% 77.0% 81.0% 72.0% 75.0% 78.0% 72.0% 1.4% 3.0% -3.8% -11.0% 1.4% 10.3% 2.6% 1.4% 70.0% 66.0% 77.0% 90.0% 73.0% 69.0% 81.0% 70.0% 70.0% 69.0% 77.0% 79.0% 72.0% 75.0% 77.0% 72.0% 0.0% 4.5% 0.0% -12.2% -1.4% 8.7% -4.9% 2.9% 51.0% 59.0% 75.0% 72.0% 57.0% 59.0% 65.0% 55.0% 62.0% 61.0% 73.0% 73.0% 57.0% 69.0% 66.0% 62.0% 21.6% 3.4% -2.7% 1.4% 0.0% 16.9% 1.5% 12.7% 1996 Percentage Change

Rather than examining a four or three firm concentration ratio in more detail, as was done in previous studies, we examine the distribution of clients compared to a uniform distribution. This method was selected because of the high concentration of clients among the Big-6 firms, which might mask increasing or decreasing concentration if three or four firm concentration ratios were used. For example, concentration ratios of more than 50% have typically been considered indicators Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

26 of high industry concentration. If however, Big-6 firms accounted for 90% of the number of clients in an industry, one would expect a four firm concentration ratio of 60% even if the industry was not concentrated (90% / 6 firms = 15% per firm, 15% x 4 firms = 60%). To further investigate concentration and its change between 1977 and 1996, Figure 1 is presented. Figure 1 presents the actuals for each of the Big-6 firms for 1977 and 1996. It also presents the level that each Big-6 firm should have if there was no concentration (total Big-6 share/6) for 1977 and 1996. Also presented is a projection for 1996 based upon the 1977 share plus the average of the decrease in non Big-6 share between 1977 and 1996. The final estimate that is presented is a projection for 1966 based upon 1977 share plus a weighted average of 1977 market share and the decrease in non Big-6 share. Since the results for NS mirror those of TA, only N and TA are presented for economy's sake. Also, since the second projection is substantially identical to the first projection, only the first projection is discussed in the text. In Figure 2 - Panel A, Agricultural and Natural Resources market share is presented using number of clients. Market share using total assets is presented in Panel B. As derived from Table 3, Big-6 firms market share in this industry increased from 65% to 82%. Hence the average market share of each Big-6 firm should have increased from approximately 10.8% to 13.6%. In 1977 and 1996 three of the Big-6 were above the median (two using client size). One firm (D&T) had a decrease in number of client firms and an increase in client size. Only two firms experienced increases above the estimate based upon a uniform distribution. KPMG and E&Y each increased more than 5% in both number of clients and size. Figure 3 presents the results for the Communications industry. Big-6 firms market share in this industry increased only slightly from 87% to 88.7%. Hence the average market share of each Big-6 firm should have increased only slightly from 14.5% to 14.8%. In 1977, two (two) of the Big-6 were above the median and in 1996 three (two) were above the median for number of clients (client size). Two firms (C&L and PW) had a decrease in number of clients and client size (despite Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

27 a claim of specialization). Four firms increased above the estimate based upon the uniform distribution.

Figure 4 presents the results for the Finance, Insurance and Real Estate industry. Big-6 firms market share in this industry increased from 78% to 85.5%. Hence the average market share of each Big-6 firm should have increased from approximately 13% to 14.3%. In 1977 three (two) of the Big-6 were at or above the median and in 1996 three were at or above the median (three using client size). Three firms (C&L, E&Y, and KPMG) had an increase in number. Only D&T had a decrease using both number and client size. Three firms (C&L, E&Y and KPMG) increased above the

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

28 projection based upon the uniform distribution for number of clients and client size. In addition, PW and AA experienced an increase based upon firm size. The results for the Manufacturing industry are presented in Figure 5. Big-6 firms market share in this industry increased from 80% to 85%. Hence the average market share of each Big-6 firm should have increased from approximately 13.2% to 14.3%. In 1977 three (four) of the Big-6 were at or above the median and in 1996 two were at or above the median (three using client size). Four firms (AA, C&L, E&Y, and KPMG) had an increase in number. Only PW had a decrease using both number and client size. Three firms (AA, E&Y and KPMG) increased above the estimate based upon the uniform distribution for number of clients and client size (C&L, E&Y, and KPMG).

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

29 In Figure 6 - Panel A, Retail market share is presented using number of clients and market share using total assets is presented in Panel B. Again, as derived from Table 3, Big-6 firms market share in this industry increased from 74.3% to 89%. Hence the average market share of each Big-6 firm should have increased from approximately 12.4% to 14.8%. In 1977 three (two) of the Big-6 were at or above the median and in 1996 four were at or above the median (four using client size). Four firms (AA, C&L, E&Y, and PW) had an increase in number. Only DT had a decrease using both number and client size. Four firms (AA, C&L, KPMG and PW) increased above the estimate based upon the uniform distribution for number of clients and client size (AA, C&L, E&Y, and KPMG).

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

30 The results for the Service industry are presented in Figure 7. Big-6 firms market share in this industry increased from 69.3% to 81%. Hence the average market share of each Big-6 firm should have increased from approximately 11.6% to 13.5%. In 1977 three (four) of the Big-6 were at or above the median and in 1996 three were at or above the median (three using client size). Three firms (C&L, E&Y, and KPMG) had an increase in number. Four firms (AA, C&L, E&Y, and KPMG) had an increase based on size. Three firms (C&L, E&Y, and KPMG) increased above the estimate based upon the uniform distribution for number of clients and client size.

Fi gure 8 presents the results for the Transportation industry. Big-6 firms market share in this industry increased from only slightly from 90.4% to 93.1%. Hence the average market share of each Big-6 Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

31 firm should have increased from approximately 15.1% to 15.5%. In 1977 three (two) of the Big-6 were at or above the median and in 1996 one was at or above the median (two using client size). Two firms (AA and C&L) had an increase in number and based on size. Two firms increased above the estimate. Figure 9 presents the results for the Wholesale Trade industry. Big-6 firms market share in this industry increased from 72.7% to 77.5% (87.0 to 90.9%) using the N (TA) measure. Hence the average market share of each Big-6 firm should have increased from approximately 12.1% to 12.9% (14.5 to 15.2%). In 1977 four (three) of the Big-6 were at or above the median and in 1996 three (four) were at the median or above.
Table 7 Summary of Changes in Actual versus Forecast Proportion of Audits by Industry and Big-6 Auditor Industry Number of Clients Agriculture & Natural Resources Manufacturing Transportation & Public Utilities Communications Wholesale Trade Retail Trade Finance, Insurance & Real Estate Services Summary: ++ + Total Assets Agriculture & Natural Resources Manufacturing Transportation & Public Utilities Communications Wholesale Trade Retail Trade Finance, Insurance & Real Estate Services Summary: ++ + Notes: ++ increase above the 1996 estimate + ++ ++ + ++ + 3 3 2 + increase ++ + + ++ ++ ++ 4 2 2 2 - decrease 4 3 ++ ++ ++ ++ ++ ++ 6 ++ ++ ++ ++ 4 ++ ++ ++ ++ ++ 5 + ++ ++ ++ 3 1 4 + ++ ++ ++ ++ ++ 5 1 2 + + ++ ++ ++ ++ ++ 5 2 1 ++ ++ ++ + ++ ++ 5 1 2 6 ++ ++ 2 ++ ++ ++ + ++ ++ ++ 6 1 1 + ++ ++ 2 1 5 AA C&L E&Y D&T KPMG PW

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

32 Using number of clients, AA, E&Y, D&T and KMPG were above the average in 1997, but only AA, E&Y and DT remained above in 1996. Using client size, three firms (AA, E&Y and KPMG) were above the average in 1977. In 1996 four firms (AA, E&Y, DT and PW) were above the estimate. Table 7 presents a summary of changes by industry based upon three classifications: an increase above the projection, some increase, or a decline. For number of clients there appears to be a marked distinction among the firms, those with five or more of the eight industries having an increase over the 1996 estimate and those with two industries having an increase over the 1996 estimate. The latter group includes D&T and PW. However, if total assets is still a valid proxy for audit fees, the changes are not as striking. Only one firm had an increase in six industries (E&Y), one in five industries (KPMG), two in four industries (D&T and C&L) and two in three industries (AA and PW). CONCLUSIONS During the time period under study, concentration increased substantially at the expense of non Big-6 firms. Non Big-6 auditors' market share declined substantially during the period. In only one industry do non Big-6 firms now audit more than 20% of the firms (wholesale trade), and their market share consists principally of the smaller firms when measured by asset size. Overall, during this period, four of the Big-6 (AA, C&L, E&Y and KPMG) had gains in market share using number of clients. However C&L did not grow as much as the other three (which increased more than the expectation of uniform growth during the period). In contrast to previous studies, our results demonstrate that firms that had the largest market share in a particular industry did not necessarily maintain that market share. For example in five of the industries, Agricultural & Natural Resources, Communications, Finance, Services and Wholesale Trade, the leading firm in the industry in 1977 was replaced by another firm by 1996. Further, this study indicates that auditor concentration research, which relies solely upon metrics such as the "four-firm concentration ratio", may provide biased or misleading results.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

33 REFERENCES Danos, P. and J. Eichenseher. 1982. Audit Industry Dynamics: Factors Affecting Changes in Client-Industry Market Shares. Journal of Accounting Research (Autumn): 604-616. Eichenseher, J. and P. Danos. 1981. The Analysis of Industry-Specific Auditor Concentration: Towards and Explanatory Model. The Accounting Review (July): 479-492 Hogan, C. and D. Jeter. 1999. Industry Specialization by Auditors. Forthcoming in Auditing: A Journal of Practice and Theory (Spring). Minyard, D. and R. Tabor. 1991. The Effect of Big Eight Mergers on Auditor Concentration. Accounting Horizons (December): 79-90. Rose-Green, E., J. Scheiner and C. Wheatley. 1998. Audit Quality in the Post Merger Era. Working Paper, Florida International University. Scheiner, J. and C. Wheatley. 1998. Auditor Concentration in the Oil and Gas Industry. Petroleum Accounting and Financial Management Journal (Spring): 1-13. Simunic, D. 1980. The Price of Audit Services: Theory and Evidence. Journal of Accounting Research (Spring): 161-190. Warren, Carl S. 1980. Uniformity of Auditing Standards: A Replication. Journal of Accounting Research. (Spring): 312-324.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

34

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

35

THE USEFULNESS OF ACCOUNTING INFORMATION IN ASSESSING SYSTEMATIC RISK: A RE-EXAMINATION


Ronald J. Woan, Indiana University of Pennsylvania
ABSTRACT This study documents the potential statistical problems in using accounting risk measures in assessing a firm's systematic risk. It is found that all three problems: measurement error, omission of variables and multicollinearity exist in this area of research. To underscore the serious nature of the problems, two most important empirical studies in this area of research are replicated with new data: the Beaver, Kettler and Scholes' study and the Eskew's study. In both cases, the results are inconsistent with their findings. An alternative model, LISREL, is recommended for this area of research. INTRODUCTION The objectives of this paper are 1) to reiterate the common problems in the application of the conventional regression model in empirical accounting research and provide some evidence that these problems do exist in accounting data and 2) to underscore these problems, two of the oft-cited earlier studies of the usefulness of accounting information in assessing systematic risk are partially replicated based on a new data set to see whether their results may be cross-validated and if not, why. But, first, some justification is given here as to why research in this area is important. Portfolio theory tells us that systematic risk is the only risk for which investors, holding diversified portfolios, need to be concerned about (e.g., Sharpe 1964). Thus, rational risk averse investors will hold well diversified portfolios. Systematic risk is an important economic decision variable for most investors because it is well known that most people are risk averse. The accounting literature also stresses the importance of risk assessment. It is stated in ASOBAT (AAA 1966, 4 and 19) that one of the objectives of accounting is to provide information for "making decisions concerning the use of limited resources" and it continues, "accounting information is the chief means of reducing uncertainty under which external users act". AICPA's Trueblood Report (1973, 13) states that, "the basic objective of financial statements is to provide information useful for making economic decisions". Also, the FASB (1983, par. 34) states that the objective of financial reporting is "to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions". Hence, investigation into the usefulness of accounting information is an important area of research and is consistent with the pronouncements and viewpoints expressed by the above groups concerned with financial reporting. Capital market based accounting research has been widely accepted for this purpose, as is evidenced by the voluminous publications in prestigious accounting and finance journals. In fact, Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

36 the article by Ball and Brown (1968), which served to introduce the capital market-based methodology in the accounting literature, was recently named the recipient of the American Accounting Association's newly established 'Seminal Contribution to Accounting Literature Awards.' This noteworthy designation underscores the important contribution that capital market-based research has provided to the body of knowledge in accounting. Since systematic risk is theoretically an important decision variable for investors, creditors and managers, the ability of accounting information to assess systematic risk is of particular importance. Since the publication of Ball and Brown (1969) numerous research studies in this area have been conducted and published (e.g., Ang et al. 1984; Beaver et al. 1970; Bildersee 1975; Ben-Zion and Shalit 1975; Bowman 1979; Breen and Lerner 1973; Brenener and Smidt 1978; Elgers 1980; Elgers and Murray 1982; Eskew 1979; Hill and Stone 1980; Lev 1974; Lev and Kunitzky 1974; Logue and Merville 1972; Mandelker and Rhee 1984; Melicher 1974; Melicher and Rush 1974; Rosenberg and Mckibben 1973; Thompson 1976; White 1972). The results have been mixed and inconsistent. The remainder of this paper is divided into four sections. Section I discusses some potential problems facing empirical researchers in this area of study. Section II describes the sample selection criteria and the resulting sample. Section III presents the results of partial replications and some extensions of the oft-cited studies by BKS and Eskew. Section IV presents the concluding remark. SOME PROBLEMS RELATED TO THE STUDIES OF THE ASSOCIATION BETWEEN THE SYSTEMATIC RISK AND ACCOUNTING RISK MEASURES The FASB recognizes the limitations of accounting information. In particular, it acknowledges that "the information often results from approximate, rather than exact, measures." and thus, "despite the aura of precision that may seem to surround financial reporting in general and financial statements in particular, with few exceptions the measures are approximations, which may be based on rules and conventions, rather than exact amounts" (FASB 1983, par. 20). That is to say, it acknowledges potential measurement errors in accounting information. The potential determinants of systematic risk are not accounting data per se. Rather, the determinants are the financial constructs, such as growth, operating leverage, profitability, liquidity, efficiency, etc., resulting from the management's operating, investing and financial decisions, which accounting data attempt to measure. These constructs are widely accepted risk measures about a firm and their surrogates have been somewhat successfully used in default predictions (Altman et al. 1977; Deakin 1972) and bond ratings (Copeland and Ingram 1982; Pinches et al. 1977; Watson et al. 1983). These surrogates are usually obtained from publicly available accounting data. Consequently, identification of the determinants of systematic risk from commonly accepted accounting risk measures has been actively studied in both the finance and accounting literature. Unfortunately, the results have so far been inconclusive, and mostly conflicting. Sound guidance in 1) the selection of variables to be incorporated (omitted variables), 2) dealing with measurement errors, and 3) coping with multicollinearity has been lacking and has contributed to the inability to reach consistent conclusions in previous studies. A brief summary of the major consequences of these problems is given below (e.g., Jensen 1967; Judge, Griffithhs, Hill, Lutkepohl and Lee 1985): Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

37

Omitting variables that are correlated with the independent variables in a regression equation will cause biased estimates of the error variance and the regression coefficients of the remaining variables. In the case of two correlated independent variables, for instance, the bias caused by leaving out one variable will be equal to the product of the partial regression coefficient of the omitted variable had it been in the equation and the simple regression coefficient of the omitted variable on the remaining independent variable. Measurement errors in variables have much more complicated consequences in regression than either omitted variables or multicollinearity problems. In the simple case of a pair of variables, it is well known that measurement errors will attenuate the correlation between the two variables. But, in multiple regression where there is more than one independent variable involved, measurement errors in the independent variables have a much more complicated impact on the partial regression coefficients. The biases may be upward or downward depending on the interrelationship among the observed variables, measurement errors, and the true scores. Wickens (1972) showed that it is better to include variables with measurement errors than omit them in a multiple regression model. The well known multicollinearity problem in regression tends to cause unstable parameter estimates. The estimates are generally highly correlated with large variances making it very difficult to isolate the effects attributable to the individual variables. Furthermore, it can cause serious numerical inaccuracies in the parameter estimates, as demonstrated in Wampler (1970). However, estimates remain unbiased provided the model is not misspecified and numerical accuracy is not sacrificed. Finally, all three problems could result in estimates having signs opposite to the true ones. Hence, the result from regression or correlation analysis could be sample sensitive and hard to interpret.

From the discussion above, one can see that any application of regression techniques demands careful thought on the part of the analyst. This is especially true in the study of the relationship between market determined risk measures and accounting data based risk measures since the relevant measures are of the ex ante type, which are difficult to obtain. Furthermore, the risk measures in accounting applications are generally abstract concepts, which have no unique well defined measures. Various ex post proxies have generally been employed in empirical research. Measurement errors and multicollinearity have thus become thorny issues. Most of the variables chosen to be included in the models examined generally lack theoretical support (see, e.g., the discussion given in BKS article). Furthermore, important variables were omitted in many of the studies. For example, operating leverage and financial leverage, which can theoretically be linked to systematic risk (Galon 1981; Galon and Gentry 1982; Subramanyan and Thomadakis 1980; Hamada 1972), were either excluded or omitted from BKS and Eskew's studies. This perhaps helps to explain the inconsistent findings. So far, none of the previous studies seem to have been replicated to cross-validate earlier findings. Each research study uses a different, even though sometimes overlapping set of accounting risk measures. Most of the researchers were somewhat aware of measurement error, omitted variables and multicollinearity problems. But, none has faced the problem seriously, let alone come up with a reasonable solution. In fact, most researchers seemed to have been content with casually mentioning these problems and went on to report their findings as if these problems did not interfere with their results. If such studies cannot be cross-validated by a new set of data, they will be of little or dubious value. Cross-validation will lend some credence to empirical studies and thus, help theoretical development. So, it seems to be reasonable to Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

38 undertake a replication of earlier works. In the following section, the findings from partial replications of the BKS and Eskew studies will be reported. DESCRIPTION OF SAMPLE The Standard and Poor's Industrial Compustat 1985 tape was used to obtain the necessary financial data, and the University of Chicago Center for Research on Security Prices (CRSP) 1985 tape was consulted for the relevant market determined systematic risk. The CRSP monthly security return tape was used to estimate each firm's market determined systematic risk measure. Of the 3,211 firms listed on the tape, only 574 firms had a complete twenty-year database (January 1966 ? December 1985) of monthly returns. The Compustat tape has a total of 2,322 firms listed, of which 875 firms use the calendar year as the fiscal year. Of these 875, firms 395 firms are also listed on the CRSP tape. Therefore, 395 firms constitute the basic sample used in this study. REPLICATIONS In this section, the essential portions of the studies by BKS and Eskew, two of the most oft-cited studies, are replicated using the new data set described in the previous section. Beaver, Kettler and Scholes' Study 355 of the 395 firms in the basic sample have complete twenty years data on the Compustat tape for all the variables examined by BKS. This twenty-year period is broken down into two sub-periods with ten years each. The summary statistics of the two periods' systematic risks are presented in Table 1.
Table 1: Summary Statistics for Distribution of Estimates of Systematic Risk (beta) Mean Period one (66-75) Period two (76-85) .805 .810 Standard Deviation .299 .346 Range .077 to 0.97 .160 to 2.20

Correlation for the two period betas:.69108

Compared to the BKS sample (BKS 1970, Tables 1 and 2, 665) it can be seen that the means of the systematic risks using the same equally weighted market index as employed by BKS are smaller than those reported by BKS (.805 and 0.810 vs. .991 and .987). Also, the product moment correlation for the two time periods is .69, which is about 16 percent higher than the .59 reported by BKS. Together with the mean of the logarithm of the size variable, as presented in Table 2, one can see that, compared to the BKS sample (BKS 1970, Table 3, 667), the current sample consists of larger, less risky firms.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

39
Table 2: Summary Statistics for Accounting Risk Measures Mean Period Dividend payout Growth Leverage Liquidity Size Earnings variability Accounting beta one .485 .104 .480 2.100 6.250 .060 1.043 two .663 .085 .478 1.910 7.200 .092 .991 one .198 .043 .155 1.145 1.324 .066 1.481 Standard Deviation two 1.587 .048 .126 1.255 1.352 .149 2.498

These firms exhibit a higher growth rate in assets, much less liquidity and higher leverage. Also, the second period has much greater earnings variability and dividend payout; the accounting betas for both periods are much larger with somewhat larger cross-sectional standard deviations than the BKS sample. These findings are not surprising, since the second period covers the recessional period of the late seventies and early eighties. Due to the oft mentioned reluctance on the part of management to reduce dividends, the mean payout ratio could be larger simply because the earnings are smaller as a result of recession. Inspection of Table 3 reveals that all but two of the inter-period correlations for the accounting risk measures are similar in magnitude to those reported by BKS (BKS 1970, Table 4, 668).
Table 3: Inter-period Correlations for Accounting Risk Measures Dividend payout Growth Leverage Liquidity Size Earnings variability Accounting beta .059 .243 .784 .811 .963 .480 .299

The two notable differences are dividend-payout, which has a much lower inter-correlation, and accounting beta, which has a much higher inter-correlation than those reported by BKS. The lower inter-period correlation for the payout is probably due to the recession affecting the business in a non-homogeneous way, whereas the higher inter-period correlation for the accounting beta supports the claim that the current sample consists of more stable firms. The non-homogeneous impact of recession on business earnings is also suggested by the larger average earnings variability Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

40 for the second period. Of course, these results could also be due solely to sample variation. Results from the multiple regression analysis are presented in Table 4.
Table 4: Multiple Regression Summary coefficients Period Dividend payout Growth Leverage Liquidity Size Earnings variability Accounting beta one -.575 -.779 .393 .056 -.040 2.606 -.051 two -.082 -.692 -.286 .202 -.052 .674 .023 one -8.477 -2.692 3.526 3.699 -4.224 12.479 -5.414 t-statistics two -.810 -1.990 -1.822 1.203 -3.920 5.032 3.055

R-square: .499 F(7, 347)-statistics: 49.4 (period one) R-square: .286 F(7, 347)-statistics: 19.8 (period two)

The coefficients for all the variables except liquidity, accounting beta and, leverage have the correct signs as predicted by the theoretical and analytical results of Myers and Thurnbull (1977), Subramanyam and Thomadakis (1980), Ang, Peterson and Peterson (1984). The growth variable has a negative coefficient for both periods conforming to the results of Myers and Thurnbull. This negative relationship also holds for the simple correlation for both periods. This contradicts most, if not all empiricists' ad hoc arguments, which assert that, ceteris paribus, growth firms should be riskier (BKS 1970, 660). For period one, all variables are statistically significant (at .05 level of significance), whereas for period two, leverage, liquidity, and dividend payout are not significant. The coefficients for liquidity and accounting beta have the wrong sign for period one, and for period two, the coefficients for liquidity and leverage have the wrong sign even though they are not statistically significant. Such inconsistent findings have also been reported in past empirical studies (e.g., Breen and Lerner 1973; Ang, Peterson and Peterson 1984). Simple correlations between the systematic risk and the accounting risk measures are presented in Table 5. Compared to the BKS result (BKS 1970, Table 5, 669) the accounting beta, size and liquidity have much higher correlation with systematic risk, and growth and leverage have much lower correlations with systematic risk. One must be careful to avoid potentially misleading inferences based solely on analyses of simple correlation coefficients. For example, financial leverage is negatively correlated with systematic risk for both periods while dividend payout is positively correlated with the systematic risk for period two. These results appear, on the surface, to be counterintuitive. One possible source of this apparent inconsistency is the violation of the ceteris paribus assumption made in theoretical and analytical arguments. In multiple regression analysis, the relationship between the dependent and the independent variables is dealt with in a partial Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

41 fashion, i.e., the regression coefficient for an independent variable has the same sign as the partial correlation coefficient between the independent variable in question and the dependent variable with all the other independent variables held constant. Thus, as long as there are no interactive effects among the independent variables, multiple regression analysis is more in line with theoretical and analytical assumptions. Of course, the model must be free of misspecifications for proper interpretation.
Table 5: Contemporaneous Correlation between Accounting Risk measures and Systematic Risk Period Dividend payout Growth Leverage Liquidity Size Earnings variability Accounting beta one -.329 -.095 -.001 .232 -.305 .535 .190 two .024 -.226 -.119 .241 -.301 .388 .361

The results of the BKS model, i.e. using accounting risk measures to reduce measurement error of period one's beta, are provided in Table 6.
Table 6: BKS Model with New Data Set Coefficients Dividend payout Growth Earnings variability R-square: .391 F(3, 351)-statistics: 74.97 -.511 -.833 2.275 t-statistics -7.744 -2.704 11.843

The multiple correlation (.63) is only slightly less than the .67 reported by BKS (BKS 1970, 672). Also, growth has a negative coefficient as opposed to the positive one reported by BKS. Another interesting similarity between the two results is that the magnitude of the coefficients (ignoring the sign difference for the growth variable) is very similar. Table 7 provides the forecasting results of various models.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

42
Table 7: Analysis of Forecast Errors Mean Square Error Naive Model BKS Model .070 .081 Mean Absolute Error .202 .233

The naive forecasting model, which uses period one betas as forecasts of their corresponding period two counterparts, produces forecasts with mean square error of .07 and mean absolute error of .202. The respective values given by BKS are .093 and .239 (BKS 1970, Table 7, 677). The BKS model produces forecasts having mean square error of .081 and mean absolute error of .233; the corresponding results given by BKS are .089 and .23 (BKS 1970, Table 7, 677). From these results, it can be seen that the instrumental variables approach actually increases forecast errors for the current sample. This is in direct contrast to the results provided by BKS. One possible explanation is that the current sample consists of more stable firms as mentioned before, and the inter-period correlation for the systematic risk is much higher. Of course, besides the possible impact of sampling variation, measurement errors and omitted variable problems are other possible causes of this contradictory finding. Notice that the improvement of mean square error from .093 to .089 and of mean absolute error from 0.239 to 0.230 as reported by BKS was not impressive and it might have occurred simply by chance. Eskew Study Eskew used the CRSP value weighted index as a surrogate for the market portfolio return. By using this index, the un-weighted arithmetic mean of the firm's betas is no longer one, as Eskew seemed to have implied in his article (1979, 108 and 117). Table 8 provides the summary statistics for the systematic risk.
Table 8 Summary Statistics for Distribution of Estimates of Systematic Risk (beta) Mean Period one Period two 1.067 .963 Standard Deviation .331 .384 Range .180 to 2.23 .230 to 2.28

Correlation for the two period betas: .62389

The mean of the betas is 1.07 and .96 for periods one and two respectively. They are slightly smaller than those given by Eskew (Eskew 1979, Table 3, 115). Note that Eskew broke his sample into three six year sub-periods. The multiple regression result is presented in Table 9.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

43
Table 9: Multiple Regression Summary Coefficients Period Dividend payout Growth Leverage Liquidity Size Earnings variability Accounting beta one -.749 .387 .180 .052 -.015 2.761 -.074 two -.009 -.567 -.507 .023 -.017 .649 .026 one -9.369 1.136 1.367 2.866 -1.334 11.225 -6.712 t-statistics two -.748 -1.385 -2.741 1.147 -1.077 4.116 2.933

R-square: .434 F(7, 347)-statistics: 38.0 (period one) R-square: .200 F(7, 347)-statistics: 12.4 (period two)

Some interesting points are worth noting when Table 9 is compared to Table 4. The only difference between the two tables is the market determined systematic risk. In Table 4, the dependent variable is estimated from the market model by using the CRSP equally weighted market index, whereas, in the current table the market index used is the value weighted index. There are differences in the significant variables as well as some of the signs of the coefficients. For period one, the significant variables are dividends payout, earnings variability, accounting beta and liquidity, and for period two, the significant variables are earnings variability, leverage and accounting beta. The coefficients for accounting beta, liquidity and growth have the wrong signs for period one; only the coefficients for leverage and liquidity have the wrong signs for period two. Again, this is consistent with the inconclusive results reported in the literature. Table 10 presents the contemporaneous correlation between the accounting risk measures and the systematic risk estimated from the CRSP value weighted market index.
Table 10: Contemporaneous Correlation between Accounting Risk Measures and Systematic Risk Period Dividend payout Growth Leverage Liquidity Size Earnings variability Accounting beta one -.417 -.091 -.076 .227 -.196 .415 .093 two .021 -.175 -.157 .208 -.169 .323 .323

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

44 Again, care must be exercised in interpreting the simple correlation coefficients as discussed above. Using the SPSS stepwise regression procedure with F set to enter and to remove at 3.5 and tolerance level set at .9, Eskew selected growth, size, and earning's variability as the three significant independent variables. Notice that dividends payout, which was used by BKS was no longer significant and was replaced by a size variable. The results of the Eskew's model are presented in Table 11.
Table 11: Eskew Model with New Data Set Coefficient Size Growth Earnings variability R-square: .226 F(3, 351)-statistics: 34.23 -.044 1.269 2.144 t-statistics -3.716 3.452 8.966

The signs of the coefficients are identical to those reported by Eskew (1979, Table 2, 113). But, the current R square (.23) is slightly less than that reported by Eskew (.27). Notice that this is much smaller than the squared inter-period correlation (.39) of the systematic risks. The model is also fitted to the systematic risk estimated from the equally weighted market index. The R?square is .36 and growth has an insignificant, though negative coefficient. From this, it appears that the usefulness of accounting information is sensitive to the choice of market index. Elgers and Murray (1982) reached a similar conclusion. The results of various forecasting models are presented in Table 12.
Table 12: Analysis of Forecast Errors Mean Square Error Naive Model Eskew Model .109 .140 Mean Absolute Error .266 .311

The naive model produces forecasts having mean square error of .109 and mean absolute error of .266; the corresponding values given by Eskew are .145 and .2995 (Eskew 1979, Table 4, 115). Using the three variables selected by Eskew as instrumental variables to reduce the measurement error for period one's betas, the resulting forecasts have a mean square error of .141 and mean absolute error of .311; the corresponding values given by Eskew are 0.0952 and 0.2315 respectively (Eskew 1979, Table 5, 115). As in the case of the replication of BKS, using accounting variables as instrumental variables actually increases the mean square error and mean absolute error of the forecasts. This is in direct contrast to the results given in Eskew's article, where he showed that accounting variables improved the forecast. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

45 When Eskew's stepwise regression approach was employed, it selected three accounting risk measures: dividend payout, earnings variability, and liquidity as the three significant variables for betas estimated from CRSP value weighted market index. These three variables were then used as instrumental variables for period one's beta. This model produces forecast errors having mean square error of .106 and mean absolute error of 0.265. This is a negligible improvement over the naive forecast. On the other hand, the same method applied to the betas estimated from CRSP equally weighted index, selects earnings variability, dividend payout, size, accounting beta and growth as the significant variables. However, the resulting model produces forecast errors having mean square error of .096 and mean absolute error of .249, which are worse than those produced by a naive model. CONCLUDING REMARKS Portions of the results of the two replications are inconsistent with those reported by BKS and Eskew. The instrumental variables approach used to reduce measurement error of the period one's betas for forecasting the second period's betas not only fails to improve forecasting accuracy, it actually increases the mean square error and mean absolute error for the current sample. Apparently, the usefulness of the accounting risk measures in improving forecast accuracy depends on the market index as well as the sample and time period studied. Also, by the nature of the instrumental variables approach, bias is not affected. This disturbing finding could potentially arise from measurement errors, multicollinearity and omitted variables problems. Users of accounting information should be cautioned against using the research results of a particular study. Without sound theoretical guidance, any empirical study must be replicated to cross-validate the results. There are some preliminary piecewise theoretical advances in this area of research (Galai and Masulis 1976; Goldenberg and Chiang 1983; Hamada 1972; Myers and Thurnbull 1977; Senbet and Thompson 1982; Subramanyam and Thomadakis 1980). To cope with measurement error and multicollinearity problems, the linear structural equation model (LISREL) suggested by Joreskog and Sorbom (1982) or the partial least squares model developed by Wold (1982) may be viable alternatives to the problem-ridden linear regression model as is commonly employed.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

46 REFERENCES Altman, E. I., Haldeman, R. G., & Naraynan, P. (1977). ZETA analysis: A new model to identify bankruptcy risk of corporations. Journal of Banking and Finance 1(June), 29-54. American Accounting Association. (1966). Committee to Prepare Statement of Basic Accounting Theory. 1966. A Statement of Basic Accounting Theory (ASOBAT). Evanston, Ill.: AAA. American Institute of Certified Public Accountants. (1973). Study Group on the Objectives of Financial Statements. Objectives of Financial Statements (Trueblood Report). New York: American Institute of Certified Public Accountants. Ang, J., Peterson, P., & Peterson, D. (1984). Investigation into the determinants of risk: A new look. Working Paper, College of Business, Florida State University, Tallahassee, Florida. Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income numbers. Journal of Accounting Research (Autumn), 157-77. Ball, R., & Brown, P. (1969). Portfolio theory and accounting theory. Journal of Accounting Research (Autumn), 300-23. Beaver, W. H., Kettler, P., & Scholes, M. (1970). The association between market determined and accounting determined risk measures. The Accounting Review (October), 654-82. Ben-Zion, U., & Shalit, S. (1975). Size, leverage, and dividend record as determinants of equity risk. Journal of Finance (September), 1015-26. Bildersee, J. S. (1975). The association between a market measure of risk and alternative measures of risk. The Accounting Review (January), 81-98. Bowman, R. G. (1979). The theoretical relationship between systematic risk and financial (accounting) variables. Journal of Finance (June), 617-30. Breen, W. J., & Lerner, E. M. (1973). Corporate financial strategies and market measures of risk and return. Journal of Finance (May), 339-52. Brenner, M., & Smidt, S. 1978. Asset characteristics and systematic risk. Financial Management (Winter), 33-39. Copeland, R. M. & Ingram, R. W. (1982). The association between municipal accounting information and bond rating changes. Journal of Accounting Research 20 (Autumn), 275?89.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

47 Deakin, E. B. (1972). A discriminant analysis of predictors of business risk. Journal of Accounting Research 10 (Spring), 167-79. Elgers, P. (1980). Accounting?based risk predictions: A re? examination. The Accounting Review (July), 389-408. Elgers, P. & Murray, D. (1982). The impact of the choice of market index on the empirical evaluation of accounting risk measures. The Accounting Review (April), 358-75. Eskew, R. K. (1979). The forecasting ability of accounting risk measures: Some additional evidence. The Accounting Review (January), 107-18. Financial Accounting Standards Board. (1983). Statements of Financial Accounting Concepts NO. 1 in Accounting Standards, Original Pronouncements(1988). Homewood, Ill: IRWIN. Gailai, D., & Masulis, R. W. (1976). The option pricing model and the risk factor of stock. Journal of Financial Economics, 53-81. Gahlon, J. M. (1981). Operating leverage as a determinant of systematic risk. Journal of Business Research, 297-308. Gahlon, J. M., & Gentry, J. A. (1982). On the relationship between systematic risk and the degrees of operating and financial leverage. Financial Management (Summer), 15-23. Goldenberg, D. H., & Chiang, R. (1983). Systematic risk and the theory of the firm. Journal of Accounting and Public Policy, 63-72. Hamada, R. S. (1972). The effect of the firm's capital structure on the systematic risk of common stocks. Journal of Finance (May), 435-52. Hill, N. C. & Stone, B. K. (1980). Accounting betas, systematic operating risk, and financial leverage: A risk composition approach to the determinants of systematic risk. Journal of Financial and Quantitative Analysis (September), 595-637. Jensen, R. (1967). Multiple regression models for cost control-assumptions and limitations. The Accounting Review (April), 265-272. Joreskog, K. G., & Sorbom, D. (1982). Recent developments in structural equation modeling. Journal of Marketing Research, 404-16. Judge, G. G., Griffiths, W. C., Hill, R. C., Lutkepohl, H., & Lee, T. C. (1985). The Theory and Practice of Econometrics. New York: John Wiley and Sons. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

48 Lev, B. (1974). On the association between operating leverage and risk. Journal of Financial and Quantitative Analysis (September), 627-41. Lev, B., & Kunitzky S. (1974). On the association between smoothing measures and the risk of common stocks. The Accounting Review (April), 259-70. Logue, D. E., & Merville L. J. (1972). Financial policy and market expectations. Financial Management (Summer), 37-44. Mandelker, G. N., & S. G. Rhee, S. G. (1984). The impact of the degrees of operating and financial leverage on systematic risk of common stock. Journal of Financial and Quantitative Analysis (March), 45-57. Melicher, R. W. (1974). Financial factors which influence beta variations within a homogeneous industry environment. Journal of Financial and Quantitative Analysis (March), 231-241. Melicher, R.W., & Rush, D. F. (1974). Systematic risk, financial data, and bond rating relationships in a regulated industry environment. Journal of Finance (May), 537-44. Myers, S. C., & Turnbull, S. M. (1977). Capital budgeting and the capital asset pricing model: Good news and bad news. Journal of Finance (May), 321-33. Eubank, K. Mingo, & Caruthers, J. (1975). The hierarchical classification of financial ratios. Journal of Business Research (October), 295-310. Pinches, G., Mingo, A. K., & Caruthers, J. (1977). The stability of financial patterns in industrial organizations. Journal of Finance (March), 389-96. Rosenberg, B., & McKibben, W. (1973). The prediction of systematic and specific risk in common stock. Journal of Financial and Quantitative Analysis (March), 317-34. Senbet, L. W. & Thompson, H. E. (1982). Growth and risk. Journal of Financial and Quantitative Analysis (September), 331-40. Sharpe, W. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance (September), 425-42. Subrahmanyam. M. G. & Thomadakis, S. B. (1980). Systematic risk and the theory of firm. The Quarterly Journal of Economics (May), 437-51. Thompson, D. J. (1976). Sources of systematic risk in common stock. Journal of Business (April), 173-88. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

49 Wampler, R. H. (1970). A report on the accuracy of some widely used least squares computer programs. Journal of the American Statistical Association, 540-65. Watson, C. J., Stock, J. D., & Watson, K. D. (1983). Multivariate normality and a bond rating decision model. Decision Science 14(Fall), 513-26. White, R. (1972). On the measurement of systematic risk. Unpublished Ph. D. Dissertation, M.I.T. Wickens, M. R. (1972). A note on the use of proxy variables. Econometrica (July), 759?61. Wold, H. (1982). Soft Modeling: The Basic Design and Some Extensions. In K. Joreskog & H. Wold (Eds.), Systems under Indirect Observation (Part II) (pp. 1-54). Amsterdam: North Holland.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

50

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

51

COMPENSATION OF INVESTMENT COMPANY ADVISORS: AN EMPIRICAL INVESTIGATION


Denise Woodbury, Weber State University Kyle Mattson, Weber State University
ABSTRACT Data about the compensation contracts of open-end investment companies is collected and empirically examined. As expected, compensation is always a function of the NAV of the investment company and, in general, compensation is (weakly) monotonically decreasing in the marginal rate paid on increasing levels of NAV. Less often, the compensation contract is also contingent on the income of the company. In the cases where the method of calculating the income proportion of compensation is identifiable, the compensation is (weakly) monotonically decreasing in the marginal rate paid on increasing levels of income. Interestingly, however, the definition of "cash income" varies across investment companies. In addition, open-end investment companies pay additional compensation (or reduce the compensation paid) as a function of excess expenses, a group fee, and/or performance relative to a benchmark component. As expected, compensation is contingent (either explicitly or implicitly) on performance. Counter to intuition and the agency framework model developed, the less risky the portfolio (measured by purpose, composition, or size), the more sensitive is the compensation contract to performance. BRIEF REVIEW OF THE AGENCY MODEL Agency models generally address the problem of moral hazard. This problem occurs when a decision made by one individual, striving to satisfy personal desires, affects the welfare of others. Furthermore, those so affected cannot observe or directly control the choice made by the individual. In an agency model, the principal is the owner of a business who, for some reason, chooses not to be directly involved in the management of the firm; instead, the principal hires an agent and delegates decision-making authority for the enterprise to that agent. The owner of the firm might choose not to be involved in the operation of the business because of a desire not to expend effort or because the agent has a comparative advantage (either in resources or ability) in the management of the firm or because of a desire to diversify personal and capital resources. If the principal and agent have different goals, if it is too costly to monitor the behavior of the agent, and if both of the parties seek to meet their own goals, the agent won't act in the best interests of the principal. If the agent has decision-making authority and the agent's choices are not easily observed and controlled, the choices he or she makes are unlikely to be consistent with the objectives of the principal. Suppose the agent expends effort to improve the outcome of the business. The principal receives the net profit of the operation of the business less the fee paid to the agent. Thus, the principal may receive the benefit of the agent's expenditure of effort through the increase in the Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

52 profitability of the enterprise. However, the agent is assumed to have some, as yet unspecified, level of disutility associated with the expenditure of effort. Because the agent may or may not, depending on the compensation scheme, receive the full benefit of any increase in effort, the agent may choose a level of effort less than the principal would like. The problem of the principal is to motivate the agent to act in a manner that will be mutually satisfying. The contract that leads to the highest level of expected utility for the principal may be relatively simple or may be quite complex. If the actions of the agent are perfectly and costlessly observable, the principal can merely reward the agent for the "correct" action and punish the agent for the "incorrect" action. However, it is usually the case that the actions or effort of the agent are not perfectly and costlessly observable. In this case, the incentives for the agent must be aligned in such a way that the agent works in a manner desired by the principal. Problems arise when the effort or actions of the agent are not perfectly and costlessly observable and the incentives of the agent do not lead to behavior that is consistent with the desires of the principal. This is the case which is typically modeled in the principal-agent literature. Moral hazard problems may be characterized by a divergence of incentives between the two parties and asymmetric information. One possible solution for this problem is to make compensation contingent on the variable of concern for the principle, which in this case is the outcome of the business venture. The agent will expend effort just as if he or she were the principal if the fee paid to the agent is a residual claim on the performance of the company. Such a contract aligns the incentives of the agent with those of the principal by having the agent bear the consequences of his/her choice of effort. However, if the risk tolerance of the principal differs from that of the agent, this contract may not be efficient; it may result in the relatively risk-averse party to the contract bearing all of the risk of the enterprise. Both effort and risk bearing are important in the design of compensation contracts. Paying the agent a residual claim induces effort, but allocates risk to the party for whom the assumption of risk may be most costly. Compensating the agent with a fixed fee will provide improved risk sharing if the agent has lower risk tolerance than the principal. It does not, however, provide the agent with incentive to expend effort. The optimal scheme would be expected to balance these two forces by compensating the agent through the use of both a fixed fee payment and a partial claim on the outcome of the enterprise. The exact form of an optimal contract would, therefore, depend on the relative degrees of risk aversion of the parties to the contract, on the relation between the outcome of the business venture and the effort of the agent, and on the degree to which the actual effort of the agent may be observed. SUMMARY OF HYPOTHESES IDENTIFIED BY WOODBURY & NEAL (1999) Compensation contracts might potentially be designed to alleviate, at least in part, the agency problem. Features of these compensation contracts might include a portion of compensation, which is a function of the objective of the individual fund, as well as of the restrictions placed on the constituent assets of the fund.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

53 In general, compensation would be expected to be a positive function of the outcomes of NAV and of income. However, the sensitivity to outcome might be expected to be lower if the portfolio is more risky, given the likely relative risk aversions of the parties to the contract. Thus, compensation would be less sensitive to outcome for investment companies with a purpose of growth or for investment companies whose portfolio compositions reduce the agent's ability to diversify the portfolio. Further, compensation should be concave in outcome, whether that outcome is a function of wealth or of income. This concavity might be due to transactions costs and a margin of inefficiency in the market, which may be exploited by the investment advisors who are risk averse; the compensation contract would be concave to balance the incentive and risk imposition aspects of the agency problem. It might be a function of the Grinblatt & Titman (1989) argument that considers compensation contracts as options on the difference between the value of the portfolio and the value of the benchmark portfolio and yields concavity in the valuation function. Alternatively, it might be a result of the U.S. tax code under which investors face convex tax schedules and therefore concave after-tax returns and would want their investment advisors to face similar concave compensation schedules to better align their incentives. Shareholders seem to indicate their degree of risk aversion, or alternatively, their desired level of risk, to the fund manager, through the statement of purpose. The compensation contract of the advisor might reasonably be designed to reinforce the stated objective of the investment company. Additionally, the stated composition of the fund might be expected to reflect the desires of the shareholders. In this statement, the documentation of the fund indicates the proportion of the fund which may be invested in particular instruments (e.g., common stocks, preferred stocks, and bonds), the extent to which the fund may be leveraged, and the allowed risk level of the constituent investments (e.g., no more than 50 percent of the fund invested in securities rated lower than "A" by a particular rating service). Given the statements of purpose and composition, risk and return do appear to be concerns of investors. Additionally, the form of the increase in wealth appears to concern the investor. One characteristic of the form of income emphasized in the objective's statement is often current income. Growth is a second characteristic of the form of increases in wealth often emphasized in the objective's statement. A third characteristic in some objective statements is a tax-free realization of returns. Other concerns are also expressed in this way. Given this range of stated objectives of the various investment companies, risk level, increases in wealth, and the form of the increase all appear to be issues of concern to the investors of investment companies. The problem of the principal appears to lie in determining how to motivate the manager to act in a manner which would be mutually satisfying to both the agent and the principal. A compensation contract that provides such incentives ties the compensation of the agent to the "outcome" of the period or of multiple periods (e.g., compensation by the week, month, or quarter but on at an annualized rate) . Finally, the effect of size on compensation is ambiguous. As the size of the fund increases, and therefore the ability of the manager to exploit the margin of inefficiency in the market improves, the sensitivity of the compensation of the agent should increase, reflecting the greater benefit to be

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

54 shared. Conversely, if the diversification of the portfolio is more limited or if the form of investment is more limited, compensation may be less sensitive to outcome in larger funds. OPEN-END INVESTMENT COMPANY SAMPLE Although managerial compensation contracts are not typically publicly available, in certain instances the contractual terms are available. If an investment company is managed by an outside entity (an investment advisor), the Securities and Exchange Commission (SEC) requires that the contract between the investment advisor and the investment company must be approved annually by the shareholders. To obtain this approval, management must publish a summary of the exact form of compensation; this compensation is usually stated in terms of observable variables. Initial identification of the sample of open-end investment companies is obtained from the Weisenberger's Mutual Fund Panorama (Panorama). The Panorama provides a listing of the mutual funds registered for sale in the U.S. as well as some basic information about each of the funds. The Panorama identifies both the primary objective and the investment policy of the fund. It also specifies total net asset and the net asset value per share. The stock of open-end investment companies is not traded in a secondary market, hence traditional stock market returns are not available. Alternatively, we may examine net income (dividends and interest received), net realized and unrealized gain or loss, dividends paid, change in NAV, or change in the number of investment company shares outstanding as a measure or indication of return on an investment in an open-end investment company. Two years of data for this sample were collected. The years selected were 1980 and 1985, which were chosen for access to the Weisenberger and Moody's information necessary for the analysis. Additional detail is available for many of the investment companies in Weisenberger's Investment Companies 1981 (for the 1980 data) and Investment Companies 1986 (for the 1985 data). From the Weisenberger's publication we obtain the total net assets of the mutual fund, the income dividend paid, the capital gains distributed, the name of the investment advisor, and a summary of the advisor's compensation contract, where possible. Additional, as well as confirmatory, detail is available from the appropriate issue of Moody's Bank and Finance Manual (Moody's). From Moody's we obtain a summary of the compensation contract of the investment advisor, the number of shareholders invested in the fund, and a statement of the Net Assets of the mutual fund as well as an identification of the securities which comprise the investment portfolio. When the compensation contract is available for a specific company from both Weisenberger's and Moody's, the Moody's information is used to verify the accuracy of the Weisenberger's report. The eight discrepancies observed are a consequence of annualizing a fee which is stated on a less than annual basis. The sample from the Panorama contains 659 open-end companies in 1980 and 1356 companies in 1985. Only a clear description of the compensation contract from either Weisenberger's or Moody's is required for inclusion in the sample. These criteria resulted in 437

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

55 observations for 1980 and 540 observations for 1985. Unfortunately, it also resulted in 23 observations which were only partially useful because of a lack of additional information. CHARACTERIZATION OF THE COMPANIES IN THE SAMPLE Tables one and two show the primary objective and the investment policy, respectively, of the companies for the 1980 and 1985 samples for which this information was available. From Table 1 we see that Growth, Income, and Income plus Growth are the three most common stated purposes for 1980. Further, Growth has nearly twice the number of observations of Income and three times the incidence of Income combined with Growth. Growth and Income, with similar incidence of observation, still, however, dominate the sample with more than three times the number of observations of either Tax Avoidance or Income plus Growth in 1985. A chi-square test for differences in purpose by year is significant at a 1 percent level, with a chi-square statistic of 33.327.
Table 1: Frequency Table of Fund Purpose by the Year of Observation Purpose Growth Income Tax-Avoidance Income and Growth Income and Security Growth and Security Income, Growth, and Security TOTAL 1980 200 105 19 72 13 1 27 437 Percent 46 24 4 17 3 0 6 100 1985 196 184 59 67 11 0 23 540 Percent 36 34 11 13 2 0 4 100

From Table 2 we see that Common Stock as a required portfolio composition dominates both the 1980 and 1985 samples. For 1980, the next most frequently cited compositions are Bond and Diversified/Flexible but these combined represent only one-fourth of the observations. By 1985, the incidence of Diversified/Flexible has fallen significantly whereas bond funds represent nearly 20 percent of the observations and money market funds are now 13 percent of the sample. Information about the portfolio of securities, including the number of securities held in the portfolio holdings, is available. Thus, the portfolio investment policy and the fund's stated purpose appear to indicate the risk characteristics of the investment company. A chi-square test of the relationship between composition by year is also significant at the 1 percent level with a chi-square statistic of 53.819.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

56
Table 2: Frequency Table of Portfolio Composition by the Year of Observation Composition Diversified / Flexible Bonds Specialized Common Stock International Balanced Bonds and Preferred U.S. Government Securities Money Market Funds Tax-Free Money Market Funds Preferred TOTAL 1980 50 57 14 251 9 21 9 0 25 0 1 437 Percent 12 13 3 57 2 5 2 0 6 0 <1 100 1985 37 104 12 251 11 18 8 14 72 10 3 540 Percent 7 19 2 47 2 3 1 3 13 2 1 100

To demonstrate the relationship between purpose and composition, Table 3 provides a frequency table of the stated fund purpose by the required portfolio composition for both years of the sample. Several of the pairs of purpose and composition seem to dominate. For instance, the portfolio of Common Stock is concentrated primarily in Growth funds with Income & Growth a distant second. Also, the required portfolio composition of Bonds has roughly equal (and dominant) representation in stated fund purpose of Income and of Tax Avoidance. A chi-square test of purpose by composition yields a chi-square statistic of 1478.775 which is significant at the 1 percent level. To reduce the number of categories, we reclassify the portfolio composition variable into three mutually exclusive categories: diversified, limited diversification, and no diversification. We also reclassify the fund purpose into four categories which are not mutually exclusive: growth, income, security, and tax-free. Table 4 provides the frequency table for the sample using this classification scheme. Table 4 indicates that funds that include Income in their stated purpose tend to allow only limited diversification. Funds that include Income in their stated purpose are fairly equally divided between full diversification and limited diversification with very few observations of no diversification. All open-end funds in the sample with a purpose of Tax Avoidance allow only limited diversification. Chi-square tests of growth by classification of composition, income by classification of composition, security by classification of composition, and tax avoidance by classification of composition are all significant at the 1 percent level.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

57
Table 3: Frequency Table of Fund Purpose by Portfolio Composition for the Entire Sample (G = Growth; I = Income; S= Security; TF=Tax-Free) Composition Diversified / Flexible Bonds Specialized Common Stock International Balanced Bonds and Preferred U.S. Government Securities Money Market Funds Tax-Free Money Market Funds Preferred TOTAL G 11 0 16 354 14 1 0 0 0 0 0 396 I 47 74 6 30 1 3 12 13 89 10 4 289 TF 0 78 0 0 0 0 0 0 0 0 0 78 I&G 18 3 3 105 4 6 0 0 0 0 0 139 I&S 3 6 1 3 0 0 2 1 8 0 0 24 G&S 1 0 0 0 0 0 0 0 0 0 0 1 I,G&S 7 0 0 10 1 29 3 0 0 0 0 50 Total 87 161 26 502 20 39 17 14 97 10 4 977

Table 4: Frequency Table of Classification of Required Portfolio Composition (mutually exclusive categories) by Classification of Fund Purpose (not mutually exclusive categories) for the Entire Sample Fund Purpose Includes Income Growth Security Tax Avoidance Number of Observations Diversified 210 73 48 0 223 Limited Diversification 252 475 24 78 684 No Diversification 40 38 3 0 70

CHARACTERIZATION OF THE COMPENSATION CONTRACTS Stock pyramid schemes, self-dealing transactions, and outright embezzlement were just a few of the abuses perpetrated against investors by the organizers of early mutual funds (Baumol, et.al., 1990). Lack of information available to the public contributed to the self-seeking behavior of these managers. These abuses led to the passage of the Investment Company Act of 1940 (the 1940 Act). The Act established an oversight structure for the investment company industry. Legislators hoped to minimize the opportunity for mutual fund providers to ignore the interests of shareholders and to practice selfish behavior to the detriment of the investors. The 1940 Act requires that every Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

58 investment company distribute, at least semiannually, a report of the company's activities to the shareholders. These reports must contain a variety of financial information as well as information about the portfolio and any portfolio activity over the time period. The 1940 Act also requires that the written compensation contract be precisely described, be renewed at least annually, be terminable without penalty and with up to 60 days' notice by the board of directors or by the shareholders, and be terminable automatically if it is assigned. In addition to the reporting requirements, the 1940 Act gave the SEC the power to intervene on behalf of a fund's shareholders; in particular, the Act allowed the SEC to sue for "gross misconduct or abuse of trust" on the part of the investment advisor. Mutual funds were a relatively new investment vehicle in the 1930s. As the popularity of mutual funds grew, Congress became more conscious of the regulation of the investment company industry. The findings of several reports commissioned by Congress in the 1960s indicated that because a particular fund is organized and managed by its investment adviser, it cannot sever its ties to its adviser without losing its unique character. Thus the likelihood of changing management is reduced and one of the mechanisms of market discipline is circumvented. Another major concern cited by the reports was a potential conflict of interest between shareholders and fund management. It was suggested that the 1940 Act did not sufficiently control for these problems. The 1970 Amendments were passed to try to control for the potential conflicts of interest and for the possible absence of arm's-length bargaining. Among other effects, the 1970 Amendments explicitly specified the fiduciary duty of the investment adviser and provided a mechanism for the challenge of an advisory fee contract by either the SEC or the shareholders with the burden of proof resting on the plaintiff. The purpose of this legislation has been to protect small investors in mutual funds against abuses by a fund's investment adviser. One way to effect this protection has been to require public dissemination of information. This section provides a simple characterization of the extant compensation contracts of investment companies. The compensation of the adviser can be determined by examining the annual report of the investment company in which the compensation package and the amount and composition of the remuneration for the prior year is generally reported. The following is an example of the detail of the investment advisor contract of an open-end company, Bond Fund of America, Inc., for 1985, as provided by Weisenberger (1986):
Investment Adviser: Capital Research and Management Co. Compensation to the Adviser is at an annual rate of 0.30% on the first $60 million of net assets and 0.21% on assets over $60 million computed and paid on a monthly basis, plus 3% of the first $450,000 of monthly gross investment income and 2.25% on the excess over $450,000.

The actual compensation contracts of investment company advisors can be expressed as a function of NAV, of some measure of fund income, of some measure of fund performance, of a group fee, and a negative function of excess expenses: C(V,W,X, Y, Z) = k + G(V) +H(W) + I(X) + J(Y) + K(Z) with: G(0), H(0), I(0), J(0), K(0) = 0 and V, W, X, Y, Z > 0. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

59 Here k is a constant, V is the NAV, W is a measure of fund income, X is a measure of fund performance relative to an explicit benchmark index, Y is the total assets managed by the investment advisor, Z is a measure of "excess expenses," and C is total compensation. Fixed Fee Component - k The constant, k, can be positive, zero, or negative. For example, a positive fixed fee might be used to provide a minimum level of expected income to managers who expend effort and face risk. In contrast, a negative fixed fee might be used to provide increased risk-bearing and hence increased incentives for the investment advisor. The fixed fee component was zero in 966 of the 977 cases where compensation contracts were identifiable, with only eleven observations of a nonzero fixed fee component. These eleven nonzero fixed fees occurred among 10 of the open-end investment companies, with two of the observations in 1985 and the other nine observations in 1980. The values of the nonzero fixed fees ranged from -$350,000 to $1,948,000. Observations of such fixed fee components indicates a lower bound on compensation for most investment companies. For companies without excess expense penalties or compensation for performance relative to a benchmark, the lower bound is attained when a loss of 100% of the assets of the investment company occurs in one year. The likelihood of a total loss of assets before shareholders either discharge the manager or redeem their proportionate share of the investment company is low. NAV Component - G(V) In every case for which the compensation package is available, the compensation contract pays the advisor a percentage of the fund's NAV. For a given contract the percentage paid often varies in NAV. Moreover, G(V) is always piecewise linear. As shown in Table 5, the observed number of intervals for the sample ranges from one to eleven with marginal rates ranging from zero to two percent. Four hundred sixty-six of the 954 observations have only one NAV interval whereas the remaining 488 contracts have two or more NAV intervals. The final interval always has infinite length with any preceding intervals of discrete length. The pattern for these NAV schedules is, in general, (weakly) monotonically decreasing in the marginal rate paid on increasing levels of NAV. When an observed NAV schedule is not monotonically decreasing, it starts at zero, after which the marginal rate becomes positive at some specified percent and is then monotonically decreasing. In 950 of the 954 cases for which the NAV portion of the compensation contracts are available, the last marginal rate being paid on NAV is greater than zero, but in four cases the last marginal rate being paid on NAV is zero. Thus most, but not all, of the investment company advisors are being compensated for increased size of the firm in all cases for all possible values of NAV. Ironically, those observations for which the last marginal rate is zero are all investment companies with a stated purpose of growth / capital appreciation. Table 6 provides statistics for the operating rate and the marginal elasticity of NAV compensation.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

60
Table 5: Descriptive Statistics Characterizing NAV Components for the Entire Sample * in millions NAV Interval Mean Marginal Rate Median Marginal Rate Maximum Marginal Rate Minimum Marginal Rate Mean Discrete Interval Length* Median Discrete Interval Length* Minimum Discrete Interval Length* Number of Observations of Infinity Number of Observations 1 2 3 4 5 6 7 8 9 10 11 .0060 .0052 .0044 .0040 .0037 .0036 .0031 .0030 .0030 .0028 .0025 .0055 .0050 .0045 .0039 .0068 .0035 .0032 .0030 .0030 .0028 .0025 .0200 .0175 .0100 .0091 .0066 .0050 .0035 .0033 .0030 .0028 .0025 .0000 .0000 .0000 .0005 .0015 .0025 .0025 .0028 .0030 .0028 .0025 165 100 1 466 954 178 150 3 157 488 271 250 25 184 331 432 250 50 101 147 528 250 50 32 46 735 250 100 4 14 231 250 250 100 2 10 100 100 100 100 7 8 100 100 100 100 0 1 100 100 100 100 0 1 100 100 100 100 1 1

Maximum Discrete Interval Length* 1500 1300 4000 5000 5000 5000

Table 6: Descriptive Statistics on Elasticity and the Operating Marginal Rate for the Entire Sample Elasticity Number of Observations Mean Median Maximum Minimum 953 .970528 1 6 .52831 Operating Rate 954 .005585 .0050 .02 0

The length of the intervals also varies both within plans and across plans. The greatest length of an interval for a closed end investment company is infinite since all of the compensation contracts provide for some percentage of NAV "in excess thereof." The minimum length for an interval is $1,000,000. The largest finite (discrete) interval is $5,000,000,000. Income Component - H(W) Another component of compensation found in these contracts is some specified percentage of cash income. For the open-end investment companies, only 41 of the 977 companies have a compensation contract explicitly contingent on income. The percentages paid ranged from one to six percent. However, in 6 of the 15 cases in which the rates paid on income were discernable, the compensation based on income was in a graduated from with decreasing percentages paid on increased income, in a manner similar to the compensation paid on the NAV of the investment company. The number of intervals ranged up to three. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

61 In a manner similar to the pattern of NAV compensation, as the level of income increases the marginal rate paid on income decreases (or remains constant) in a piecewise fashion. The definition of "cash income" does differ across funds. In most cases cash income is designated as dividends and interest received in cash less interest paid by the investment company. However, in a few cases cash income is defined as interest and dividends received in cash with no mention of interest paid by the investment company. Performance Relative to a Benchmark - I(X) In 24 of the 977 open-end investment companies the managers were compensated for the performance of their investment company relative to some index, commonly the S&P 500. Ten of the companies have contracts that evaluate performance relative to a benchmark during both 1980 and 1985. Eight additional companies had such contracts in 1980 while six additional contracts were observed in 1985. Of these 34 observations, 31 are for common stock portfolios and 27 of these companies have stated growth as the sole purpose of their fund. Four more have growth as one of their principle, though not sole, purposes. Group Fee Component - J(Y) In 35 of the 977 open-end contracts, the investment advisor is compensated by each of the investment companies under their portfolio umbrella for the total assets being managed. Twenty-four of these contracts are observed in 1980 and 11 in 1985 with no overlap in the sample of companies. Recall that the same companies are not necessarily included in the sample during both 1980 and 1985. Thus, the lack of overlap does not necessarily mean that the company changed their contract over time. Excess Expenses Component - K(Z) In 19 observations (for 17 companies, with two of the companies observed in both 1980 and 1985) the investment companies explicitly reduced the compensation of their advisor by some measure of excess expenses. For example, ten of these observations were for 1980 and 9 cases were observed for 1985. Again, to the extent that expenses reduce the NAV of the fund, open-end investment companies implicitly reduce managerial compensation. The excess expenses for which open-end companies are explicitly penalized include interest on debt used to finance the portfolio of the investment company, the investment advisor's fee above some specified level, and transactions costs above some specified level. Summary of the Characteristics of the Compensation Contracts All of the contracts in the sample are contingent on NAV. Some, but not most, compensation contracts are contingent on some measure of income. A few of the contracts contains a nonzero fixed fee component. Some are negatively related to excess expenses, some are contingent on a Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

62 group fee, and some are compensated for performance relative to a benchmark. All of the observed contracts are weakly positively related to NAV and to income, with weak concavity in both NAV and income. There are up to 11 intervals in the NAV component of compensation and up to three intervals in the Income component of compensation. EMPIRICAL EXAMINATION OF COMPENSATION CONTRACTS Compensation and Performance: A Positive Relationship Agency theory suggests that the manager, through an expenditure of effort, may be able to improve performance, on average; however, the agent has a personal disincentive to expend that effort. A fundamental prediction of agency models that exploit compensation to help alleviate the agency conflict is that compensation should be a positive function of performance. Further, to the extent that the manager is able to improve performance, the compensation should be positively contingent on performance, rather than be merely a function of performance. Observable compensation contracts of investment advisors can depend on performance in two ways. First, compensation can depend on performance relative to some benchmark. Such performance compensation is observable in 34 of the 977 companies in the sample. For each of these 34 contracts, the performance compensation clause demonstrates positive dependence. Second, compensation depends on performance through the NAV portion of the compensation. That is, the typical compensation contract contains a portion of compensation which is contingent on the NAV of the investment company. To the extent that the proportion paid on NAV is positive at higher levels of NAV, the manager is rewarded for growth of the investment company. As Table 5 shows, performance compensation, as a function of a compensation component stated in terms of NAV, is apparent in all of the compensation contracts in the data set. Further, all of the compensation contingent on NAV is non-negative. However, some intervals exist, for some companies, over which the compensation rate is zero. These intervals are always either at the start of the NAV compensation (providing a kind of cushion for the shareholders over which no compensation is paid) or at the end of the compensation contract (reducing the incentive to expend effort as the growth of assets exceeds some fixed point). Only one company in the sample actually operates over an interval where the marginal NAV compensation is zero.. Only nine open-end companies exist that have a contractual marginal rate of zero over any NAV interval. Compensation and Performance: Concavity We not only expect compensation to be positively related to performance, but also to be concave in performance. Concavity is predicted for three reasons. First, concavity might follow from a declining marginal ability to shift the distribution of portfolio returns. Second, Grinblatt & Titman assert that adverse risk incentives of performance based fees mean that penalties for poor performance should be at least as great as the rewards for good performance. Third, convexity in the U.S. tax code and thus concavity in after-tax income, could lead fund holders to face managers Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

63 with concave compensation schemes. Note that these explanations are not mutually exclusive, and may be reinforcing. Thirty-four of the 977 observations in the data set contain a compensation component for performance relative to a benchmark. For each of these, the performance component is weakly concave in performance relative to a specified, observable benchmark. For 33 of the 34 companies, the performance is strictly linear in performance relative to the specified benchmark. This benchmark is usually the S&P 500 Index but may be any publicly observable index or combination of indices. Consider compensation which is a function of NAV. Performance compensation, as a function of NAV, is almost always weakly concave in performance. For only 5 of the 540 companies in the 1985 sample, 2 of which are managed by the same investment advisor, no compensation is paid on the initial discrete interval of NAV but compensation on NAV in excess of the initial interval is weakly concave in performance. Table 5 shows that the mean marginal rate paid on NAV also weakly declines. Again, evidence about the median and maximum marginal rates also shows a similar pattern. The minimum marginal rate paid on NAV intervals also shows the effect of not only contracts which pay zero compensation on the initial interval but even on the final interval. There are 466 of the 954 (204 of 414 and 262 of 540 for 1980 and 1985) with only one NAV interval. Further, 157 contracts have two intervals and 184 have three intervals, while 147 have four or more intervals specified in their contracts. When examined by year, the evidence remains consistent. The length of the intervals over which the NAV compensation is paid varies widely; the minimum length is $1,000,000 and the maximum discrete interval length is $5,000,000,000, while the maximum interval length is, of course, infinity. Thus, concavity of individual plans is manifested. One question that arises is whether the concavity ever comes into play. That is, are investment company managers ever subject to changes in interval and corresponding changes in marginal operating compensation rates? To respond to this question, we examined the companies which were in the sample in both 1980 and 1985 to determine whether they operated in a different NAV compensation interval between the two years. As shown in Tables 7 and 8, nearly 40 percent of the 124 companies changed interval over this five year period, with the largest change in either direction being three intervals. This indicates that the advisors are subject to the concavity of marginal returns on NAV and the incentives of advisors would be better aligned with the desires of the owners of the funds. Compensation and Required Portfolio Composition To the extent that the agent may negate or otherwise neutralize the risk imposed by a compensation contract by trading in his/her personal portfolio, the effectiveness of incentive contracting is reduced. This same principle can be applied to the situation in which the risk can be neutralized, not in his/her personal portfolio, but in the portfolio he/she advises and through which he/she is compensated. Further, to the extent that the restrictions placed on the asset mix available to the manager limits the ability of agents to exercise their expertise in the management of the portfolio or to trade on any information they may have, we might expect the compensation to be less sensitive to performance. An agent who manages a portfolio that can be fully diversified might have Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

64 compensation more sensitive to outcome than would be the compensation of an investment advisor of a relatively limited portfolio. That is, the increased risk should imply less sensitivity to performance whereas a greater ability to shift the distribution of returns should imply a greater sensitivity of compensation to performance.

Table 7: Frequency Table of Interval Changes Number of Intervals Changed -3 -2 -1 0 1 2 3 TOTAL Frequency 1 1 5 76 34 6 1 124 Proportion of Observations .8% .8% 4.0% 61.3% 27.4% 4.8% .8% 100%

Table 8: Descriptive Statistics of Interval Changes Mean Median Maximum Minimum .314516 0 3 -3

Table 9 shows a variety of compensation rate measures for the sample as a whole as well as partitioned on stated composition and on class of composition. Surprisingly, all of the measures provided have weakly higher compensation rates, in both mean and median, for the last contract rate, the average NAV rate paid based on their contract and NAV, and operating marginal rate, as diversification becomes more limited. That 18 of the 19 companies that have performance compensation relative to a benchmark are common stock funds is also interesting, because we have no reason to expect that common stock funds would explicitly compensate for performance while other funds would not.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

65
Table 9: Descriptive Statistics for the Entire Sample Mean Median Mean Median Mean Median Mean Median Last Last Average Average NAV NAV Operating Operating Contract Contract NAV NAV plus plus Marginal Marginal Rate (#) Rate (#) Compen- Compen- Perform- Perform- Rate (#) Rate (#) sation sation ance ance Rate Rate Rate* (#) Rate* (#) Paid (#) Paid (#)
By Composition Diversified Bonds Specialized Common Stock International Balanced Bonds & Preferred US Government Securities Money Market Funds Tax-Free Mon Mkt Funds Preferred By Class of Composition Diversified Limited Diversification No Diversification Entire Sample .0044 (218) .0052 (667) .0053 (69) .0050 (954) .0045 (218) .0050 (667) .0050 (69) .0050 (954) .0051 (218) .0059 (667) .0060 (69) .0058 (954) .0050 (218) .0055 (667) .0054 (69) .0050 (954) .0125 (1) .0082 (18) N/A .0084 (19) .0125 (1) .0080 (18) N/A .0080 (19) .0050 (218) .0057 (667) .0058 (69) .0056 (954) .0050 (218) .0050 (667) .0050 (69) .0050 (954) .0050 (83) .0046 (157) .0056 (25) .0054 (489) .0058 (20) .0041 (38) .0043 (17) .0047 (14) .0041 (97) .0043 (10) .0033 (4) .0050 (83) .0050 (157) .0050 (25) .0050 (489) .0055 (20) .0040 (38) .0050 (17) .0048 (14) .0040 (97) .0050 (10) .0028 (4) .0060 (83) .0050 (157) .0069 (25) .0063 (489) .0064 (20) .0050 (38) .0053 (17) .0049 (14) .0044 (97) .0043 (10) .0044 (4) .0060 (83) .0050 (157) .0063 (25) .0061 (489) .0070 (20) .0050 (38) .0050 (17) .0043 (14) .0050 (97) .0050 (10) .0040 (4) N/A N/A N/A .0082 (18) N/A N/A N/A N/A .0125 (1) N/A N/A N/A N/A N/A .0082 (18) N/A N/A N/A N/A .0125 (1) N/A N/A .0058 (83) .0049 (157) .0066 (25) .0060 (489) .0062 (20) .0048 (38) .0052 (17) .0050 (14) .0044 (97) .0043 (10) .0042 (4) .0060 (83) .0050 (157) .0063 (25) .0060 (489) .0067 (20) .0050 (38) .0050 (17) .0048 (14) .0050 (97) 30050 (10) .0039 (4)

The results are inconsistent with our explanation that the manager of a diversified portfolio would need compensation which is more contingent on outcome to provide incentives to work. One Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

66 possible explanation would be that opportunities for profitable trading are more limited for well-diversified portfolios than for portfolios that are less diversified. In terms of the agency framework, the ability of the agent to shift the distribution of outcomes to the right is far less for diversified portfolios. Another possible explanation is that the manager is compensated for risk by higher expected levels of compensation. In the sample, less diversified portfolios are generally compensated at a higher rate per dollar of NAV. This weakly supports the contention of the relationship between increased risk and increased compensation. However, those funds that are either diversified or do not allow diversification compensate, both in terms of NAV and of total reported compensation, at a higher level than do firms that allow only limited diversification. Thus, evidence in this area is inconclusive. Compensation and Size Another explanation might be that all funds are actually diversified, either generally or within asset class, and so the classification scheme being employed is not informative. Indeed, all of these portfolios are fairly large. The observable NAVs of the funds range from $1,200,000 to $11,875,300,000, with 91 companies with NAV less than $10,000,000 and 62 companies with NAV greater than $1,000,000,000. To the extent that a manager may more easily diversify away any unsystematic risk in a larger portfolio, even if the security types in which the portfolio may be invested are limited, larger portfolios might need more risk-contingent compensation to induce effort. However, examination of the data indicates that both the mean and median last contract rate, both the mean and median average NAV compensation rate paid, and both the mean and median operating marginal rate are all weakly decreasing with increasing NAV size. Median NAV plus performance is also weakly decreasing with increasing size while mean NAV plus performance is weakly decreasing only until the last NAV quartile when it increases slightly. Compensation and Fund Purpose Perhaps a better indicator of the systematic risk of the portfolio is the stated fund purpose of the investment company. Intuition suggests that "growth" funds are probably invested in riskier securities than are other funds. Examination of the data indicates that for all variables except NAV compensation plus performance, companies with a fund purpose that includes growth pay higher marginal compensation than do companies with a fund purpose that excludes growth. For the combined forms of performance compensation (i.e., performance relative to a benchmark plus NAV compensation), mean compensation increases when the purpose excludes growth but median compensation decreases. However, caution must be used in interpreting this fact; only 2 of the 19 companies that compensate for performance relative to a benchmark have a stated purpose that excludes growth. Sixteen of these 17 companies that include growth in their stated purpose have growth as the sole stated purpose.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

67 Thus, counter to the intuition that more risk should imply less sensitivity to performance, a stated purpose of growth appears to be associated with greater sensitivity of compensation to performance (i.e., both performance relative to a benchmark and NAV compensation). This may indicate that the manager of a growth fund has a greater ability to induce first-order stochastically dominating shifts in the distribution of portfolio returns than does the manager of an income fund. Finally, those companies which include growth in their stated purpose have lower average levels of compensation ($1,113,608) than do either funds that include income in their stated purpose ($1,600,850) or funds that include security in their stated purpose ($1,428,169). Income versus Performance Stated fund purpose can indicate a desire for "growth" or for "income." It can also indicate a combination of these two as well as security or tax avoidance. To the extent that investors in such funds have made explicit their desire for a particular form of return, we would expect to observe compensation which is a function of that form of return. That is, income funds might be more dominantly rewarded for income while growth funds might be more dominantly rewarded for NAV performance. All compensation contracts in the sample include NAV contingent compensation of some kind. Of the 31 compensation contracts that have an income component to their compensation, 15 have income as their sole stated purpose and 14 more have income in combination with growth or growth and security. Only 2 of the companies that compensate on income exclude income from their stated purpose. Of the 34 companies that compensated explicitly based on performance, 27 have growth as their sole stated purpose and 4 of the remaining 7 include growth as one, though, not sole, explicit purpose. Only 3 exclude growth from their stated purpose. Summary of Empirical Results In examining the extant managerial compensation contracts of investment advisors we can see that compensation is generally contingent on performance, through compensation as a function of NAV if not through performance relative to a benchmark; further, compensation is at least weakly concave in performance. Further, the majority of those funds that include compensation for performance relative to a benchmark in their compensation packages have growth as one of their stated purposes. Furthermore, funds that state that they are interested in income have many more incidents of explicit income compensation than do funds with stated purposes that do not include income. In addition, counter to intuition, the less risky the portfolio as measured by purpose, composition, or size, the more sensitive is the compensation contract to performance. It is also possible that the negative relationship between risk and sensitivity of compensation to performance is due to limited opportunities for profitable trading when the portfolio is large, well diversified, and relatively risk free.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

68 CONCLUSION Among the proposed relationships tested in this paper are that compensation should be performance contingent and that the contingency should be concave in performance. In general, these relationships are borne out. All of the contracts are contingent on performance, either through an NAV contingent component or through compensation for performance relative to a benchmark. Further, 972 of the 977 open-end observations are weakly concave in performance. The investment companies differ by stated purpose and by portfolio composition. Investment companies which have compensation contingent on income tend to have income as one of their stated purposes. Funds that have compensation contracts with both NAV contingent compensation and compensation for performance relative to a benchmark tend to have growth as one of their stated purposes. Further, larger portfolios tend to be less performance contingent at the margin than smaller portfolios. Perhaps the inability of the manager to diversify the portfolio is positively related to his/her ability to shift the distribution of outcomes. However, in general, counter to the intuition of the standard agency model, the greater the ability of the manager to diversify the fund's investment portfolio the less performance contingent is the compensation. REFERENCES Baumol, W.J., S.M. Goldfeld, L.A. Gordon, and M.F. Koehn, 1990, The economics of mutual fund markets: Competition versus regulation, Kluwer Academic Publishers, Boston. Grinblatt, M. and Titman, S. (1989) Adverse risk incentives and the design of performance-based contracts, Unpublished manuscript (University of California at Los Angeles). Moody's Investors Service, 1981, Moody's Bank and Finance Manual, New York. Moody's Investors Service, 1986, Moody's Bank and Finance Manual, New York. Weisenberger Financial Services, 1981, Investment Companies 1981, New York. Weisenberger Financial Services, 1986, Investment Companies 1986, New York. Woodbury, D. and Neal, W. (1999) Fund advisor compensation: An application of agency theory, Academy of Accounting and Financial Studies Journal, 3, 73-83.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

69

EARNINGS MANAGEMENT USING PENSION RATE ESTIMATES AND THE TIMING OF ADOPTION OF SFAS 87
Marianne L. James, California State University, Los Angeles
ABSTRACT Concerns about earnings management and its effect on the usefulness of financial reporting continue to be pervasive and have prompted the Securities and Exchange Commission (SEC) to increase its enforcement activities. Flexibility in applying accounting provisions frequently provides opportunities for earnings management. Statement of Financial Accounting Standards No. 87, Employers Accounting for Pensions, (SFAS 87), provides extensive flexibility in choosing required pension estimates, and in timing the adoption of the standard. Several studies suggested that early adopters of SFAS 87 were motivated by its positive income effect. This study investigated the relationship between the timing of adoption of SFAS 87 and earnings management using pension rate estimates subsequent to adoption. Study of 1,035 firms found that early adopters tended to use higher estimates of the rate-of-return on pension plan assets (ROR) subsequent to adoption, than on-time adopters. In the absence of higher actual returns, these findings suggest that early adopters were using the ROR estimates to facilitate earnings management subsequent to adoption. This may provide important information for the Financial Accounting Standards Board in assessing the effect of multi-year transition periods on earnings management. INTRODUCTION Concerns about earnings management continue to be pervasive, and prompted the SEC to increase its regulatory enforcement activities to both prevent and detect earnings management. For example, in 1998, the SEC informed 150 firms that it may be reviewing their earnings reports and directed its Division of Corporate Finance to appoint a special task force to investigate potential earnings management problems (MacDonald, 1999, A2-6). In several of his speeches, Arthur Levitt, until recently chair of the SEC, and other SEC officials, such as former Chief Accountant, L.E. Turner have spoken out against earnings management that firms practice within the boundaries of Generally Accepted Accounting Principles (GAAP). The potential for earnings management tends to arise when accounting standards provide for flexibility, require extensive estimates, and when long time horizons are involved. Accounting for defined benefit pensions combines all three of these criteria: it requires extensive estimates (e.g., of longevity, employee turn-over rates, and pension rates), permits flexibility in applying some of its provisions (e.g., in choosing pension rates), and typically involves an unusually long time horizon (i.e., employees for whom pensions benefits are currently accrued may not retire for several decades). In addition, SFAS 87, like a number of other recent accounting standards, provided for Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

70 a long, multi-year transition period. In fact, the standard permitted firms to choose an adoption date from among three years. Pension accounting evolved from the initial cash-as-you-go-basis to accrual accounting. SFAS 87 represents the newest in a series of accounting standards and was expected to improve the relevance and reliability of financial reporting related to defined benefit pension plans. However, Ali and Kumar (1993) found that the new standard provides more earnings management opportunities, than were available under the prior authoritative standard, APBO 8, Accounting for the Cost of Pension Plans. These enhanced earnings management opportunities arise in part from the provision that permits the discount rate to differ from the ROR, and due to income smoothing incentives (Ali & Kumar, 1993). Prior research also found independent evidence of (1) an association between adoption timing of SFAS 87 and increased earnings at time of adoption (e.g., Langer & Lev, 1993; Tung & Weygandt, 1994), and (2) manipulation of pension rates subsequent to adoption (Blankley, 1992; Blankley & Swanson, 1995; Amir & Benartzi, 1998). Both of these findings are consistent with earnings management. A review of the related literature yielded no studies investigating the potential relationship between early adoption of the pension accounting standard and choice of pension rate estimates subsequent to adoption. The purpose of this study was to investigate the relationship between timing the adoption of SFAS 87 and firms' choice of pension rate estimates subsequent to adoption. A sample of firms that adopted SFAS 87 were identified from the Standard and Poor COMPUSTAT industry files, and related financial statement data and disclosures were extracted. The relationships between adoption timing and pension rate estimates (expected ROR on pension plan assets, discount rate, and salary trend rate) were evaluated through multiple regression analyses. This study found evidence of a significant positive relationship between early adoption of SFAS 87 and the ROR estimates utilized by the sample firms subsequent to adoption for each of the four years tested. That is, early adopters tended to use higher ROR estimates than on-time adopters, and these were not supported by higher actual returns. These findings are consistent with earnings management and thus may provide an alternate or additional explanation for the adoption timing decision. Thus, while previous studies linked SFAS 87 adoption timing to earnings management only at time of adoption, this study linked adoption timing to earnings management subsequent to adoption. These findings are important, as they may assist the Financial Accounting Standards Board (FASB) in assessing whether the intended purpose of long multi-year transition periods for standards requiring extensive estimates is being achieved. REVIEW OF LITERATURE Schipper defines "Earnings Management" as a "purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain..." (1989, 92). The implication of this definition is that earnings may reduce the representational faithfulness and thus the usefulness of financial reporting. Arthur Levitt, in his now famous speech The Numbers Game asserted that earnings management if not addressed soon, will have adverse consequences for Americas financial reporting system (Levitt, SEC, 1998). Firms that manage earnings usually Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

71 do not restrict their efforts to a single accrual, instead they tend to use a portfolio of accruals, including pension accruals (Zmijewski and Hagerman, 1981). Using a portfolio approach, some firms manage earnings only when perceived necessary, or when a special opportunity arises (e.g., a new earnings management tool becomes available; or the adoption timing of a new standard). For others, earnings management may be a more ongoing practice (Schipper, 1989). Standards with long transition periods may provide a one-time earnings management opportunity by permitting firms to choose the timing of the effect of the change on the financial statements. Standards may also provide earnings management opportunities by providing flexibility in choosing extensive required estimates. During the past few decades FASB has issued a number of accounting standards with long, multi-year transition periods and flexibility in choosing extensive required estimates. For example, the transition period was four years for SFAS 106, Employers' Accounting for Postretirement Benefits Other than Pensions, and three years for SFAS 109, Accounting for Taxes. SFAS 87 requires extensive estimates, permits considerable flexibility in choosing those estimates, and provided for a three-year transition period. The primary purpose of long transition periods for new accounting standards is to assist firms in generating reliable estimates. The purpose stated in SFAS 87 is: "to give time for employers and their advisors to assimilate the requirements...[,] to obtain the information required....[and] to renegotiate or to obtain waivers of provisions of some legal contracts" (FASB 1985, par. 259-260). A number of studies have examined the timing of adoption of accounting standards with long transition periods, including the adoption of SFAS 87. Some of the major studies are discussed in the following paragraphs. Recent studies found evidence that income smoothing, a form of earnings management, was associated with the adoption timing of new accounting standards. For example, Gujarathi and Hoskin (1992) found evidence of income smoothing in their study of 284 early adopters of SFAS 96, Accounting for Income Taxes. Their study showed that some entities that experienced significant income-increasing effect from the standards early adoption, would otherwise have reported a loss or no earnings increase. Their follow-up study (Gujarathi & Hoskin,1995) provided additional evidence suggesting that the long transition period was utilized by early adopters to "present their financial picture in the best light" (p. 28), and that those firms with the largest positive income effect on adoption tended to adopt at the earliest possible date. Studies on early adoption of SFAS 52 also found evidence of income smoothing. For example, Ayres (1986) investigated the relationships between choice of adoption date and proximity of debt and dividend-constraints, control of entities, size, and earnings. They found that early adopters tended to experience lower rates of income growth prior to adoption of the Standard, that they tended to be smaller, closer to debt and dividend-constraint violations, and tended to have smaller percentages of stock owned by directors and managers, than late adopters. A number of studies also examined adoption timing of SFAS 87 and found evidence consistent with earnings management. SFAS 87 was issued in December 1985; its effective date, the date for which adoption was required, was for fiscal years ended after Dec. 15, 1986. Thus, for most firms on-time adoption was for their 1987 fiscal period. However, since early adoption of the

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

72 standard was permitted, firms could choose to adopt the standard for fiscal years ending in 1985, 1986, or 1987. Fifty-one percent of the entities surveyed in Accounting Trends and Techniques that disclosed defined benefit pension plans early-adopted SFAS 87 during 1985 and 1986 (based on information reported by the AICPA, 1987, p. 274). Most of these early adopters reported increased income from the adoption. A number of studies found a positive association between the positive income effect and the timing of adoption. For example, Tung and Weygandt (1994) investigated whether debt contracting and/or political cost influenced adoption timing, and found that early adopters reported significantly higher increases in income than on-time adopters, and that of 1,011 early adopters only 35 reported decreased income associated with their adoption of SFAS 87. Langer and Lev (1993) investigated both compliance costs and investor perceptions and found that the motive to increase earnings consistently discriminated between early and late (ontime) adopters of SFAS 87; these results also held true regardless of the quarter during which the standard was adopted. Other studies such as Norton (1989), Stone & Ingram (1988), and Senteney & Strawser (1990) also found that early adopters reported income increases at time of adoption. Norton (1989) found that early adopters also had better funded pension plans, and that those firms that adopted during the earliest possible year had better funded plans than those that adopted later; i.e., 1985 adopters had better funded plans than 1986 adopters, and 1986 adopters had better funded plans than 1987 adopters. Thus, early adopters generally were not required to record additional minimum liabilities that would have increased debt-to-equity ratios. SFAS 87 not only provided a one-time opportunity for earnings management at time of adoption, but also provides continued opportunities for earnings management subsequent to adoption through the choice of extensive required estimates, including pension rate estimates. SFAS 87 requires that firms estimate three pension rates: the discount rate, the expected ROR on pension plan assets, and the salary trend rate, and utilize them in calculating pension expense and pension benefit obligations. The standard does not prescribe specific pension rates or set specific limits, and instead provides suggested guidelines. For example, it emphasizes (FASB 1985, par. 43) that the "best" estimate for each future event should be given for each rate. Choice of these three rates tends to significantly affect pension expense and the pension benefit obligations. The ROR estimate is utilized in calculating the return on plan assets and pension expense, with a higher ROR estimate typically resulting in lower expense and higher income. The discount rate also affects the interest component of pension expense, the pension benefit obligations reported in the financial notes, and the minimum pension liability. The salary trend rate affects the current service cost component of pension expense and the projected benefit obligation disclosed in the notes. Firms typically engage actuaries to assist in deriving estimates, including pension rate estimates. However, actuaries primary responsibility is to ensure that pension plans are adequately funded (Fogarty & Grant, 1995), and management ultimately decides which actuary to hire, and what pension rate estimates to use in accounting for defined benefit pension plans. Thus, firms have considerable flexibility in choosing estimates, and as a result, the rates utilized by firms vary considerably. To illustrate, information reported by Accounting Trends and Techniques for fiscal year 1992 indicated that six percent of the entities disclosing discount rates utilized rates of 7.5 Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

73 percent or less, while 18 percent utilized rates of 9.0 percent or greater (AICPA, 1993, p. 300). Furthermore, for fiscal year 1994, 19 percent utilized rates of 7.5 percent or less, while 7 percent utilized rates of 9 percent or more (AICPA, 1995, p. 342). Pension rates provide an excellent tool for earnings management, as rates can be chosen to uniformly increase or decrease income, or one rate can be chosen to offset the effect of another. For example, the salary trend rate can be decreased, along with an increase in the estimated ROR on pension plan assets (both decreasing expense); or an increase in the salary trend rate can be offset partially or totally by an increase in the expected ROR. While SFAS 87 was issued to improve the relevance and reliability of financial reporting, Ali and Kumar (1993) found that this new standard provides more opportunities for earnings management than APBO 8 did. Some of these opportunities may arise from a provision that permits the interest rate used for calculating the return on pension plan assets to differ from that used for calculating the interest cost component of pension expense; i.e., the ROR and the discount rate do not have to be the same (Ali & Kumar, 1993). Several other studies found that the extensive pension rate estimates required under SFAS 87 may provide opportunities for earnings management. For example, Mittelstaedt (1989) and Thomas (1989) found that prior to pension plan terminations, actuarial assumptions, (such as the discount rate), were frequently manipulated. Ghicas (1990) found that firms tended to increase discount rates to reduce funding requirements in periods of cash shortages. Blankley (1992) and Blankley and Swanson (1995) linked the choice of pension rates to the opportunistic behavior of managers. Amir and Benartzi (1998) found that the actual ROR on pension plan assets was not associated with the estimated ROR. Another recent study examined rate choices under SFAS 106, Employers Accounting for Postretirement Benefits Other than Pensions, which is very similar to and deals with similar isues as SFAS 87. Amir and Gordon (1996) investigated cross-sectional variations in firms' choice of the discount rate and healthcare cost trend rates, and found that firms that chose more conservative estimates tended to have lower debt-to-equity ratios, smaller postretirement benefit obligations, more extreme (high or low) earnings, and more significant postretirement plan amendments. They also found that investors based their valuations of an entity on reported, instead of actual rates; the authors interpreted this as another incentive for using less conservative estimates that facilitate earnings management goals. This last finding also supports the contention that using pension rates for earnings management (which is investigated in this study) also would not be detected easily. HYPOTHESES DEVELOPMENT Firms that manage earnings usually do not restrict their efforts to a single accrual, instead they tend to use a portfolio of accruals (Zmijewski & Hagerman, 1981). Several studies (e.g., Tung & Weygandt, 1994, Senteney & Strawser, 1990, and Langer & Lev, 1993) showed that most early adopters of SFAS 87 increased income upon adoption. This suggests that early adoptions may have been motivated by a desire to manage income. However, SFAS 87 can be used to manage income not only upon adoption, but also subsequent to adoption through the choice of pension rate estimates. Ali and Kumar (1993) found Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

74 that SFAS 87 provides more opportunities for earnings management than the previous accounting standard did. Because pensions typically have long time horizons, such earnings management cannot be detected easily. Firms that were motivated to early-adopt a standard that increases opportunities for earnings management may be more likely to utilize this new standard to manage earnings subsequent to adoption. The following hypotheses were tested to investigate the relationships between the timing of adoption of SFAS 87 and pension rate estimates subsequent to adoption.
H1: H2: H3: Firms that adopted SFAS 87 early choose different ROR estimates than firms that adopted on the effective date. Firms that adopted SFAS 87 early choose different discount rates than firms that adopted on the effective date. Firms that adopted SFAS 87 early choose different salary trend rates than firms that adopted on the effective date.

For testing Hypotheses H1, H2, and H3, the independent variable of interest was the adoption year, and the dependent variables were the pension rates. All variables are defined in the methodology section. METHODOLOGY A sample of 1,035 firms that adopted SFAS 87 and disclosed pension rate and other financial information for the 1991-1994 fiscal periods were chosen from the COMPUSTAT industry files. The relationships between adoption timing and pension rate estimates were evaluated utilizing multiple linear regression. The years 1991-1994 were chosen as study period to avoid compounding of too many additional factors with that of interest. Thus, the period surrounding the initial adoption was excluded, and the analysis restricted to four years to avoid the influence of new factors on the rates chosen (i.e., economic changes, new accounting standards and regulation that may affect choice of rates). The dependent variables were the pension rates used and disclosed by the firms; that is, the ROR for testing H1, the discount rate for testing H2, and the salary trend rate for testing H3. The independent variable for testing all three hypotheses was the adoption year of SFAS 87 (YRADOPT). A dichotomous classification, similar to that used in most studies on timing choice (e.g., Tung & Weygandt,1994; Langer & Lev, 1993, Senteney & Strawser, 1990), was chosen; a value of one (1) was assigned to the independent variable for firms that adopted SFAS 87 early (in fiscal years 1985 or 1986), and a value of zero (0) for firms that adopted on the effective date. Other factors may have influenced the timing of adoption, and may influence the choice of pension rate estimates. A number of studies have investigated these factors (e.g., Tung & Weygandt, 1994, Stone & Ingram, 1988, Senteney & Strawser, 1990, Norton, 1989). The variables found significant in one or more of pertinent prior studies were included as control variables; these were measured in the year prior to the year tested and scaled by beginning-of-year total assets. The control variables were: Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

75
1 Earnings variable: Prior-year earnings may create earnings expectations and influence subsequent year accruals and pension rate choices. Previous SFAS 87 studies (e.g., Tung & Weygandt, 1994, and Langer & Lev, 1993) found that earnings influenced adoption timing. In this study, earnings were measured by income before extraordinary items (EARN). Funding: Senteney and Strawser (1990) and Norton (1989) found that firms with well-funded plans tended to adopt SFAS 87 early. Funding status also may affect choice of pension rates, particularly choice of the discount rate, which can influence the funding status. The unfunded or over funded accumulated pension benefit obligation was included as a control variable (FUND). Debt Contracting: The more likely an entity is to violate a debt-covenant ratio, the less likely it is to make income-decreasing accounting choices (Watts & Zimmerman 1986, 216). Tung and Weygandt (1994) found the debt/equity ratio (a measure of leverage frequently used as proxy for debt-covenant tightness) to be significantly higher for early adopters of SFAS 87, than for on-time adopters. In this study, the debt/equity ratio (DE) was utilized to measure leverage. Pension Benefit Obligation: The size of the pension benefit obligation may affect the interest component of pension expense, and may influence the choice of pension rates, particularly the discount rate. Amir and Gordon (1996) found that the relative size of the postretirement benefit obligation affects firms' selection of health care and discount rates. This study used the scaled accumulated pension benefit obligation to measure the pension benefit obligation (ABO). International or Domestic firm: The model included a dichotomous variable to control for potential differences between domestic and foreign firms. A value of 0 was assigned to domestic firms and a value of 1 to foreign firms (FOREIGN). Size variable: Firm size may influence firms' desire to increase/decrease accruals (Watts & Zimmermann, 1986). The most frequently used measures of size are the natural logs of sales revenue and total assets; both have been found to be valid measures of size (e.g., Tung & Weygandt, 1994). In this study, size was measured by the natural logarithm of total assets (SIZE).

The statistical model tested for hypotheses H1, H2, and H3 was: H1 H2 H3 RORit, DISCit, SALit = bo + b1xit1 + b2xit2 + b3xit3 + b4xit4 + b5xit5 + b6xit6 + b7xit7 + eit, where xit1 was the independent variable (YRADOPT), and xit2 ... xit7 were the control variables (EARN, FUND, DE, ABO, FOREIGN, and SIZE); eit = stochastic error term. Since the year of adoption (YRADOPT) was the variable of interest, this study tested Ho: b1 = 0, against H1: b1 0 for Hypotheses H1, H2, and H3. EMPIRICAL RESULTS Of the 1035 sample firms, 490 (47 percent) adopted the new pension accounting standard prior to its effective date. Some firms were omitted from the final sample due to missing data. The means, medians, and standard deviations of the pension rates, and the sample sizes used in the analysis are presented in Table 1. Table 2 presents the mean, median, and standard deviations for the control variables. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

76
Table 1: Descriptive Statistics - Pension Rates in Percentage Pension Rate ROR Mean Median Std. Deviation Sample Size Discount Rate Mean Median St. Deviation Sample Size Salary Trend Rate Mean Median Standard Deviation Sample Size 1991 9.02 9.00 1.29 743 8.33 8.50 0.65 724 5.63 5.95 1.05 668 1992 8.96 9.00 1.34 757 8.17 8.21 0.62 756 5.44 5.50 1.03 681 1993 8.67 8.83 1.25 766 7.44 7.50 0.52 759 4.96 5.00 0.98 676 1994 8.78 9.00 1.21 752 8.13 8.25 0.56 749 4.95 5.00 0.98 655

The mean estimated RORs utilized by the firms were 9.02, 8.96, 8.67, and 8.78 for years 1991, 1992, 1993, and 1994, respectively. The rates ranged from a minimum of 0 to a maximum of 13 percent. The mean discount rates were 8.33, 817, 7.44, and 8.13 for years 1991, 1992, 1993, and 1994, respectively. The decrease between 1991 and 1993 was consistent with the overall decrease in interest rates during this period. The rates ranged from a minimum of 4.2 to a maximum of 13 percent. For all years tested, the mean estimated RORs exceeded the mean discount rates. Differences in these two rates may facilitate smoothing of periodic pension expense and the pension liability/asset, since a higher (lower) ROR decreases (increases) periodic pension expense, while a lower (higher) discount rate increases (decreases) the present value of the pension benefit obligation and may increase (decrease) pension expense. The standard deviations for the estimated RORs were higher than those for the discount rate, indicating more extreme inter-firm variations in the estimated ROR, than in the discount rate.
Table 2: Descriptive Statistics - Control Variables Scaled by Total Assets Variable EARN Mean Median Std. Deviation. 1991 0.03 0.03 0.03 1992 0.02 0.02 0.03 1993 0.02 0.02 0.03 1994 0.03 0.03 0.03

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

77
FUND Mean Median Std. Deviation DE Mean Median Std. Deviation ABO Mean Median Std. Deviation SIZE Mean Median Std. Deviation YRADOPT EARN FUND DE ABO SIZE FOREIGN 0.03 0.00 0.06 2.18 1.53 3.44 0.12 0.08 0.13 6.82 6.85 1.89 0.03 0.02 0.06 2.30 1.58 3.80 0.13 0.08 0.17 6.90 6.90 1.91 0.02 0.01 0.07 2.28 1.70 2.53 0.14 0.08 0.17 6.87 6.97 1.91 0.02 0.01 0.06 2.23 1.63 2.47 0.15 0.09 0.19 6.92 7.03 1.91

= Adoption year = Income before extraordinary items, divided by total assets = Accumulated pension benefit obligation minus pension plan assets, divided by total assets = Total debt divided by total equity = Accumulated pension benefit obligation divided by total assets = Natural Log of Total Assets = Domestic or Foreign Company: for all years tested, the mean percentage of foreign companies was 3.58 percent.

The mean salary trend rates were 5.63, 5.44, 4.96, and 4.95 for the years 1991, 1992, 1993, and 1994, respectively. The year-to-year decreases were consistent with overall lower rates of salary and wage increases during this period of low inflation. Table 3 presents Pearson correlation matrixes for the pension rates in 1991-1994. Since the sample sizes were large for each year, the coefficients of correlation obtained between the discount rate and the estimated ROR were highly significant. This suggests that estimated ROR and discount rates were correlated. However, further analysis showed that the coefficients of correlation between the estimated and the actual RORs were not significant, and positive for some years and negative for others. These findings are consistent with those of Amir and Benartzi (1998) who also did not find a significant correlation between actual and estimated RORs, and interpreted their findings as a potential indication of earnings management.
Table 3: Correlation Matrix Using Pooled 1991-1994 Pension Rates Numbers are Pearson Correlations DISC 1991 DISC 1992 DISC 1993 DISC 1994 EROR 1991 EROR 1992 EROR 1993 EROR 1994 DISC 1991 DISC 1992 1 0.84 1 0.48 0.53 0.40 0.47 0.47 0.37 0.48 0.43 0.43 0.40 0.40 0.39

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

78
DISC 1991 DISC 1992 DISC 1993 DISC 1994 EROR 1991 EROR 1992 EROR 1993 EROR 1994 DISC 1993 DISC 1994 EROR 1991 EROR 1992 EROR 1993 EROR 1994 AROR 1991 AROR 1992 AROR 1993 AROR 1994 SAL 1991 SAL 1992 SAL 1993 SAL 1994 AROR 1991 AROR 1992 AROR 1993 AROR 1994 SAL 1991 SAL 1992 SAL 1993 SAL 1994 DISC EROR* AROR* SAL 0.03 -.032 -.041 -.036 0.09 0.01 -0.15 -0.11 1 0.00 -0.01 -0.04 -0.05 0.06 0.08 -0.13 -0.06 -0.06 1 0.13 -0.14 -0.03 -0.13 0.09 0.06 0.17 0.25 0.28 0.11 1 -0.11 0.09 0.03 0.05 0.04 0.02 -0.14 -0.04 -0.22 0.13 0.01 1 0.04 -0.05 -0.12 -0.05 0.01 -0.02 -0.13 -0.09 -0.00 0.25 0.00 -0.07 1 -0.06 -0.06 -0.15 -0.05 -0.01 -0.02 -0.13 -0.09 SAL 1992 -0.01 0.02 0.02 -0.05 0.81 1 -0.13 -0.06 0.04 0.01 0.02 0.01 -0.08 -0.05 SAL 1993 -0.01 -0.00 -0.05 -0.05 0.63 0.75 1 1 0.25 1 0.17 0.25 1 0.20 0.30 0.91 1 0.24 0.34 0.78 0.88 1 0.22 0.42 0.62 0.75 0.88 1 DISC 1991 DISC 1992 DISC 1993 DISC 1994 EROR 1991 EROR 1992 EROR 1993 EROR 1994 -0.14 -0.07 0.05 0.02 0.05 0.04 -0.07 -0.05 SAL 1994 -0.05 0.00 -.05 -.01 0.61 0.69 0.78 1

AROR1991 AROR1992 AROR1993 AROR1994 SAL 1991

= Discount rate used in calculating pension benefit obligations and interest component of expense = Estimated ROR used in calculating pension expense = Actual ROR achieved = Estimated salary trend rate used in calculating projected pension benefit obligation and service component of pension expense *E and R was added to the ROR variable to distinguish between the estimated ROR (which is used in calculating pension expense), and the actual ROR achieved by the pension plan assets.

Hypotheses H1, H2, and H3 tested the effects of SFAS 87 adoption timing on the pension rate estimates chosen by the firms subsequent to adoption.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

79
Table 4: Relationship Between Estimated ROR and Choice of Adoption Date of SFAS 87 Model: RORit = bo + b1xit1 + b2xit2 + b3xit3 + b4xit4 + b5xit5 +b6xit6 + b7xit7 + eit Year 1991 coeff. t-stat. p-val. 1992 coeff. t-stat. p-val. 1993 coeff. t-stat. p-val. 1994 coeff. t-stat. p-val. Yradopt B1 0.43 6.45 0.00 0.36 5.58 0.00 0.35 5.74 0.00 0.26 4.28 0.00 Earn B2 0.77 1.58 0.11 0.55 1.26 0.21 0.87 1.85 0.07 0.29 1.05 0.29 Fund B3 -4.43 -7.52 0.00 -3.26 -6.94 0.00 -2.75 -5.71 0.00 -2.11 -4.89 0.00 De B4 -0.00 -0.05 0.96 -0.00 -0.34 0.74 -0.00 -0.33 0.74 -0.00 0.19 0.85 Abo B5 1.19 4.60 0.00 1.07 4.71 0.00 0.61 2.92 0.00 0.43 2.24 0.03 Foreign B6 -0.26 -1.25 0.21 -0.25 -1.18 0.24 -0.71 -3.65 0.00 -0.90 -4.40 0.00 Size B7 0.10 5.48 0.00 0.11 6.19 0.00 0.12 6.91 0.00 0.10 5.88 0.00 Sample Size 743 R2 Adj R2 0.15 0.15

757

0.15 0.14

766

0.15 0.14

752

0.12 0.11

YRADOPT = Adoption year (1=early, 0=on-time); EARN = Income before extraordinary items, divided by total assets; FUND = accumulated pension benefit obligation minus pension plan assets, divided by total assets; DE = total debt divided by total equity;; ABO = accumulated benefit obligation divided by total assets; FOREIGN = Domestic or Foreign Company; SIZE = Natural Log of Total Assets

Hypothesis H1 tested the effect of adoption timing on the ROR chosen by sample firms for fiscal periods 1991-1994. Regression analysis showed that the coefficients for YRADOPT were positive and highly statistically significant for each of the years 1991-1994 (p-values <0.01). These results suggest that early adopters tended to utilize higher ROR estimates, than on-time adopters. Higher ROR estimates decrease pension expense and increase reported income; this may indicate an earnings management strategy if the higher ROR estimates are not supported by higher actual returns. To further investigate this, the relationship between the timing of adoption and actual RORs earned by the pension plan assets was analyzed. This analysis showed that the pension plans of early adopters did not tend to earn higher actual RORs, than those of on-time adopters for any of the years tested. Hypothesis H2 tested the relationship between adoption timing and the estimated discount rate chosen by the firms subsequent to adoption. Regression analysis found that the adoption year (YRADOPT) was statistically significant for years 1991 and 1992 (p-values < 0.01), but not for 1993 and 1994. The coefficients were positive, which means that early adopters tended to use significantly higher discount rate estimates during 1991 and 1992, than on-time adopters. Higher discount rates reduce the present value of the reported pension benefit obligations, which tends to reduce the minimum pension liability that must be recognized by firms sponsoring the pension plans, and may reduces the interest cost component of pension expense. Because of the typically high magnitude of the pension benefit obligations of

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

80 many plans, even a small difference in the discount rate can significantly change reported expenses and liabilities.
Table 5: Relationship Between Discount Rate and Choice of Adoption Date of SFAS 87 Model: DISCit = bo + b1xit1 + b2xit2 + b3xit3 + b4xit4 + b5xit5 +b6xit6 + b7xit7 + eit Year 1991 coeff. t-stat. p-val. 1992 coeff. t-stat. p-val. 1993 coeff. t-stat. p-val. 1994 coeff. t-stat. p-val. Yradopt B1 0.18 3.97 0.00 0.11 2.53 0.01 0.04 1.12 0.26 0.03 0.74 0.46 Earn B2 0.18 0.55 0.58 0.05 0.19 0.85 0.26 0.99 0.32 -0.29 1.71 0.09 Fund B3 -0.00 -1.67 0.95 -0.00 -1.61 0.11 0.00 -0.81 0.42 -0.00 -2.18 0.03 De B4 -0.01 -0.97 0.33 0.00 0.24 0.81 -0.00 -0.77 0.44 0.00 0.46 0.64 Abo B5 0.55 3.15 0.00 0.41 2.82 0.01 0.35 3.05 0.00 0.33 2.87 0.00 Foreign B6 0.20 1.33 0.18 0.19 1.39 0.16 0.43 3.83 0.00 -0.49 -3.82 0.00 Size B7 0.05 3.65 0.00 0.04 2.81 0.01 -0.02 -1.66 0.10 0.94 8.47 0.00 Sample Size 724 R2 Adj R2 0.062 0.053

756

0.036 0.027

759

0.040 0.032

749

0.112 0.104

YRADOPT = Adoption year (1=early, 0=on-time); EARN = Income before extraordinary items, divided by total assets; FUND = accumulated pension benefit obligation minus pension plan assets, divided by total assets; DE = total debt divided by total equity; ABO = accumulated benefit obligation divided by total assets; FOREIGN = Domestic or Foreign Company; SIZE = Natural Log of Total Assets.

Hypothesis H3 tested the relationship between adoption timing and the salary trend rate subsequent to adoption. Regression analysis showed that the adoption year (YRADOPT) was not statistically significant for any of the years tested. Thus, the estimated salary trend rates utilized by the early adopters was not significantly different from those utilized by the on-time adopters. Significant Control Variables Funding status (FUND) was significantly related to the ROR chosen by firms subsequent to adoption (p-values <0.01). The regression coefficients were negative, which suggests that firms with underfunded pension plans were more likely to choose higher ROR estimates than those that had well-funded plans. Funding status did not appear to effect choice of the discount and salary trend rates. The relative size of the accumulated pension benefit obligation (ABO) was statistically significantly related to all three pensions rates. The coefficients were positive for the ROR and the discount rate hypotheses, and negative for the salary trend rate hypothesis. The positive coefficient for the ROR regression suggests that firms with relatively high pension benefit obligations chose Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

81 higher RORs, which decrease pension expense and increase income. The negative coefficient for salary trend rate suggests that firms with relatively large pension benefit obligations choose lower salary trend rates, which decrease the projected pension benefit obligation and pension expense. The positive coefficient for ABO in the discount rate regression suggests that firms with relatively large pension benefit obligations tend to choose higher discount rates, which tends to decrease the vested, accumulated, and projected pension benefit obligations and may also decrease pension expense for pension plans with long time horizons.
Table 6: Relationship Between Estimated Salary Trend Rate and Choice of Adoption Date of SFAS 87 Model: SALit = bo + b1xit1 + b2xit2 + b3xit3 + b4xit4 + b5xit5 +b6xit6 + b7xit7 + eit Year 1991 coeff. t-stat. p-val. 1992 coeff. t-stat. p-val. 1993 coeff. t-stat. p-val. 1994 coeff. t-stat. p-val. Yradopt B1 0.07 0.96 0.34 0.01 0.16 0.87 0.69 1.13 0.26 0.07 1.13 0.26 Earn B2 0.31 0.60 0.55 1.24 2.99 0.00 1.26 2.51 0.01 1.41 3.83 0.00 Fund B3 -0.00 -1.21 0.23 -0.00 -0.59 0.56 0.00 0.48 0.63 0.00 2.12 0.03 De B4 0.00 -0.28 0.78 0.00 0.87 0.38 0.00 -0.08 0.94 0.00 0.08 0.94 Abo B5 -0.45 -1.47 0.14 -0.48 -2.08 0.04 -0.59 -2.65 0.01 -0.58 -2.74 0.01 Foreign B6 0.41 1.74 0.08 0.59 2.73 0.01 0.73 3.40 0.00 0.47 1.95 0.05 Size B7 0.04 1.67 0.10 0.01 0.54 0.59 -0.04 -2.31 0.02 -0.02 -1.24 0.22 Sample Size 668 R2 Adj R2 0.02 0.00

681

0.03 0.02

676

0.04 0.03

655

0.05 0.04

YRADOPT = Adoption year (1=early, 0=on-time); EARN = Income before extraordinary items, divided by total assets; FUND = accumulated pension benefit obligation minus pension plan assets, divided by total assets; DE = total debt divided by total equity; ABO = accumulated benefit obligation divided by total assets; FOREIGN = Domestic or Foreign Company; SIZE = Natural Log of Total Assets.

Firm size was significantly related to the estimated ROR and the discount rates chosen subsequent to adoption. The coefficients were positive which suggests that large firms tended to use higher ROR estimates and higher discount rates than small firms. Size was not significantly related to salary trend rate choice. Thus, firms with underfunded pension plans, and large firms were more likely to choose higher ROR estimates. Firms with relatively large pension plans tended to use higher ROR and discount rate estimates, and lower salary trend rates. The other control variables (EARN, DE, FOREIGN) were not consistently statistically significant in any of the regression analyses.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

82 CONCLUSIONS Several studies suggested that firms that early-adopted SFAS 87 were motivated by the income increasing effect at time of adoption of the new pension standard (e.g., Langer and Lev, 1993; Tung & Weygandt, 1994). However, SFAS 87 can be used to manage earnings not only upon adoption, but also subsequent to adoption through the choice of pension rate estimates (the ROR, discount rate, and salary trend rate). This study investigated the relationship between adoption timing and choice of pension rate estimates subsequent to adoption. This study found that early adopters tended to use higher ROR estimates than on-time adopters for all the years tested. In addition, early adopters tended to use higher discount rates during two of the years tested. In the absence of higher actual returns, this suggests that early adopters were utilizing the ROR estimates to manage earnings. These findings may provide an additional explanation for the timing of adoption of SFAS 87. The findings may also provide useful input to FASB for assessing (1) whether its intended purpose for long multi-year transition periods is being achieved, and (2) whether future accounting standards requiring extensive estimates should combine the flexibility of choice of estimates with the flexibility of choice of the adoption year.

Acknowledgment I am grateful to the members of my dissertation committee for their guidance, especially to Professor Harvey Hendrickson, my major professor, to whose memory this paper is dedicated, and Professor Arun Prakash, who also provided useful suggestions on this paper. REFERENCES Ali, A., and K.R. Kumar (1993). Earnings Management Under Pension Accounting Standards: SFAS 87 Versus APB 8. Journal of Accounting, Auditing & Finance, 8(4), 427-446. American Institute of Certified Public Accountants (1966, November). Accounting for the Cost of Pension Plans. Accounting Principles Board Opinion No. 8. American Institute of Certified Public Accountants (1986, 1987, 1988,1991, 1992, 1993, 1994, 1995). Accounting Trends and Techniques. Amir, E, & Gordon, E. (1996, Summer). Firms' Choice of Estimation Parameters: Empirical Evidence from SFAS 106. Journal of Accounting, Auditing and Finance, 11(3), 427-448.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

83 Amir, E., & S. Benartzi, S. (1998). The Expected Rate of Return on Pension Funds and Asset Allocation as Predictors of Portfolio Performance. The Accounting Review, 73(3), 335-352. Ayres, F. L. (1986). Characteristics of Firms Electing Early Adoption of SFAS 52. Journal of Accounting and Economics, 64(3), 143-158. Blankley, A. I. (1992). Incentives in Pension Accounting: An Empirical Study Investigation of Reported Rate Estimates. Dissertation, Texas A&M University. Blankley, A.I., & E.P. Swanson (1995). A Longitudinal Study of SFAS 87 Pension Rate Assumptions. Accounting Horizons, 9(4), 1-21. Financial Accounting Standards Board (1981, December). Foreign Currency Translation. Statement of Financial Accounting Standards No. 52. Financial Accounting Standards Board (1985, December). Employers' Accounting for Pensions. Statement of Financial Accounting Standards No. 87. Financial Accounting Standards Board (1987, December). Accounting for Income Taxes. Statement of Financial Accounting Standards No. 96. Financial Accounting Standards Board (1990, December). Employers' Accounting for Postretirement Benefits Other Than Pensions. Statement of Financial Accounting Standards No. 106. Financial Accounting Standards Board (1992, February). Accounting for Income Taxes. Statement of Financial Accounting Standards No. 109. Fogarty, T. J., & J. Grant (1995) Impact of Actuarial Profession on Financial Reporting. Accounting Horizons, 9(3), 23-33. Ghicas, D. C. (1990). Determinants of Actuarial Cost Method Changes for Pension Accounting and Funding. The Accounting Review, 65(2), 384-405. Gujarathi, M. R., & R.E. Hoskin (1992). Evidence of Earnings Management by the Early Adopters of SFAS 96. Accounting Horizons, 6(4) 18-31. Gujarathi, M. R., & R.E. Hoskin (1995). Managers' Use of Adoption Timing and Choice of Transition Method as a Strategic Financial Reporting Opportunity: Additional Evidence from the Early Adopters of SFAS 96. Working Paper. Bentley College, University of Connecticut.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

84 Langer, R., & B. Lev (1993). The FASB's Policy of Extended Adoption for New Standards: An Examination of FAS No. 87. The Accounting Review, 68(3), 515-533. Levitt, A. (1998, Sept. 28). The Numbers Game. Remarks of the Chairman of the Securities and Exchange Commission. Retrieved August 10, 2001 from www.sec.gov/news/ speech/speecharchive/1998/spch220.txt. MacDonald, E. (1999, January 22). SEC Weighs Wide Review of Write-Offs. The Wall Street Journal, A2-6. Mittelstaedt, H. F. (1989). An Empirical Analysis of the Factors Underlying the Decision to Remove Excess Assets from Overfunded Pension Plans. Journal of Accounting and Economics. (November), 11(4), 399-418. Norton, C. (1989). Transition to New Accounting Rules: The Case of FAS 87. Accounting Horizons, 3(4), 40-48. Schipper, K. (1989). Commentary on Earnings Management. Accounting Horizons, 3(4), 91-101. Senteney, D. L., & J.R. Strawser (1990). An Investigation of the Association Between Financial Statement Effects and Management's Early Adoption of SFAS 87. Review of Business and Economic Research, 25(2), 12-22. Stone, M.S., and R. Ingram (1988). The Effect of Statement No. 87 on the Financial Reports of Early Adopters. Accounting Horizons, 2(3), 48-61. Thomas, J. K. (1989). Why Do Firms Terminate Their Overfunded Pension Plans. Journal of Accounting and Economics, 11(4), 361-398. Tung, S. S., & J.J. Weygandt (1994). The Determinants of Timing in the Adoption of New Accounting Standard: A Study of SFAS No. 87, Employers' Accounting for Pensions. Journal of Accounting, Auditing, and Finance, 9(2), 325-337. Watts, R. L., & J.L. Zimmerman (1986). Positive Accounting Theory. Englewood Cliffs, N.J.: Prentice-Hall, p. 216. Zmijewski, M. E., & R.J. Hagerman (1981). An Income Strategy Approach to the Positive Theory of Accounting Standard Setting/Choice. Journal of Accounting and Economics, 3 (1), 129149.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

85

EARNINGS RESPONSE TO AUDITOR SWITCHES USING A MULTI-TIERED AUDITOR CLASSIFICATION


Ronald A. Stunda, Birmingham-Southern College David H. Sinason, Northern Illinois University
ABSTRACT Previous studies have provided evidence indicating that the securities market values audits performed by large audit firms more then audits performed by smaller audit firms. This may be due to a perception that large audit firms provide higher quality audits or that large audit firms provide greater insurance to investors in the event of a loss. Findings in this study are based on studies between big-five (big-six, big-eight) audit firms and smaller audit firms. While the market may value big-five audit firms, it would be unreasonable to expect the market to treat all other audit firms equally. This study provides evidence that the market reacts differently to earnings when an audit firm of a different classification is associated with the financial information provided by the firm and is not limited to changes from or to the big-five audit firms. INTRODUCTION The fact that large audit firms enjoy a reputation as the premier quality auditors has been accepted in audit research as a valid construct. The recognition of this size relationship has been operationalized in research as a two-class system consisting of the "quality" big-five auditors and all other audit firms. While firms like Arthur Andersen and KPMG enjoy international reputations which are shared by only a select group of firms, other firms like McGladrey & Pullen, BDO Seidmans and Grant Thornton, enjoy national reputations that are not shared by smaller regional firms. Therefore, it may be logical to expect investors to find value in a change from a small regional firm to a non-big-five firm with a national reputation. This study evaluates the market reaction to auditor switches using a multi-tiered classification based on the number of audit clients for each audit firm. This market reaction may be the result of an increase in information quality or an increase in the insurance provided by the larger audit firm. The recognition of a different market reaction to distinct classifications of auditors is important for two reasons. First, audit researchers have dichotomized audit quality between big-five audit firms and all other audit firms. This classification has been utilized in many studies that investigate auditor-client relationships. If the market views auditors as a multi-classification and reacts differently to each classification, this information may facilitate future research in auditor-client relationships. Second, if the market views auditors as a multi-classification, clients may need to give more consideration to the markets perceptions when selecting an auditor. The remainder of the paper is organized in five sections. The first section outlines significant prior research in the area of auditor switching. The next section provides the theoretical development of the hypotheses being tested. This is followed by the section that describes the Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

86 sample selection. The next section provides the discussion of the results. This is followed by the Conclusions of the study. PRIOR RESEARCH Previous studies regarding changes in auditors have focused on the reasons companies change auditors and the market reaction to changes in auditor type (i.e. big-five and non-big-five). Most of this research utilizes a dichotomous variable, where 1 is assigned to big-five firms and 0 to non-big-five firms, as either the dependent or independent variable. As an independent variable, this classification is usually used as a proxy for audit quality. Francis and Wilson (1988) tested whether a positive relationship exists between a firm's agency costs and its demand for a quality-differentiated audit. The authors utilized two models:
1 2 a brand name model where the dependent variable of big-eight/non-big-eight, and a continuous size model where the dependent variable was defined as the natural logarithm of the ratio of combined sales of the public companies audited by the new auditor to that of the old auditor in the year of the auditor change.

Results of the brand name model supported the agency cost relationship, however, the results of the continuous size model did not support the hypothesis. Johnson and Lys (1990) evaluate whether changes in clients' financing, investing, and operating characteristics are related to auditor changes. They evaluate auditor changes between and among big-eight audit firms and non-big-eight firms. The authors used a cross-sectional regression and logit analysis to study the relation between relative audit firm size and the change in client characteristics for the period 1973-1982. They maintain that auditor changes are a response to shifts in the client's financing and operating characteristics that result in an auditor-client mismatch. The authors also presented an event study that evaluated common stock returns at the time of the auditor change. The results of the event study provide no statistical evidence of a market reaction to auditor changes. In a 1993 article on perceived audit quality, Teoh and Wong provided an analysis of the market reaction to firms changing from big-eight to non-big-eight or non-big-eight to big-eight. This study evaluated market reaction to earnings during a period prior to the change in auditors with the period subsequent to the change in auditors. The results of this part of Teoh and Wong study were inconclusive with regards to a market reaction to changes in auditor. Krishnan (1994) examined auditor switching as a function of auditor conservatism. The author concluded that switching is triggered by conservative treatment rather than by the issuance of qualified opinions. Krishnan used an ordered probit regression that includes a dichotomous independent variable BIG6. This variable is not defined as to its representation in the equation, but appears to proxy for the quality of the auditor. Krishnan et. al. (1996) indicate that auditor switching is more likely to occur when the auditor issues a qualified opinion, however, the authors

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

87 find no support that a change in auditor influences the opinion provided. In the research, the authors use an independent variable BIG6 to proxy for auditor quality and reputation. This paper extends the market reaction to auditor switching studies of Johnson and Lys (1990) and Teoh and Wong (1993) by looking at a multi-tiered classification scheme based on the number of clients for an auditor. THEORETICAL DEVELOPMENTS Audit Quality The users of financial information desire an independent audit as means of monitoring financial information to ensure that information is reliable. Information reliability incorporates the characteristics of precision and bias. Precision implies that stated measurement methods were properly applied, while bias indicates that the measurement results were correctly displayed (Kinney, 2000). The users of financial information require a quality audit to ensure that numbers are precise (within the confines of materiality) and free from bias. The quality of an audit may be defined as the market-assessed joint probability that an auditor will discover a financial reporting impression or bias, and report the situation to the information users (DeAngelo, 1981). Although audit quality is not directly observable, users develop proxies that they believe are associated with audit quality (Wilson and Grimlund 1990; Palmrose 1991). One such proxy is audit firm size. It has been stated in many studies that large audit firms provide a higher quality audit then smaller firms (DeAngelo 1981; Chow and Rice 1982; Schwartz and Menon 1985). According to DeAngelo (1981)
.the larger the auditor as measured by the number of clients, the less incentive the auditor has to behave opportunistically and the higher the perceived quality of the audit.

In addition, large audit firm investments in specialized resources such as training and technology yield economies of scale and scope for audit services (Johnson and Lys 1990). If investors believe that large audit firms provide a better quality audit then smaller audit firms, and that this quality results in improved reliability of financial information, changes to larger audit firms could lead to a positive share price reaction around the announcement of the auditor change. Insurance Hypothesis Prior research indicates that investors perceive auditors as providing a type of implicit insurance to users and investors (Hill et. al. 1993). The auditors are deemed to be a "deep pocket" because CPA firms often carry malpractice insurance or, in many cases, are the only solvent defendant in a lawsuit. Therefore, the auditor is considered a potential indemnifier to investors and creditors if a loss is experienced. Menon and Williams (1994) assert that the legal right to seek Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

88 indemnification from an auditor for losses sustained is assigned a value by investors and is a component of the stock price of publicly traded companies. The insurance hypothesis indicates that investors will react to changes that may affect their ability to collect damages from the auditor. Changes to larger, more solvent audit firms could lead to a positive share price reaction for audit clients around the announcement of the auditor change. The Timing of the Market Reaction Many auditor switching studies have used the announcement of a change in auditor as the event date. Studies such as Smith (1988), Mangold (1988), Teoh (1989), and Johnson and Lys (1990) do not find a market reaction to the announcement of an auditor switch. Fried and Schiff (1981) find a negative cumulative abnormal return for a 21-week period following the filing of an 8-K report for an auditor change. Wells and Louder (1997) find evidence that the market views an auditor resignation as bad news and a resultant negative price reaction occurs. It should be noted that at the announcement date of the change in auditor, the successor auditor has not yet performed any work for the client. Legally the successor auditor cannot be held responsible for the work performed or information provided by the predecessor auditor. Therefore, should the investors find fault in published financial information, it is still the predecessor auditor that is liable. This may lead to a perceived difference in the risk of relying on financial information associated with the successor auditor. In addition, when a new auditor is announced, investors may anticipate an audit of higher quality from the successor auditor. However, until information prepared or audited by the new firm is made available to the market, there is no "product" that the market can assess. This may lead to a perceived difference in the reliability of the financial information associated with the successor auditor. For these reasons, the market may react differently to earnings announcements when a new auditor is associated with the financial statements. This reaction may be in addition to any reaction that the market has to the announcement of the auditor change. Hypothesis Development The theory that large audit firms provide higher quality audits and that large audit firms provide greater insurance protection for investors and creditors does not indicate that size advantages are limited to the big-five audit firms. Indeed, it is only the perpetuation of prior methodology that has resulted in an audit quality proxy as a dichotomy between big-five firms and all other firms providing audit services. The following hypotheses will be tested to determine if there are cumulative abnormal returns at the earnings announcement date when clients change auditor class in a multi-tiered classification system.
H1: H2: Clients that change from a non-big-five audit firm to big-five audit firm experience positive cumulative abnormal returns in the market place. Clients that change from a big-five audit firm to a smaller audit firm experience negative cumulative abnormal returns in the market place.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

89 If the market place perceives a quality difference in a big-five auditor, the results of H1 should be statistically significant with a positive sign, while the results of H2 should be statistically significant with a negative sign.
H3: H4: Clients that change from one big-five audit firms to another non-big-five audit firm experience cumulative abnormal returns in the market place. Clients that change from a non-big-five to another non-big-five audit firm experience cumulative abnormal returns in the market place.

Hypotheses 3 and 4 are designed to indicate that the market does not react to auditor changes when auditor changes do not involve changes in auditor class. The results of the testing of these hypotheses should not be statistically different from zero.
H5: H6: Clients that change to a larger audit firm experience positive cumulative abnormal returns in the market place. Clients that change to a smaller audit firm experience negative cumulative abnormal returns in the market place.

Hypotheses 5 and 6 are designed to test whether the market reacts to changes in audit firm size when the auditor is not a big-five auditor. SAMPLE SELECTION Six regressions are estimated with samples of firms obtained from the COMPUSTAT industrial tapes, which include firms listed on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the National Association of Security Dealers Automated Quotations (NASDAQ). The sample is selected from files of the 1999 annual industrial tapes, and is limited to firms with earnings information in each year of the period 1989-1998. As a measure of unexpected earnings, we use consensus analysts' forecast, therefore, we require the sample firms to be followed by the Institutional Brokers Estimate System (IBES) similar to Baginski, Hassell and Waymire (1994) and Stunda (1996). We also require that firms have daily stock returns data available on tape from the Center for Research in Security Prices (CRSP) during the period under study. The first sample is a control sample that contains industry-matched pairs of firms to control for differences in the information environment. Industry matching is accomplished by matching four-digit, three-digit, and two-digit SIC codes for each firm audited by one of the big-five firms versus a firm in the same industry audited by non-big-five firm. For the period under study, 1,485 firms were observed that met the sample criteria. The second sample contains firms that have switched from a non-big-five firm to a big-five audit firms during the study period. The sample is selected from COMPUSTAT and must meet the data availability criteria. For the study period, 147 firms were observed which met the sample parameters. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

90 The third sample contains firms that have switched from one of the big-five firms to a non-big-five audit firms during the study period. For the study period, 42 firms were observed which met the sample criteria. The fourth sample contains firms that have switched from a big-five audit firm to another big-five audit firms during the study period. For the study period, 26 firms were observed which met the sample criteria. The fifth sample contains firms that have switched from a non-big-five audit firm to another non-big-five audit firm during the study period. For the study period, 31 firms were observed which met the sample criteria. The sixth sample stratifies firms that have switched auditors during the study period. Four groups of audit firms are created using the number of clients identified for each firm . This means of classification is appropriate, since this study utilizes many smaller audit firms. Information, such as total audit firm revenue, is not readily available for such clients. Information concerning the number of COMPUSTAT clients for an audit firm is objective and measurable for all firms. Group 1 consists of the five largest firms (big-five). These firms average more than 2,000 clients as reported on COMPUSTAT for the years 1989-1998. Group 2 consists of audit firms with an average number of clients between 500 and 2,000 as reported on COMPUSTAT for the years 1989-1998. These firms proxy for the large national firms. Group 3 consists of audit firms with an average number of clients between 200 and 400 as reported on COMPUSTAT for the years 1989-1998. These firms proxy for the large regional audit firms. Group 4 consists of audit firms with less than 200 clients as reported on COMPUSTAT for the years 1989-1998 of small regional firms. These cut-offs are arbitrary in nature, but based on the data appear reasonable.
audit group 1 (Big 5) 2 (non-Big 5 national) 3 (large regional) 4 (small regional) Total # of audit firms 5 6 16 10 37 # of sample firms 535 326 418 206 1,485

Dummy variables are utilized and an analysis is made of sample firms that switch as follows:
Change from group 1 auditors to group 2 auditors Change from group 1 auditors to group 4 auditors Change from group 2 auditors to group 4 auditors Change from group 2 auditors to group 1 auditors Change from group 3 auditors to group 1 auditors Change from group 4 auditors to group 2 auditors Change from group 1 auditors to group 3 auditors Change from group 2 auditors to group 3 auditors Change from group 3 auditors to group 4 auditors Change from group 3 auditors to group 2 auditors Change from group 4 auditors to group 3 auditors Change from group 4 auditors to group 1 auditors

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

91 Methodology The first regression assesses the relative information content of unexpected earnings in matched pair samples of firms in comparable industries audited by big-five and non-big-five audit firms. This regression is run as a control from which subsequent regressions will be compared. The following model is used to evaluate information content:
CARit = a+b1UEit+b2DitUEit+b3MBit+b4DitMBit+b5LMVit+b6DitLMVit+b7Nit+b8DitNit +b9Bit+b10DitBit+eit Where: CARit a UEit Dit MBit LMVit Nit Bit eit [1]

= Cumulative abnormal return for firm i, time t = Intercept term = Unexpected earnings forecast for firm i, time t = Dummy variable, 1 for NB5 client, 0 for B5 client = Market value to book value as a proxy for growth and persistence = Natural log of market value as a proxy for firm size = Number of analysts forecasts included in IBES as a proxy for noise in predisclosure environment =Market value slope coefficient as a proxy for systematic risk = Error term for firm i, time t

The coefficient a measures the intercept. The coefficient b1 is the earnings response coefficient (ERC) for all firms in the sample (both big-five and non-big-five clients). The coefficient b2 represents the incremental ERC. Therefore, b2 captures the difference in the information content for firms that are big-five clients versus those who are not. The remaining coefficients are contributions to the ERC for all firms in the sample. To investigate the effects of the information content of unexpected earnings, there must be some control for variables shown by prior studies to be determinants of the ERC. For this reason, variables represented by these coefficients are included in the study. Unexpected earnings (UEit) is measured as the difference between the actual earnings and the security market participants expectations for earnings proxied by consensus analysts forecast as per IBES. The unexpected earnings are scaled by the firms stock price 180 days prior to the forecast:
UEit = Actual Earnings Expected Earnings / Price

For each disclosure sample, an abnormal return (ARit) is generated for event days 1, 0, +1, where day 0 is defined as the date of the earnings disclosure identified by the Dow Jones News Retrieval Service (DJNRS). The market model is utilized along with the CRSP equally-weighted market index and regression parameters are estimated between days 290 and 91. Abnormal returns are then summed to calculate a cross-sectional cumulative abnormal return (CARit). Regressions two through five address the switching of client firms among and between audit firm groupings. These switches are observed as follows:
1) NB5 to B5 2) B5 to NB5 3) B5 to B5 4) NB5 to NB5

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

92 The following model is used to evaluate information content among the switched groups:
CARit = a+b1UEit+b2MBit+b3LMVit+b4Nit+b5Bit+eit [2]

Variables and model parameters used are the same as those utilized in equation 1, except for the elimination of the dummy variable. The above equation is run four times, substituting switched groups in each run. For regression six, the following equation is used:
CARit = a+b1UEit+b2UEit+b3UEit+b4UEit+b5UEit+b6UEit+b7UEit+b8UEit+b9UEit +b10UEit+b11UEit+ b12UEit+b13MBit+b14LMVit+b15Nit+b16Bit+eit [3]

Where: b1 = Variable for change from group 1 auditors to group 2 auditors b2 = Variable for change from group 1 auditors to group 3 auditors b3 = Variable for change from group 1 auditors to group 4 auditors b4 = Variable for change from group 2 auditors to group 3 auditors b5 = Variable for change from group 2 auditors to group 4 auditors b6 = Variable for change from group 3 auditors to group 4 auditors b7 = Variable for change from group 2 auditors to group 1 auditors b8 = Variable for change from group 3 auditors to group 2 auditors b9 = Variable for change from group 3 auditors to group 1 auditors b10= Variable for change from group 4 auditors to group 3 auditors b11= Variable for change from group 4 auditors to group 2 auditors b12= Variable for change from group 4 auditors to group 1 auditors b13= Market value to book value as a proxy for growth and persistence b14= Natural log of market value as a proxy for firm size b15= Number of analysts forecasts included in IBES as proxy for noise in predisclosure environment b16 = Market value slope coefficient as a proxy for systematic risk All parameters are the same as used in the first two regression equations.

DISCUSSION OF RESULTS Table 1 provides the results from the first regression of matched pair firms. As can be seen, none of the variables contained in the regression are significant in explaining the CAR. This is similar to results found by Teoh and Wong (1993). Table 2 provides results from the first switch sample where client firms switched from nonbig-five audit firms to big-five audit firms. As can be seen from the table, the unexpected earnings variable is positively significant in providing information content relative to CAR. The implication is that unexpected earnings contain information content for firms switching to big-five auditors, and this information is positively correlated. This result confirms hypothesis 1 and indicates that the marketplace adds value to a publicly traded stock when the company changes to a big-five auditor.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

93
Table 1: Summary of Pair-Matched Samples 1989-1998 n= 1,485 client firms CARit = a+b1UEit+b2DitUEit+b3MBit+b4DitMBit+b5LMVit+b6DitLMVit+b7Nit+b8DitNit +b9Bit+b10DitBit+eit Mean Variable UE MB LMV N B B5 -0.0286 2.7190 4.1911 5.2218 1.3856 NB5 -0.0180 2.4881 4.2832 5.0190 1.3249 B5 -0.0009 1.6021 4.2901 4.0000 1.2019 Median NB5 -0.0011 1.7872 4.0098 3.0000 1.2001 Coeff -0.1103 0.0829 -0.0541 0.0423 -0.0218 t-statistic -0.6475 0.2183 -0.3389 2.9090 -1.1391 p-value 0.4362 0.5768 0.4976 0.1586 0.4027

Table 2: Summary of Client Firms Switching From NB5 to B5 Audit Firms n = 147 CARit = a+b1UEit+b2MBit+b3LMVit+b4Nit+b5Bit+eit Variable UE MB LMV N B Mean 0.0329 2.2802 4.5890 4.5890 1.2819 Median 0.0190 1.2081 4.2891 4.0000 1.1947 Coeff. 0.0921 0.0538 -0.0322 0.0725 0.0198 t-statistic 2.3284 0.4492 -0.1938 1.5947 1.1149 p-value 0.0219 0.6304 0.7984 0.2609 0.2531

Table 3 provides results from the second switch sample where client firms switched from big-five audit firms to non-big-five audit firms. As can be seen from the table, the unexpected earnings variable is negatively significant in providing information content relative to CAR. The implication is that unexpected earnings contain information content for firms switching to non-bigfive auditors, and this information is negatively correlated. These results support hypothesis 2 and indicate that the marketplace reduces value to the stock when a change from a big-five auditor is made. Tables 4 and 5 provide results from the remaining two switch samples between big-five firms and non-big-five firms respectively. As expected, no significant results were noted in these switch samples. While the lack of significance cannot imply the acceptance of the alternative hypothesis that the marketplace adds no value to changes among the big-five or among the non-big-five auditors, it is comforting that the results were as expected.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

94
Table 3: Summary of Client Firms Switching From B5 to NB5 Audit Firms n = 42 CARit = a+b1UEit+b2MBit+b3LMVit+b4Nit+b5Bit+eit Variable UE MB LMV N B Mean -0.0217 2.1546 4.3862 3.7652 1.1597 Median -0.0209 1.8253 4.1170 3.0000 1.2089 Coeff. -0.1053 0.0486 -0.0251 0.0665 0.0249 t-statistic 2.7562 0.5417 -0.1764 1.7621 1.0018 p-value 0.0118 0.6728 0.8194 0.4153 0.2764

Table 4: Summary of Client Firms Switching From B5 to B5 Audit Firms n = 26 CARit = a+b1UEit+b2MBit+b3LMVit+b4Nit+b5Bit+eit Variable UE MB LMV N B Mean 0.0568 1.9976 4.1876 4.8431 1.3196 Median 0.0419 1.9541 4.0091 4.0000 1.2922 Coeff. 0.0291 0.0447 -0.0210 0.0655 0.0200 t-statistic 0.8915 0.4876 -0.2018 1.6291 1.1551 p-value 0.4956 0.6219 0.7847 0.2987 0.3281

Table 5: Summary of Client Firms Switching From NB5 to NB5 Audit Firms n = 31 CARit = a+b1UEit+b2MBit+b3LMVit+b4Nit+b5Bit+eit Variable UE MB LMV N B Mean 0.1521 2.0198 4.2819 3.8219 1.4003 Median 0.1019 1.9827 4.0989 3.0000 1.3821 Coeff. 0.0313 0.0521 -0.0198 0.0715 0.0249 t-statistic 0.4987 0.5121 -0.4942 1.8431 1.0089 p-value 0.6636 0.7147 0.7767 0.2262 0.3724

Table 6 provides results of firms that have switched between auditor classes for the period under study. As can be seen, the unexpected earnings variable is positive and significant in providing information content relevant to CAR in switches from smaller firms to larger firms (i.e., Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

95 variables b7 through b12). These results are consistent with hypothesis 5 and indicate that the market adds value to firms that switch to a larger firm, even if the larger firm is not a big-five audit firm. This result may be associated with an audit quality or an insurance factor associated with a larger audit firm.
Table 6: Summary of Client Firms Switching Auditor Types n = 220 CARit=a+b1UEit+b2UEit+b3UEit+b4UEit+b5UEit+b6UEit+b7UEit+b8UEit+b9UEit+b10UEit+b11UEit+ b12UEit+b13MBit+b14LMVit+b15Nit+b16Bit+eit Variable b1 b2 b3 b4 b5 b6 b7 b8 b9 b10 b11 b12 b13 b14 b15 b16 Number * 28 11 3 8 0 3 87 10 51 6 9 4 Mean -0.1021 -0.1085 -0.1407 -0.1182 N/A Median -0.1035 -0.1062 -0.1318 -0.1168 N/A Coeff. -0.09431 -0.08271 -0.0915 -0.0622 N/A -0.0449 0.0591 0.0774 0.0820 0.0338 0.0516 0.0249 0.0418 -0.0302 0.0467 0.0128 t-statistic 1.2846 1.3102 1.4519 1.3422 N/A 1.1950 2.3515 2.2412 2.3802 2.1921 2.2056 2.3601 0.6072 0.2019 1.8721 1.1526 p-value 0.3015 0.2795 0.2102 0.2820 N/A 0.3102 0.0211 0.0372 0.0146 0.0486 0.0437 0.0203 0.7519 0.8209 0.2398 0.4001

-0.1201 -0.1159 0.0739 0.0901 0.0995 0.0840 0.1014 0.0785 2.1608 4.1005 3.5821 1.5109 0.0801 0.0889 0.1010 0.0809 0.1041 0.0798 2.1554 4.1001 3.5618 1.5007

* Number of switches in the Group

The variables b1 through b6 (excluding b5 which did not include any samples) represent switches from larger audit firms to smaller audit firms. While the signs for these switches are negative, as expected, none of the coefficients are statistically significant at any of the conventional levels. It should be noted that many of these groups contained few, if any, audit switches. Where only a few firms exist, a contrary reaction to even one switch can greatly skew the data. Table 3 Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

96 presented the results for switches from big-five auditors (group1) to non-big-five auditors (groups 2, 3, and 4 combined). Using that grouping, the changing from a large auditor to a smaller auditor was statistically significant. The limited number of firms in these groups is a limitation of this study and may account for the lack of statistical significance for variables b1 through b6. CONCLUSION It has been noted in many studies that the financial statement users value large audit firms because they perceive these firms as either providing a higher quality audit or greater insurance in the event of a financial loss. These studies have resulted in audit quality as a dichotomous variable where big-five auditors represent the quality firm. This study provides some evidence that the market does value a larger audit firm, even if that firm is not a big-five firm. REFERENCES Baginski, S., J. Hassell, and G. Waymire, 1994, Some Evidence on the News Content of Preliminary Earnings Estimates, The Accounting Review, January, pp. 265-271 Chow, C. W. and S. J. Rice, 1982, Qualified Audit Opinions and Auditor Switching, Accounting Review, April, pp. 326-335 DeAngelo, Linda, 1981, Auditor Size and Audit Quality, Journal of Accounting and Economics, pp. 183-199 Francis, J. R. and E. R. Wilson, 1988, Auditor Changes: A joint Test of Theories Relating to Agency Costs and Auditor Differentiation, Accounting Review, October, pp. 663-683 Fried, D. and A. Schriff, 1981, CPA Switches and Associated Market Reactions, The Accounting Review, April, pp. 326-341 Hill, J. W., M. Metzger, and J. Schatzberg, 1993, Auditings Emerging Legal Peril Under the National Surety Doctrine: A Program for Research, Accounting Horizons, March, pp. 12-28 Johnson, W. B. and T. Lys, 1990, The Market for Audit Services: Evidence from Voluntary Auditor Changes, Journal of Accounting and Economics, January, pp. 281-308 Kinney, Willian R., 2000, Information Quality Assurance and Internal Control for Management Decision Making, Irwin McGraw-Hill:Boston Krishnan, J., 1994, Auditor Switching and Conservatism, Accounting Review, January, pp. 200-215

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

97 Krishnan, J., J. Krishnan, and R.G. Stephens, 1996, The Simultaneous Relation Between Auditor Switching and Audit Opinion: An Empirical Analysis, Accounting and Business research, 3, pp. 224-236 Mangold, N. R., 1988, Changing Auditors and the Effect on Earnings, Auditors Opinions, and Stock Prices, UMI Research Press Menon, K. and D. Williams, 1994, The Insurance Hypothesis and the Market Prices, Accounting Review, April, pp. 327-342 Palmrose, Z. , 1991, An Analysis of Auditor Litigation Disclosures, Auditing: A Journal of Theory and Practice, Supplement, pp. 54-76 Shwartz, K. B. and K. Menon, 1985, Auditor Switches by Failing Firms, Accounting Review, April, pp. 248-261 Smith, D.B., 1988, An Investigation of Securities and Exchange Commission Regulation of Auditor Change Disclosures: The Case of Accounting Series Release No. 165, Journal of Accounting Research, Spring, pp/ 134-145 Stunda, R., 1996, The Credibility of Management Forecasts During Corporate Mergers and Acquisitions, The American Academy of Accounting and Financial Studies Journal, December, 352-358 Teoh, S.H., 1989, Auditor Independence, Dismissal Threats, and the Market Reaction to Auditor Switches, Journal of Accounting Research, 30, pp. 1-25 Teoh, S. H. and T. J. Wong, 1993, Perceived Auditor Quality and the Earnings Response Coefficient, Accounting Review, April, pp. 346-366 Wells, D.W. and M.L. Loudder, 1997, The Market Effects of Auditor Resignations, Auditing: A Journal of Theory and Practice, Spring, pp: 138-144 Wilson, T. and R. Grimlund, 1990, An Examination of the Importance of an Auditors Reputation, Auditing: A Journal of Theory and Practice, Spring, pp. 43-59

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

98

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

99

ACCOUNTING FOR ACQUISITIONS AND FIRM VALUE


Oliver Schnusenberg, St. Joseph's University W. Richard Sherman, St. Joseph's University
ABSTRACT The accounting of an acquisition is based on either the pooling or the purchase method. Pooling (or pooling of interests) treats the combined companies (acquirer and acquired) as though they had always operated as one company. The purpose of this study is to investigate the extent to which the accounting method used affects the value of the acquiring firm. One argument is that the accounting method used should not affect this value inasmuch as the accounting method does not directly affect cash flow. Our sample consists of 146 pooling and 46 purchase announcements from 1981 to 1995. Results indicate that valuation effects are more favorable for acquisitions using the purchase method in the eleven-day period surrounding the announcement and for at least six months following the announcements. These results stand even after conducting a cross-sectional analysis that controls for the firms' price/earnings ratio, size, market parameter estimates, earnings surprises, and leverage. These results suggest that market participants value the added flexibility and indirect tax benefits that are provided by the purchase method of accounting as opposed to the higher reported future earnings associated with the pooling method. INTRODUCTION The accounting of an acquisition is based on either the pooling or the purchase method. Pooling (or pooling of interests) treats the combined companies (acquirer and acquired) as though they had always operated as one company. Consequently, the financial statements of the new company merely reflect the consolidation of statements of the two previously separate entities. In contrast, purchase accounting revalues the assets and liabilities of the acquired company at their current fair market values with the possible difference between the acquisition price and the market value of the acquired company's net identifiable asset (i.e. goodwill) being amortized over a period not to exceed 40 years. This amortization creates an expense that reduces reported earnings of the acquiring firm. The purpose of this study is to investigate the extent to which the accounting method used affects the value of the acquiring firm. One argument is that the accounting method used should not affect this value inasmuch as the accounting method does not directly affect cash flow. However, there are other arguments relating to valuation effects from future cash flows and/or indirect cash flows that provide a rationale for how and why the choice of accounting method can impact value.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

100 ADVANTAGES OF POOLING Research by Ball & Brown (1968), Gonedes (1975), Hoskins, Hughes & Ricks (1986), and others has shown that reported earnings can partially drive stock prices. To the extent that the accounting method affects future earnings, the valuation effects may be more favorable for acquirers using the pooling method. Earnings for pooling firms are generally higher for a number of reasons. The first is due to the way in which the acquired firm's earnings are folded into the new entity's reported earnings. Under pooling, the net earnings for the entire year of acquisition are carried into the merged firm's income statement; under purchase accounting, only the income earned by the acquired firm after the acquisition date are reported by the acquiring firm. Depending on when during the year the acquisition takes place, this difference may be more (late in the year) or less (early in the year) significant in the reported earnings for the first year. Pooling would also result in higher earnings reporting for reason related to the treatment of the acquired firm's assets and liabilities after acquisition. The tax aspects of mergers and acquisitions are extraordinarily complex but can be roughly divided between tax-free reorganizations and taxable acquisitions. In general, tax-free reorganizations under IRC Section 368 will be accounted for under the "pooling of interest" method. Taxable acquisitions, with re-valuation of assets to their fair market value (an election under IRC Section 338 is available for stock acquisitions), are usually reported using the "purchase" method of accounting. The discussion of the reporting aspects of pooling vs. purchase accounting assumes a parallel to the tax consequences of tax-free reorganizations vs. taxable acquisitions. It further assumes that market participants implicitly understand the relevant tax consequences related to the method of accounting disclosed in the acquisition announcement. Under pooling, the valuation of these assets and liabilities remains unchanged from how they appeared on the pre-acquisition balance sheet of the acquired firm. Under purchase accounting, the assets and liabilities of the acquired firm are restated at their current market values. Because there is no re-valuation (i.e., "write-up") of the acquired firm's assets under pooling, depreciation expenses after the acquisition are generally lower (with the resultant reported earnings being generally higher) than the depreciation that would taken for the same acquisition under purchase accounting. Related to this non-revaluation of assets is the fact that there is no possibility for the recognition of "goodwill" (i.e. the difference between the purchase price and the market value of the acquired firm's net identifiable assets) from an acquisition under pooling. Had a firm recognized goodwill upon acquisition (as would have been the case under purchase accounting), it would be required to amortize (i.e., expense) this intangible asset, which, in turn, would negatively impact reported earnings. In fact, under the Exposure Draft on a proposed Statement, Business Combinations and Intangible Assets, issued by the FASB in September, 1999, not only would the purchase method be required for all business combinations but any goodwill that is recognized as a result of the acquisition would not be subject to amortization. Instead, goodwill would be reviewed for impairment (i.e., its fair value is less than its carrying amount) on a regular basis (FASB, 1999). As a final consequence of non-revaluation of assets, pooling firms will generally report higher gains (or lower losses) upon the disposal of the assets of the acquired firm due to the lower basis of these

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

101 assets. In contrast, because of the revaluation to current market values at the time of acquisition, the acquired firm's assets lose whatever pre-acquisition gains which are inherent in them. As a result of these accounting differences, a company using pooling would be expected to report higher earnings after the acquisition than a company using the purchase method. (Also see Herz & Abahoonie (1990) for a more detailed discussion of earnings differentials between the purchase and pooling methods.) If market participants do indeed use reported earnings in assessing a firm's value, one would expect abnormal returns associated with the pooling method to be larger than those associated with the purchase method of accounting for acquisitions. This leads to the following null hypothesis:
HO: Abnormal returns surrounding the announcement of a pooling acquisition are larger than those associated with a purchase acquisition.

ADVANTAGES OF THE PURCHASE METHOD While its use will generally result in lower reported earnings, the purchase method of accounting does offer some advantages over pooling. As shown in Appendix A, firms must meet twelve criteria in order to be allowed to report an acquisition under the pooling method. (APB Opinion 16) A firm may, therefore, be restricted from restructuring in order to meet these criteria. For example, because a company utilizing the pooling method must agree not to enter into other financial arrangements for the benefit of the former stockholders of a combining company, an exchange of equity securities would be prohibited. Furthermore, the company also must agree not to dispose of a significant part of the assets of the combining companies. To the extent that the twelve criteria (none of which apply to the purchase method of accounting) can be perceived as restricting a firm's future financing or operating flexibility, market participants may penalize firms using the pooling method. Therefore, acquisitions reported under the purchase method may result in more favorable valuation effects than those reported under pooling. The choice of accounting for an acquisition may also affect future indirect cash flows of a firm. As was discussed in the previous section, purchase accounting requires the revaluation of the acquired firm's assets to their market values as of the date of acquisition. This results in higher expenses being reported for the depreciation of the assets and for the amortization of the goodwill that may result from the acquisition. However, as Bittker & Eustice (1994) note, "as is often the case, an acquirer's desires to increase book income generally are at odds with its desires to reduce tax income". Inasmuch as both depreciation (Internal Revenue Code Sections 167 & 168) and amortization of goodwill (Internal Revenue Code Section 197) are tax deductible, the purchase method may be preferable over pooling because it reduces future cash tax outflows resulting from relatively high future earnings. Another tax-related indirect cash flow relates to the method of payment. Due to the fact that pooling requires stock-for-stock acquisitions, no recognition of gain or loss is possible for tax purposes. No such restriction applies to purchase accounting.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

102 These potential advantages of the purchase method form the basis for the alternative hypothesis (relative to HO) that acquisitions using the purchase method of accounting should result in more favorable valuation effects.
HA: Abnormal returns surrounding the announcement of a purchase acquisition are larger than those associated with a purchase acquisition.

LITERATURE REVIEW Studies investigating the stock returns associated with purchase and pooling acquisition announcements are relatively few. Two studies measured the abnormal stock price movements over a long window surrounding acquisition announcements and compared the movements of the sub-sample that was identified as using purchase accounting to the sub-sample using pooling. Hong, Kaplan & Mandelker (1978) examined 138 pooling and 62 purchase method mergers from 1954-1964. The accounting method associated with these mergers was identified using proxy statements issued in connection with the mergers. The authors found no reaction associated with pooling announcements but did find significant cumulative abnormal returns during the twelve months preceding the announcement of a purchase and that these abnormal returns were maintained for eight subsequent months. The authors conclude that the pooling of interests method does not lead to abnormal stock price behavior for acquiring firms but offer no explanation for the large abnormal returns associated with the purchase method of accounting for acquisitions. A related study by Davis (1990) examined 108 pooling and 69 purchase acquisitions over the period of 1971-1982. The accounting method associated with these acquisitions was identified in Mergers & Acquisitions. Davis' findings were similar to those reported by Hong et al. Purchase acquisitions exhibited positive and statistically significant abnormal returns while pooling acquisitions exhibited largely positive but statistically insignificant returns over a period from 26 weeks before the announcement to 26 weeks after the effective date of the acquisition. Other empirical studies have addressed the reasons for choosing one method over the other. Nathan & Dunne (1991) studied 30 purchase and 291 pooling acquisitions that occurred between 1963 and 1985. Using the firms' proxy statements to identify the accounting method used, they found that the purchase/pooling choice was influenced by goodwill, acquirer leverage, and the issuance of APB Opinion No. 16. Using the Wall Street Journal to identify the type of accounting used, Robinson & Shane (1990) investigated 59 pooling and 36 purchase acquisitions taking place 1972-1982. They found that bid premiums are generally larger for firms using the pooling method. The authors conclude that since the costs associated with structuring an acquisition to qualify for pooling are greater than those for the purchase method, acquirers will only structure an acquisition as a pooling of interests if the perceived benefits are greater than those that would be achieved under purchase accounting. Finally, Haw, Jung, & Ruland (1994) found that analysts' forecast accuracy decreased greatly after mergers in general but even more so for firms who used the purchase method due to the fact that purchase accounting interrupts the past time series of earnings. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

103 SAMPLE SELECTION Both Hong et al. (1978) and Davis (1990) investigated the extent to which abnormal returns were associated with the "announcement" of the method by which the acquisitions would be accounted - pooling or purchase. Yet both studies identified this accounting method by sources not directly associated with the announcement date (i.e. by proxy statement or by information published in Mergers & Acquisitions). While these sources identify the accounting method accurately, information of the method used is not necessarily available to market participants at the time that the merger is announced. Thus, these two studies implicitly assume that the market participants could, at the time of the merger announcement, properly guess whether pooling or purchase accounting would be used. However, Hong, et al., and Davis were investigating mergers that occurred in 1954-1964 and 1971-1982, respectively. The method of accounting was rarely disclosed at the time of that the merger was announced until the 1990s. To avoid this flaw in the previous studies and ensure that the accounting method was known by market participants, the sample of this study was created by identifying all acquisitions in which the method of accounting was stated at the time of the acquisition announcement. The Wall Street Journal Index and the Lexis/Nexis database were used to search for acquisitions during 1981-1985 for which there were corresponding announcements of the method being used to account for the merger. (Huang & Walking (1987) investigated acquisition attempts that were resisted and not resisted, using a sample based on announcements in the Wall Street Journal. As we do in our study, they argue that sample selection bias is avoided because only information known at the time of the acquisition announcement is used.) This resulted in an initial sample of 229 acquisitions (173 pooling and 56 purchase). This sample was screened by removing any companies for which the stock price data were not consistently reported over a period of 240 days before the acquisition announcement and 5 days after the announcement. Thirty-seven companies were removed for this reason, leaving a total of 192 acquisitions (146 pooling; 46 purchase) that could be assessed. The sample is segmented by year in Table 1. While 76% of the acquisition reflected the use of pooling, purchase accounting was announced more frequently in the early 1980s and was more evenly distributed throughout the period studies than is the case for pooling. Furthermore, as was noted previously, the choice of accounting method in the acquisition announcement was not generally disclosed until the 1990s. 92% of all the relevant announcements (i.e., those which disclosed the method that was being used to account for the merger) were in the 1990-1995 period, with most of these announcements occurring in 1994 and 1995. As shown by the descriptive statistics provided in Table 2, firms undertaking pooling acquisitions are, on average, larger than those firms using the purchase method of accounting. Pooling firms also experienced a higher growth rate, a higher return on assets (ROA), and also paid higher taxes as a percentage of before-tax income than those using purchase accounting. However, those firms using the purchase method showed higher returns on equity (ROE) than those using pooling.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

104
Table 1: Distribution of Pooling and Purchase Acquisitions Over Time Acquisitions Involving the Pooling Method 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Total 1 0 0 0 2 2 0 0 6 7 12 25 17 32 42 146 Acquisitions Involving the Purchase Method 0 0 1 2 1 3 3 2 2 0 3 2 6 11 10 46 Total Acquisitions 1 0 1 2 3 5 3 2 8 7 15 27 23 43 52 192

Table 2: Summary Information for Pooling and Purchase Acquisitions Pooling Sample Mean Asset Size of Acquirer ($million) Mean Taxes Paid as % of EBT in Year Before Acquisition Three-Year Growth Rate of Acquirer (Sales) Mean ROA of Acquirer Mean ROE of Acquirer 8,758 34.86% 20.15% 3.18% 10.40% Purchase Sample 6,053 32.58% 19.18% 4.24% 10.12% Total Sample 8,053 34.26% 19.90% 3.45% 10.33%

METHODOLOGY Valuations effects are measured for all firms contained in the sample. The abnormal return of each acquirer is estimated with prediction errors using the procedure of Mikkelson & Patch Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

105 (1988). The alpha and beta of each acquirer are derived over an estimation period of from t = -240 to t = -20 by applying the market model to returns of the University of Chicago's Center for Research in Security Prices (CRSP). CRSP calculates the raw return as:
Rit = (Pt + Dt)/Pt-1 - 1, where Rit Pt Dt Pt-1 = the rate of return on security i for event day t, = last sale price or closing bid/ask average on day t = cash adjustment for day t, and = last sale price or closing bid/ask average at time of last available price less than t, and

The intercept and beta resulting from application of the market model are then used long with the actual market movement over an examination period to derive an expected return. The prediction error (PE) for each acquirer is measured as:
PEit = Rit (ai biRmt), where Rmt a i , bi (1)

= the rate of return on the S&P 500 index on event day t, and = ordinary-least-squares estimates of the intercept and slope of the market model regression from the estimation period.

The mean of prediction errors for all acquirers that announced the use of pooling is derived for each day within the examination period. The same process is used to derive the mean prediction errors for acquirers that announced the use of the purchase method. The primary focus of the examination window is on the two-day window (t-1, t), in which day t serves as the announcement date. Because wire services may have reported the news of the acquisition before stock trading closed on the day prior to the announcement, day t-1 is also assessed in order to determine if the market response (if any) could have occurred on this day. Test for significance are based on Mikkelson and Partchs (1988) Z-statistic, which for each day is calculated as:
Zt = 3 SPEit/N, where SPEit = ARit/Sit, and Sit is calculated according to Mikkelson and Partch (1988). (2)

Two day-interval prediction errors are tested for significance using the following Z-statistic:
Zt = 1/N * 3 ASCARi, (3)

where ASCARi is the standardized cumulative abnormal return defined by Mikkelson and Partch (1988). The denominator required for this calculation is the variance of the cumulative prediction error of firm i.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

106 RESULTS Stock Price Reaction in the Announcement Period Results for various intervals are presented in Table 3. As mentioned above, the two-day (t = -1, 0) prediction errors are of primary interest. The mean two-day PE for acquisitions in which pooling was announced is -0.49% (Z = -7.54). The mean PE for purchase acquisitions is 0.31% (Z = 1.27). A Z-test was applied to test for a significant difference in the two sub-samples for the cumulative abnormal returns over the [-1, 0] interval. The difference of 0.80% is significant with a Z-statistic of 3.39 (p = 0.00069). The results support HA and suggest that the market responds more favorably to acquisition announcements involving the purchase method of accounting. The results are attributed to the greater restructuring flexibility and the indirect tax benefits afforded by purchase accounting.
Table 3: Summary of CARs Over Various Intervals for Pooling vs. Purchase Methods of Accounting for an Acquisition (Test-Statistic in Parentheses) Interval [-5,+5] [-3,0] [-1,0] [0,180] [0,360] CAR of Acquisitions Using the Pooling Methoda -1.57% (-3.60)*** -0.62% (-4.19)*** -0.49% (-7.54)*** -15.97% (-5.09)*** -35.81% (-5.60)*** CAR of Acquisitions Using the Purchase Methodb 3.31% (2.34)** 2.24% (2.82)*** 0.31% (1.27) -2.42% (-0.40) -17.26% (-1.82)* Test for Difference 4.88% (1.15) 2.86% (2.26)** 0.80% (3.39)*** 13.55% (2.12)** 18.55% (1.62)*

* Significant at the 10% level ** Significant at the 5% level *** Significant at the 1% level a The number of pooling firms utilized over the five intervals are 146, 146, 146, 108, and 87, respectively. b The number of purchase firms utilized over the five intervals are 46, 46, 46, 37, and 27, respectively.

Long-Term Effects Valuation effects are also measured over an extended period in order to estimate long-term performance following acquisitions. Unfortunately, in order to retain a relatively large sample, the initial sample was screened to retain only those firms with returns data available for up to five days following the acquisition announcement. Consequently, investigation of long-term valuation effects results in additional sample attrition due to missing returns data. As shown in Table 3, 108 pooling firms and 37 purchase firms had available data for intervals [0, 180]. This number drops to 37 pooling and 27 purchase firms with available data for intervals [0, 360].

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

107 The results summarized in Table 3 show that regardless of whether pooling or purchase accounting is used, acquirers suffer large negative returns in the year following the acquisitions. Pooling firms experience significant negative abnormal returns of 35.81% over the 360-day period after the merger (t = -1.82; p < 0.0005); firms announcing the use of purchase accounting experience significant abnormal returns of 17.26% over the same time period (t = -1.82; p = 0.0808). The difference (18.55%) in these negative returns is marginally significant (t = 1.62; p = 0.1114). Thus, even when assessing extended periods, acquisitions using the purchase method are associated with relatively more favorable valuation effects than those acquirers using pooling. Hong et al. (1978) found that purchase firms maintained their positive cumulative abnormal returns for a period of eight months following the announcement. While the negative abnormal returns of -2.42% experienced by purchase firms in our study are not significant (t = -0.40; p = 0.6894), the returns of pooling firms (-15.97%) are highly significant (t m= -5.09; p < 0.00005), with the 13.55% difference in returns between the two sub-samples being significant at the 5% level (t = 2.12; p = 0.0361). Cross-Sectional Analysis Since the two sub-samples may have distinct characteristics, a complimentary cross-sectional analysis is conducted to control for these while testing whether valuation effects are related to the type of accounting method announced. Previous research has identified the following variables for which the accounting method may be proxying: Price: Earnings (P/E) ratio, size, market model parameter estimates, earnings surprise, and leverage. (See, among others, Basu (1983); Banz (1981); Beaver, Clark & Wright (1979); Bernard (1979); Elgers & Clark (1979); Hagerman & Shah (1984); and Reinganum (1981).) Each of these variables is discussed below. Price/Earnings Ratio In an efficient capital market, all available information is rapidly reflected in security prices. However, previous studies have found that the efficient market hypothesis may be violated in certain circumstances. For example, Basu (1977; 1983) found that low P/E ratios may be an indicator of future stock price performance. Low P/E ratios may lead to exaggerated investor optimism regarding future growth in earnings and dividends, thereby leading to higher future returns for low P/E stocks. Because the two sub-samples in our study may exhibit different P/E ratios, this ratio was included as a control variable. Size In addition to proxying for a firm's P/E ratio, the abnormal negative returns found in our study may be attributable to firm size rather than to the accounting method used. Prior research indicates that there may be a 'size effect' - i.e., small firms' stocks experience, on average, higher risk-adjusted returns than large firms' stocks. (For a more detailed discussion, see Banz (1981) and Reinganum (1981).) This finding may be due to the higher risk associated with small firms, which, Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

108 in turn, may be a result of the limited information available about small firms. A size variable was included in our cross-sectional analysis to control for a potential 'size effect'. Size may also be proxying for an income-reducing policy. For example, Watts & Zimmerman (1978) believe that larger firms tend to lobby for accounting standards that reduce reported income. Consequently, the size variable included here may be proxying for an income deflating policy rather than for the accounting method itself. It follows that since the purchase firms in our sub-sample are, on average, smaller than those in the pooling sub-sample, the pooling firms would be expected to pursue an income reducing policy to a greater extent than the purchase firms. Therefore, choosing the pooling method of acquisition accounting may have negative valuation consequences for these firms inasmuch as pooling will result in higher future earnings relative to purchase accounting. Market Model Parameter Estimates Elgers & Clark (1980) found important differences in risk effects across merger types. More specifically, conglomerate (as opposed to smaller) mergers are often undertaken due to a risk motive. This difference is somewhat puzzling in light of the capital asset pricing model (CAPM). Unless investors are constrained from achieving the same risk diversification effects by revising their own portfolios, there should be no economic reward from mergers undertaken to create risk shifts. In order to control for risk differences as well as for a disproportionate ratio of conglomerates in one of our samples, the beta of the estimation period is included in the cross-sectional analysis. Furthermore, Blume (1971; 1975; 1979) suggests that market model parameter estimates may be non-stationary over time, viz. that the market model parameter are mean-reverting over time. In other words, any abnormal returns calculated using the market model parameter estimates of an estimation period could be attributable to the parameter estimates themselves if the parameters are non-constant. (For example, non-constant parameters could occur if the target's risk level is different from the acquirer's risk level inasmuch s the acquirer's operations include the target's operations following the acquisition.) To control for this possibility, our estimated alpha parameter is also included in the cross-sectional analysis. Earnings Surprise As noted previously, accounting research indicates that positive earnings forecast errors are associated with positive stock returns and, conversely, for negative earnings forecast errors. To the extent that the announced method of acquisition accounting (or the acquisition itself) was anticipated, future earnings may substantially differ from forecasted earnings. Therefore, in order to test whether the abnormal returns associated with the announcement of purchase and pooling methods as opposed to other variables for which the accounting method may be proxying, it is also necessary to control for earnings surprises in a cross-sectional analysis. It is important to note that this variable directly accomplishes the purpose of testing the null hypothesis (H0) as the relatively low future earnings of firms using the purchase method are the primary reason for expecting higher

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

109 abnormal returns for firms using the pooling method. Thus, if this variable is insignificant in explaining the abnormal returns, H0 is rejected. Leverage Davis (1990) found that purchase firms have significantly higher leverage than pooling firms. This finding may be explained by Crawford (1986), who finds that firms using the purchase method are more likely than pooling firms to have debt covenants based on assets or intangible assets rather than on earnings. In this context, the higher abnormal returns experienced by purchase firms may be attributable to the higher leverage of these firms rather than to the accounting method itself. To control for this, leverage is included as a control variable in this cross-sectional analysis. Accounting Method To directly test whether the abnormal returns are significantly related to the accounting method employed as opposed to any of the control variables described above, the cross-sectional analysis employs an indicator variable to identify the accounting method used. If the coefficient of this variable is significant after controlling for the other variables, then it is likely that the higher abnormal returns of purchase method firms are due to the higher organizational flexibility and indirect tax cash flows which the purchase method offers. Cross-Sectional Model The resulting cross-sectional model was applied to both the purchase and pooling sub-samples and is stated below:
ASCARi = a0 + a1ALPHAi + a2BETAi + a3EARSURi + a4LEVi + a5PEi + a6SIZEi + a7POOLi + ei, where = ASCARi ALPHAi , BETAi = EARSURi = (4)

LEVi
Pei

= = = = =

SIZEi POOLi ei

the cumulative standardized [-1,0] prediction error for firm i, the market model parameter estimates for firm i, earnings surprise for firm i, defined as the change in EPS in the announcement year divided by share price at the beginning of the announcement year; thus, the surprise represents the abnormal earnings based on a nave random walk earnings forecast model, leverage of firm i, defined as the ratio of total liabilities to total assets, the price/earnings ratio of firm i, defined at the end of the year prior to the announcement year, firm is total assets, a dummy variable equal to unity if firm i uses the pooling method and zero otherwise, and error term.

Correlations of Variables Used in the Cross-Sectional Model Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

110 The correlation coefficients for all pairs of independent variables are disclosed in Table 4. The ALPHA, BETA, LEV, and SIZE exhibit some degree of correlation. Consequently, the significance tests for these variables may be biased. However, the maximum variance inflation factor (VIF) of the full model is only 1.4, which, according to Neter, Kutner, Nachtsheim & Wasserman (1996) does not present a serious multi-collinearity problem. Variance inflation factors for the individual variables measure how much the variances of the estimated regression coefficients are inflated as compared to when the predictor variables are not linearly related. However, in order to account for potential multi-collinearity effects, our original model is supplemented with three reduced models.

Table 4: Correlation Coefficients of Independent Variablesa ALPHA BETA EARSUR POOL LEV PE SIZE
a

BETA

EARSUR

POOL

LEV

PE

0.4448 0.1471 0.1527 -0.2034 0.0539 -0.1863 -0.0201 0.1839 -0.3084 -0.0506 0.017 -0.0889 0.1733 -0.0573 0.0178 0.0544 0.1409 0.0772 0.02 0.3133 0.0032

ALPHAi, BETAi = the market model parameter estimates for firm i, EARSURi = earnings surprise for firm i, defined as the change in EPS in the announcement year divided by share price at the beginning of the announcement year. POOLi = a dummy variable equal to unity if firm i uses the pooling method and zero otherwise. LEVi = leverage of firm i, defined as the ratio of total liabilities to total assets, PEi = the price/earnings ratio of firm i, defined at the end of the year prior to the announcement year, SIZEi = firm is total assets

Cross-Sectional Results Results from the cross-sectional analysis are summarized in Table 5. The first row presents the results of the full model. Model 2 excluded the PE variable due to its extreme insignificance (p = 0.9693). Models 3 and 4 additionally exclude variables BETA and SIZE to counteract any potential multi-collinearity problems. Once a variable was omitted, it did not re-enter the cross-sectional model. The POOL variable is of primary importance in this analysis. If this variable exhibits a significant coefficient, the accounting method itself explains a portion of the distribution of abnormal returns associated with the acquisition announcement. As shown in Table 5, the POOL variable is significant in all models examined, with a maximum p-value of 0.0314. Note that the size of the coefficient of this variable is very close to the difference over the [-1, 0] interval found in Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

111 stock price reaction summarized in Table 3. (While the Z-statistic used in our original analysis was computed using standardized values (in accordance with Mikkelson & Partch (1988)), the 0.08% difference shown in Table 3 was computed using the raw cumulative abnormal returns. Consequently, it is possible for the coefficient in the cross-sectional model to be larger than this difference because the standardized cumulative abnormal returns are used as the dependent variable in this cross-sectional analysis.) These findings lend support to the results in the previous section. Apparently, in addition to any indirect tax benefits that may accrue under purchase accounting, market participants highly value that purchase method firms are not constrained by the same requirements set out in APB Opinion No. 16 for pools.

Table 5: Cross-Sectional Analysis for Valuation Effects of Pooling and Purchase Acquisitions (t-Statistic Parentheses)a
Model Full Model (N = 119) Model 2 (N = 119) Model 3 (N = 119) Model 4 (N = 119) Intercept -0.836 (-0.93) -0.834 (-0.93) -1.402 (-1.81)* -1.243 (-1.58) ALPHA 409.94 (2.23)** 409.34 (2.25)** 314.30 (1.89)* 365.382 (2.18)** BETA -0.537 (-1.27) -0.535 (-1.27) --EARSUR -4.179 (-1.48) -4.172 (-1.49) -4.079 (-1.45) -4.064 (-1.42) LEV PE SIZE -0.000096 (-1.89)* -0.000096 (-1.90)* -0.000108 (-2.17)** --INDIC -0.893 (-1.68)* -0.896 (-1.71)* -0.989 (-1.90)* -1.087 (-2.06)** Adj. R2 7.40% F 2.35**

2.904 -0.000091 (2.06)** (-0.04) 2.904 (2.07)** 3.429 (2.55)** 2.631 (2.00)** ---

8.22%

2.76**

---

7.72%

2.97**

---

---

4.71%

2.46**

* Significant at the 10% level ** Significant at the 5% level a ALPHAi, BETAi = the market model parameter estimates for firm i, EARSURi = earnings surprise for firm i, defined as the change in EPS in the announcement year divided by share price at the beginning of the announcement year. POOLi = a dummy variable equal to unity if firm i uses the pooling method and zero otherwise. LEVi = leverage of firm i, defined as the ratio of total liabilities to total assets, PEi = the price/earnings ratio of firm i, defined at the end of the year prior to the announcement year, SIZEi = firm is total assets

Three other variables - the market model parameter (ALPHA), the firm's leverage (LEV), and firm size (SIZE) - are significantly related to the [-1, 0] standardized cumulative abnormal returns. The significance of ALPHA suggests that the market model parameters may be non-constant over time as discussed by Blume (1979). The significance of leverage is similar to the findings by Davis (1990). In other words, purchase firms tend to exhibit higher leverage than pooling firms, lending further support to Crawford's (1986) notion that firms using the purchase method may have Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

112 debt covenants based on net assets or intangibles rather than on income. (The coefficient of this variable is highly positive. When this variable is examined separately for the two sub-samples, it is significant for the purchase group but not for the pooling firms. The difference (see Model 4) is highly significant (t = 2.39; p = 0.0183).) Consequently, even though their future income is expected to be relatively low relative to that reported by pooling firms, purchase firms are more likely to employ debt in their capital structure. The last significant variable in the cross-sectional analysis is firm size as measured by total assets. There are two possible explanations for the negative coefficient of this variable. First, larger firms seem to experience lower abnormal returns than smaller firms, lending support to the size effect (i.e., smaller firms exhibit higher returns than larger firms regardless of the time period examined) documented in the previous literature. Consequently, the large returns for relatively small acquirers may be driven by the size anomaly. On the other hand, since pooling firms are larger than purchase firms, previous literature suggests that they would pursue an income reducing policy. However, as we have seen, the pooling method will generally result in the reporting of higher earnings than would be the case under purchase accounting causing market participants to interpret the use of pooling as suboptimal. Given the contradictory results, it is reassuring that the difference in size between the two sub-samples is not significant (t = 0.61; p = 0.5446). (Model 3 was used to test for this difference because the SIZE variable is omitted in Model 4.) Thus, it appears that the significance of the SIZE variable is attributable to a general size effect rather than to pooling firms not pursuing an income reducing policy. SUMMARY AND CONCLUSION The purchase method of accounting can reduce future reported earnings as a consequence of increased expenses for amortization of goodwill and depreciation of tangible assets. However, as a trade-off, this method of accounting for acquisitions allows more restructuring flexibility than does the pooling method and can also provide greater indirect tax benefits. Given these conflicting advantages of the two methods, the objective of this study is to determine whether and how the valuation effects of acquisition announcements are conditioned on the type of accounting method employed. The sample used is pure inasmuch as it focuses solely on acquisitions in which the method of accounting was disclosed at the same time as the acquisition announcement, eliminating the need to assume that market participants have other information except what was contained in the acquisition announcement itself. Valuation effects are found to be more favorable for acquisitions using the purchase method in the eleven-day period surrounding the announcement and for at least six months following the announcements. These results stand even after conducting a cross-sectional analysis that controls for the firms' price/earnings ratio, size, market parameter estimates, earnings surprises, and leverage. These results suggest that market participants value the added flexibility and indirect tax benefits that are provided by the purchase method of accounting as opposed to the higher reported future earnings associated with the pooling method.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

113 REFERENCES APB Opinion No. 16, Business Combinations. Ball, R. & P. Brown (1968). An Empirical Evaluation of Accounting Income Numbers. Journal of Accounting Research, Autumn, 159-178. Banz, R. W. (1981). The Relationship Between Return and Market Value of Common Stocks. Journal of Financial Economics, March, 3-18. Basu, S. (1977). Investment Performance of Common Stocks in Relation to their Price-Earnings Ratios: A Test for Market Efficiency. Journal of Finance, June, 663-682. Basu, S. (1983). The Relationship Between Earnings Yield, Market Value and Return for NYSE Common Stocks. Journal of Financial Economics, June, 129-156. Beaver, W. H., R. Clarke & W. F. Wright (1979). The Association Between Unsystematic Security Returns and the Magnitude of Earnings Forecast Errors. Journal of Accounting Research, Autumn, 316-321. Bernard, V. L. (1986). Unanticipated Inflation and the Value of the Firm. Journal of Financial Economics, March, 285-321. Bittker, B. I. & J. S. Eustice (1994). Federal Taxation of Corporations and Shareholders, 6th Edition. Boston: Federal Tax Press. Blume, M. E. (1971). On the Assessment of Risk. Journal of Finance, March, 1-11. Blume, M. E. (1975). Betas and Their Regression Tendencies. Journal of Finance, June, 785-795. Blume, M. E. (1979). Betas and Their Regression Tendencies: Some Further Evidence. Journal of Finance, March, 265-267. Davis, M. L. (1990). Differential Market Reaction to Pooling and Purchase Methods. The Accounting Review, July, 696-709. Davis, M. L. (1991). APB 16: Time to Reconsider. Journal of Accountancy, October, 99-107. Elgers, P. T. & J. J. Clark (1980). Merger Types and Shareholder Returns: Additional Evidence. Financial Management, Summer, 66-72.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

114 FASB (1999). Exposure Draft of Statement of Financial Accounting Standard: Business Combinations. Stamford, CT: FASB. Gonedes, N. J. (1975). Risk, Information and the Effects of Special Accounting Items on Capital Market Equilibrium. Journal of Accounting Research, Autumn, 220-256. Hagerman, R. L. & P. Shah (1984). The Association Between the Magnitude of Quarterly Earnings Forecast Errors and Risk-Adjusted Stock Returns. Journal of Accounting Research, Autumn, 526-540. Hagerman, R. L. & M. E. Zmijewski (1979). Some Economic Determinants of Accounting Policy Choice. Journal of Accounting and Economics, August, 141-161. Haw, I. M., K. Jung & W. Ruland (1994). The Accuracy of Financial Analysts' Forecasts After Mergers. Journal of Accounting, Auditing, and Finance, Summer, 465-486. Herring, C. B. & F. Norris (1990), Merger Mania. The National Public Accountant, June, 38-42. Herz, R. H. & E. J. Abahoonie (1990). Innovations to Minimize Acquisition Goodwill. Mergers & Acquisitions, March/April, 35-40. Hong, H, R. S. Kaplan & G. Mandelker (1978). Pooling vs. Purchase: The Effects of Accounting for Mergers on Stock Prices. The Accounting Review, January, 31-47. Hoskin, R. E., J. Hughes & W. Ricks (1986). Evidence on the Incremental Information Content of Additional Firm Disclosures Made Concurrently With Earnings. Journal of Accounting Research, Supplement, 1-32. Huang, Y. & R. A. Walking (1987). Target Abnormal Returns Associated With Acquisition Announcements: Payment, Acquisition Form, and Managerial Resistance. Journal of Financial Economics, December, 329-349. Mikkelson, W. H. & M. M. Partch (1986). Valuation Effects of Security Offerings and the Issuance Process. Journal of Financial Economics, January/February, 31-60. Mikkelson, W. H. & M. M. Partch (1988). Withdrawn Security Offerings. Journal of Financial and Quantitative Analysis, June, 119-133. Nathan, K. & K. M. Dunne (1991). The Purchase-Pooling Choice: Some Explanatory Variables. Journal of Accounting and Public Policy, Winter, 309-323.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

115 Neter, J., M. H. Kutner, C. J. Nachtsheim & W. Wasserman (1996). Applied Linear Statistical Models, 4th Edition. Chicago: Richard D. Irwin, Inc. Reinganum, M. R. (1981). Misspecification of Capital Asset Pricing: Empirical Anomalies Based on Earnings' Yields and Market Values. Journal of Financial Economics, March, 19-46. Robinson, J. R. & P. B. Shane (1990). Acquisition Accounting Method and Bid Premia for Target Firms. The Accounting Review, January, 25-48. Watts, R. L. & J. L. Zimmerman (1978). Towards a Positive Theory of the Determination of Accounting Standards. The Accounting Review, January, 112-134. Zmijewski, M. E. & R. L. Hagerman (1981). An Income Strategy Approach to the Positive Theory of Accounting Standard Setting/Choice. Journal of Accounting and Economics, August, 129149.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

116
APPENDIX: TWELVE CONDITIONS FOR USE OF POOLING (AS PER APB OPINION NO. 16) 1 2 3 4 Each of the combining companies is autonomous and has not been a subsidiary or division of another corporation within two years before the combination is initiated. Each of the combining companies is independent of other combining companies. While joint ventures are permissible, independence is generally interpreted as 10% or less ownership of voting stock at any time between the initiation and consummation date of the combination. The combination is effected in a single transaction or is completed in accordance with a specific plan within one year after the plan is initiated. The acquiring company offers and issues only common stock with rights identical to those of the majority of its outstanding common stock in exchange for substantially all of the voting stock of the acquired company. "Substantially all" means at least 90% of the shares outstanding and is measured as of the date of consummation. Within the period beginning two years before the plan's initiation and ending at the date of consummation, none of the combining companies change the equity interest of voting common stock in contemplation of effecting the combination. Each of the combining companies reacquires voting common stock only for purposes other than business combinations and no company reacquires more than a normal number of shares between the plan's initiation and combination. The proportionate share of ownership of each shareholder remains the same after the combination as it was before the combination. The voting rights to which the common stock ownership interests in the resulting corporation are not restricted. The combination is resolved at the date of the plan's consummation and no provisions of the plan relating to the issuance of securities or other compensation are pending. The combined company does not agree to retire or reacquire, directly or indirectly, all or part of the common stock issued to effect the combination. The combined company does not enter into other financial arrangements for the benefits of former stockholders of the combining company (e.g. guaranty of loan secured by the stock of the combined company) which in effect negates the exchange of equity securities. The combined company does not intend or plan to dispose of a significant part of its assets within two years after the combination. Disposals in the ordinary course of business and to eliminate duplicate facilities or excess capacity are permissible.

5 6 7 8 9 10 11 12

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

117

LEASE FINANCIAL STATEMENT ACCOUNTING PRACTICES TYPES AND NUMBERS FOR HONG KONG
Gary A. Miller, Texas A&M International University
ABSTRACT The purpose of this research study was to investigate existing lease disclosure practices for financial statements in Hong Kong. Part of the purpose of this project is descriptive. The study classified, summarized and analyzed the lease accounting practices for a sample of Hong Kong companies. Annual reports for a year ending during 1996 were examined to gather information about the accounting practices for leases for financial reporting in Hong Kong. The fifty companies were selected in a systematic random selection process. The fifty companies selected represent approximately nine percent of all the companies traded on the Hong Kong Stock Exchange for 1996. Some of the major conclusions from this study include the following: 1 2 3 Most Hong Kong companies are involved in lease transactions as either lessees or lessors or both. The dollars committed to lease transactions are significant. The profit and loss effect is, also, significant. INTRODUCTION International leasing markets are rapidly becoming a single global market. Salameh, General Manager for Hewlett Packard for Asia Pacific, Central and Eastern Europe, has recently stated that globalization of financing services is driven by natural globalization of accounts and partners (Salameh, 1997). Leasing activities have become "big" business. Leasing volume in the Asia Pacific area was approximately US $111 billion in 1995. Total worldwide activity exceeded US $409 billion in the same year. Four of the twenty-two largest leasing companies in the world were located in Asia in 1995. Orix Corporation in Asia was the third largest with leasing volume greater than US $8.9 billion. Leasing is one of the fastest growing segments of the US financial services industry. The US $147 billion in new capital leases written in 1995 was a significant 5.3% increase over the 1994 total (McConville, 1996). Most large institutional users are not satisfied with the existing levels of general disclosures by multinational firms (Taylor, 1995). This study will examine the lease accounting practices including footnote disclosures in Hong Kong. The accounting treatment for leases can be considered part of the general issue, the controversial use of off-balance sheet activities. The flexibility allowed companies under the existing general rules for leases may allow different companies to treat similar events in different ways. This inconsistent treatment may make financial comparisons very difficult. For example, certain financial measures such as solvency and debt ratios may be effected. Some Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

118 companies may interpret accounting events in such a manner that the events are not reflected on the company's balance sheet. In some cases, information about an event may be disclosed in a footnote depending on certain criteria. Related accounting areas including contingencies may be effected by the procedures for leases. The treatment for leases has been particularly controversial. Some leases, if the lease meets certain rules, are classified as finance leases. In that case, an asset and liability would be included in the lessee's balance sheet. If the lease is classified as an operating lease instead of a finance lease, then only a lease or rental charge reduces the profit and loss and no balance sheet accounts are effected. Some Hong Kong companies disclose information about leases only in a footnote and, therefore, these transactions can be classified as off-balance sheet financing. A discussion paper, Accounting for a New Approach, has been published by the respective accounting standards board in Australia, Canada, New Zealand, the UK, US, and the IASC proposes that all finance leases and most, if not all, operating leases would qualify as assets and liabilities (McGregor, 1996). In Hong Kong, different groups are concerned about lease accounting practices. Many companies have been involved as lessees in Hong Kong. For example, Cathay Pacific has used a mixture of UK, US, German, French, Hong Kong and Swedish leases to finance its' aircraft fleet. Cha, Securities and Futures Commission (SFC) executive director, has stated it is important to adopt international standards as part of the SFC and stock exchange's commitment to maintaining Hong Kong's competitiveness (Ibison, 1995). Based on the latest survey of members of The Hong Kong Equipment Leasing Association (HKELA), members' leased equipment assets in China amounted to US $386 million. There are thirty-six full and eleven associate members in the HKELA. Lessors do face some difficulties conducting leasing business in China because the finance lease has not been given substantial attention by the Chinese Government. Predictions are that the China market will continue to grow in the future. Review of Leasing In Selected Asian Countries Other Asian countries have substantial leasing industries. For example, Indonesia had 254 leasing companies in 1995 that had total lease contracts of $8,498,020 (million Rp). The average lease contract per company was $33,456 million Rp (Indonesian Ministry of Finance). The Special Accounting Standard for Lease Accounting, No. 30, that provides the guidance to classify leases was issued in 1990. In Malaysia, only 53 companies were classified as pure leasing companies. In recent years, more companies are using hire purchase contracts for the financing of assets. Leasing accounts for only 2% to 5% of total gross capital formation in Malaysia. In 1995, new leasing business totaled RM 2,007 million. In the Philippines, only companies registered under Republic Act 5980 are allowed to conduct leasing activities. As of March 1997, there were 167 registered finance companies with 27 actively offering financial leasing services. Only one company is, solely, engaged in leasing. The leasing industry is not fully developed in the Philippines.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

119 In India, there are over 3000 companies that are involved in some type of leasing activity. The 500 largest leasing companies contribute approximately Rs. 9000 crones worth of equipment leasing. However, this accounts for only 5% of the fixed asset acquisition for the industrial sector in the country. Internationally the average percentage is approximately 22%. The most popular users of lease financing have been medium and small-scale companies. Lease Practices Accounting guidance for lease contracts is provided by HKSSAP No. 14, Accounting for Leases and Hire Purchase Contracts, that was issued in August 1988 by the HKSA. The definition of a finance lease is a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. An operating lease is a lease other than a finance lease (HKSA, 1988). Criteria such as length of useful life and the existence of a bargain purchase are provided to determine if a lease should be classified as a finance or operating lease. Many companies include an explanation in a footnote. The actual narratives vary somewhat, but the basic description is the same. In a hire purchase, the customer generally becomes the legal owner of the asset assuming the terms of the original agreement are met by the lessee. Disclosure requirements are, also, included in the standard. Some have criticized the existing lease accounting practices. The IASC had been requested to examine some of the lease reporting issues. However, recently, the International Accounting Standards Committee (IASC) decided not to instigate a major project related to lease accounting. At present, the UK and Australia have completely different views, but both believe changes need to be made. The US seems to fall between the two (Accountancy, 1997). Others, also, have expressed concerns about lease accounting reporting practices. McGregor, executive director of the Australian Research Foundation, has stated existing lease accounting standards are deficient (McGregor, 1996). He believes a discussion paper, Accounting for a New Approach, published by the respective accounting standards board in Australia, Canada, New Zealand, the UK, US and the IASC could solve some of the problems. Based on the proposed practices, all finance leases and most, if not all, operating leases would qualify for recognition as assets and liabilities (McGregor, 1996). At the present time, the rules related to the classification of finance and operating leases can in many cases be circumvented if desired. In most cases, companies would prefer to have a lease classified as an operating lease instead of a capital or finance lease. PURPOSE The purpose of this research study was to investigate existing lease disclosure practices for financial statements in Hong Kong. Part of the purpose of this project is descriptive. The study classified, summarized and analyzed the lease accounting practices for a sample of Hong Kong companies. In a recent study, Barth and Murphy (1994) developed a framework to analyze the required footnotes including lease disclosures for companies in the United States. Another study uses a similar approach to examine the situation in Hong Kong, also, including lease disclosures Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

120 (Miller, 1997). Lease disclosures met two main purposes, disaggregation of unrecognized items and provided information on future cash inflows and outflows. In the next section, the methodology for this study is described. METHODOLOGY Annual reports for a year ending during 1996 were examined to gather information about the accounting practices for leases for financial reporting in Hong Kong. The fifty companies were selected in a systematic random selection process. The fifty companies selected represent approximately nine percent of all the companies traded on the Hong Kong Stock Exchange. See Table 1 for list of companies included in the study.
Table 1: Leases Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Company Acme Landis Holdings Allan International Holdings Bossini International Holdings Burwill Holdings Chaifa Holdings China Investments Holdings Cheerful Holdings Dynamic Holdings Daido Concrete East Asiatic Company (HK) Esprit Asia Holdings First Sign International Holdings Fairyoung Holdings Great Eagle Holdings Goldlion Holdings Harbour Centre Development Hong Kong Ferry (Holdings) Indesen Industries IDT International Jusco Stores (HK) Johnson Electric Holdings Kwong Sang Hong International Kingfook Holdings Le Saunda Holdings Year Dec-96 Mar-96 Mar-96 Jun-96 Mar-96 Dec-96 Dec-96 Jun-96 Apr-96 Dec-96 Jun-96 Jun-96 Dec-96 Sep-96 Mar-96 Dec-96 Dec-96 Mar-97 Mar-96 Feb-96 Mar-96 Dec-96 Mar-96 Feb-96 Type 2 4 2 4 3 2 2 2 3 2 1 2 2 2 2 2 2 2 1 1 5 2 1 2

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

121
Table 1: Leases Number 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 Company Lane Crawford International Midland Realty (Holdings) Min Xin Holdings Ngai Hing Hong Nority International Group Oriental Press Group Orient Power Holdings Pacific Concord Holdings Peregrine Investment Holdings QPL International Holdings Rivera (Holdings) RPJ Electronics S.Megga International Holdings Same Time Holdings Tem Fat Hing Fung (Holdings) Topstyle International Holdings USI Holdings Universal Appliances Varitronix International Vanda Systems & Communications Wang On Group Wong's Kong King International (Holdings) Yanion International Holdings Yaohan HK Yeebo International (Holdings) YGM Trading Year Mar-96 Dec-96 Dec-96 Jun-96 Dec-96 Mar-96 Dec-96 Dec-96 Dec-96 Apr-96 Mar-96 Jun-96 Jun-96 Mar-96 Apr-96 Mar-96 Dec-96 Dec-96 Dec-96 Mar-96 Mar-96 Dec-96 Dec-96 Mar-96 Mar-96 Mar-96 Type 2 2 2 1 2 2 4 2 2 1 2 1 4 1 2 1 2 3 2 3 3 4 1 1 1 1

RESULTS All fifty companies had, at least, one example of a finance or operating lease. For convenience, companies were classified into five groups.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

122 Type 1 Type 1 companies were involved as both lessees and lessors. As a lessee, these companies had both finance and operating leases. As a lessor, these companies had only operating leases. Thirteen companies were classified as Type 1 companies (See Table 2 for list)
Table 2: Type 1 No. Company Lessee Profit & Loss Account Finance Lease Depreciation 1 Esprit Asia Holdings 2 IDT International 3 Jusco Stores (HK) 4 Kingfook Holdings 5 Ngai Hing Hong 6 QPL International Holdings 7 RPJ Electronics 8 Same Time Holdings 9 Topstyle International Holdings 10 Yanion International Holdings 11 Yaohan HK 12 Yeebo International (Holdings) 13 YGM Trading Average 1011 1240 3849 486 2845 36550 1170 1101 20 Interest 230 193 715 92 984 18645 257 1404 10 Operating Lease Rentals 408673 14188 109004 50880 1325 15379 4012 2442 4804 Gross Rental Income N/A N/A 76394 3276 550 3197 750 N/A 4461 Lessor Profit & Loss Account Operating Lease Ongoings N/A N/A 0 0 0 -350 -194 N/A -253 Net Rental Income N/A N/A 76394 3276 550 2847 556 N/A 4208

1541 29618 1050 700 6245

416 5726 436 603 2285

11008 417561 3729 127248 90019

N/A 20216 N/A 7534 14547

N/A 0 N/A -837 -204

N/A 20216 N/A 6697 14343

All figures shown above are in HK thousand dollars.

Depreciation for the lessee finance leases, on average, was HK $6.3 million for the thirteen companies with a low of HK $20,000 to a high of HK $36.6 million. Interest expense for the finance leases was HK $2.3 million on average. All amounts are denominated in Hong Kong dollars. The operating lessee lease rental was an average $90 million. For the lessor transactions, the thirteen companies had an average net rental income of $14.3 million. See Table 2 for additional details. For the lessee operating leases, details about the obligations under finance or hire purchase contracts is grouped during the following time categories, 1 year, 1-2 years, 2-5 years, current Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

123 liabilities and after 1 year in Table 3. Information about lessee operating lease commitments is, also, provided.

Table 3: Type 1 No Company Finance Lease Balance Sheet Obligations under Finance Leases & Hire Purchase Contracts 1 year 1 Esprit Asia Holdings 2 IDT International 3 Jusco Stores (HK) 4 Kingfook Holdings 5 Ngai Hing Hong 6 QPL International Holdings 7 RPJ Electronics 8 Same Time Holdings 1599 3117 2537 528 4002 101553 415 3026 1-2 years 2-5 years Current after 1 Liability year 609 2589 370 348 4180 75275 33 2359 0 777 72858 16 822 12325.85 0 0 0 0 483 -1599 -3117 -2537 -528 -4002 609 2589 370 348 4663 Operating Lease Balance Sheet Operating Leases Commitments 1 year 29673 2114 19756 7127 25 10278 1048 40 163 546 1458 908 22652 7368 2-5 years > 5 years 152132 8170 55101 37518 229 14191 0 453 491 2660 201907 1128 74824 42216 13497 828 23925 0 1288 0 707 1635 1608 7298 247021 249 7569 23510 Total 195302 11112 98782 44645 1542 24469 1755 2128 2262 10504 450386 2285 105045 73094

110857 -320453 626149 0 0 0 0 0 0 702 8619 -415 -3026 -19437 -1159 -44198 -490 -822 -30906 33 2359 0 777 72858 16 1524 54792

9 Topstyle International Holdings 19437 10 Yanion International Holdings 11 Yaohan HK 12 Yeebo International (Holdings) 13 YGM Trading Average 1159 44198 490 822 14068

All figures shown above are in HK thousand dollars. Note: For Obligations under Finance Leases & Hire Purchase Contracts 1 year Amount payable within one year 1-2 years Amount payable for more than one year, but not exceeding two years 2-5 years Amount payable for more than two years, but not exceeding five years Current Liabilities Amount repayable within one year, shown under current liabilities after 1 year Amount repayable after one year For Operating Lease Commitments 1 year Annual commitments payable under non-cancellable operating leases which expire within one year in one year 2-5 years Annual commitments payable under non-cancellable operating leases which expire in second to the fifth years inclusively > 5 years Annual commitments payable under non-cancellable operating leases which expire over five years

The average total operating lease commitments for the thirteen companies was $73.1 million.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

124 Type 2 Type 2 companies had only lessee and lessor operating leases. Twenty-six companies had either operating leases as a lessee or lessor. All companies had, at least, one lessee operating lease. Six companies had only lessee operating leases. See Table 4 for details such as rentals (lessee), Gross rental income, Ongoings and net rental income for lessors.
Table 4: Type 2 No. Company Lessee Profit & Loss Account Operating Lease Rentals 1 Acme Landis Holdings 2 Bossini International Holdings 3 China Investments Holdings 4 Cheerful Holdings 5 Dynamic Holdings 6 East Asiatic Company (HK) 7 First Sign International Holdings 8 Fairyoung Holdings 9 Great Eagle Holdings 10 Goldlion Holdings 11 Harbour Centre Development 12 Hong Kong Ferry (Holdings) 13 Indesen Industries 14 Kwong Sang Hong International 15 Le Saunda Holdings 16 Lane Crawford International 17 Midland Realty (Holdings) 18 Min Xin Holdings 19 Nority International Group 20 Oriental Press Group 21 Pacific Concord Holdings 22 Peregrine Investment Holdings 6668 230894 3035 3975 1410 52144 2009 8275 2914 12485 140100 18572 1058 1795 142226 223100 88202 357 4248 1648 9506 78312 Lessor Profit & Loss Account Operating Lease

Gross Rental Income 816 222 6925 N/A 62024 N/A N/A 1747 748 16877 100300 116422 N/A 58633 677 45700 932 3350 N/A 68879 76311 32863

Ongoings 0 0 -2112 N/A -1584 N/A N/A -1112 -25 -348 -12600 -14042 N/A -7965 -116 -10300 0 -295 N/A -1237 -262 -2876

Net Rental Income 816 222 4813 N/A 60440 N/A N/A 635 723 16529 87700 102380 N/A 50668 561 35400 932 3055 N/A 67642 76049 29987

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

125
Table 4: Type 2 No. Company Lessee Profit & Loss Account Operating Lease Rentals 23 Rivera (Holdings) 24 Tem Fat Hing Fung (Holdings) 25 USI Holdings 26 Varitronix International AVERAGE 201 6505 7800 332 40299 Lessor Profit & Loss Account Operating Lease

Gross Rental Income 2222 4978 56600 N/A 32861

Ongoings 0 -339 -600 N/A -2791

Net Rental Income 2222 4639 56000 N/A 30071

All figures shown above are in HK thousand dollars.

Table 5: Type 2 No. Company 1 year 1 Acme Landis Holdings 2 Bossini International Holdings 3 China Investments Holdings 4 Cheerful Holdings 5 Dynamic Holdings 6 East Asiatic Company (HK) 7 First Sign International Holdings 8 Fairyoung Holdings 9 Great Eagle Holdings 10 Goldlion Holdings 11 Harbour Centre Development 12 Hong Kong Ferry (Holdings) 13 Indesen Industries 14 Kwong Sang Hong International 15 Le Saunda Holdings 16 Lane Crawford International 17 Midland Realty (Holdings) 18 Min Xin Holdings 5147 76990 0 45 866 9017 220 0 449 11 2400 2565 695 167 33054 12700 21269 124 Operating Lease Balance Sheet Commitments 2-5 years 575 182832 2611 4904 0 28071 1856 183 1348 6573 44800 1474 900 1707 97018 200900 88595 88 > 5 years 0 0 0 0 0 0 523 8093 0 2822 0 0 0 0 0 10100 0 0 Total 5722 259822 2611 4949 866 37088 2599 8276 1797 9406 47200 4039 1595 1874 130072 223700 109864 212

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

126
Table 5: Type 2 No. Company 1 year 19 Nority International Group 20 Oriental Press Group 21 Pacific Concord Holdings 22 Peregrine Investment Holdings 23 Rivera (Holdings) 24 Tem Fat Hing Fung (Holdings) 25 USI Holdings 26 Varitronix International Average 180 0 1804 30592 99 558 0 0 7652 Operating Lease Balance Sheet Commitments 2-5 years 2887 5494 7969 37599 0 4415 2900 485 27930 > 5 years 3156 1001 1520 6522 0 0 800 0 1328 Total 6223 6495 11293 74713 99 4973 3700 485 36911

All figures shown above are in HK thousand dollars. Note: For Commitments 1 year Annual commitments payable under non-cancellable operating leases which expire within one year within one year 2-5 years Annual commitments payable under non-cancellable operating leases which expire in second to the fifth years inclusively > 5 years Annual commitments payable under non-cancellable operating leases which expire over five years

For lessee operating leases, the twenty-six companies had an average rental expense disclosed in their respective profit and loss statement of $40.3 million for 1996. The average rental income for lessor operating leases was $30.0 million (See Table 4 for additional details). Footnote disclosures information is provided in Table 5. The average total lease commitment was $36.9 million for the twenty-six companies. The average commitments payable within one year was $7.7 million. Type 3 Type 3 companies were similar to Type 1 as these companies, also, had lessee finance and operating leases and lessor operating leases. The profit and loss information that was provided such as depreciation and interest for lessee finance leases was similar, but the format for the footnote disclosures for the obligations under finance leases and hire purchase contracts was somewhat different (See Table 6). For these companies, the average depreciation and interest for finance leases was $1.4 million and $870,000 respectively. Lessee operating lease rentals was an average of $6.3 million. Lessor net rental income was $472,000.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

127
Table 6: Type 3 No Company Lessee Profit & Loss Account Finance Lease Depreciation 1 Chaifa Holdings 2 Daido Concrete 3 Universal Appliances 4 Vanda Systems & Communications 5 Wang On Group Average 144 3507 2742 102 330 1365 Interest 31 2888 1313 5 111 870 Operating Lease Rentals 12276 4029 9710 4286 1125 6285 Lessor Profit & Loss Account Operating Lease

Gross Rental Income N/A N/A N/A N/A N/A

Ongoings N/A N/A N/A N/A N/A

Net Rental Income 432 N/A 584 399 N/A 472

All figures shown above are in HK thousand dollars.

Table 7: Type 3 No. Company Finance Lease Balance Sheet Obligations under finance leases & hire purchase contracts 1 year 2-5 years 510 13417 50895 158 319 13060 Min. Finance Lease Charge Pmts 893 32838 84545 281 530 23817 -118 -2371 Net Total 775 30467 Curr Liab -313 -17942 -26881 -114 -169 -9084 LT portion 462 12525 46458 145 288 11976 Operating Lease Balance Sheet Operating Leases Commitments 1 year 2-5 years 5068 2490 1864 1066 1198 2337 >5 years 0 0 1236 64 9548 2169.6 Total

1 Chaifa Holdings 2 Daido Concrete 3 Universal Appliances 4 Vanda Systems & Communications 5 Wang On Group Average

383 19421 33650 123 211 10758

4495 1539 3123 1069 451 2135

9563 4029 6223 2199 11197 6642

-11206 73339 -22 -73 -2758 259 457 21059

All figures shown above are in HK thousand dollars. For Obligations under Finance Leases & Hire Purchase Contracts 1 year Amount payable within one year 2-5 years Amount payable in two years to five years time inclusively Min. Lease Pmts Total minimum lease payments Finance Charges Future finance charges Net Total Total net lease payables Curr Liab Portion classified as current liabilities LT Portion Long term portion of lease payables For Operating Lease Commitments 1 year Annual commitments payable under non-cancellable operating leases which expire within one year 2-5 years Annual commitments payable under non-cancellable operating leases which expire in second to the fifth years inclusively > 5 years Annual commitments payable under non-cancellable operating leases which expire over five years

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

128 The details for lessors were 1 year, 2-5 years, Min. lease payment, finance charges, net total, current liabilities and long term portion (See Table 7). Five companies were classified as Type 3 companies. The average total operating lease commitments for the five companies was $6.6 million. Net total obligation under finance and hire purchase contracts was an average $21.1 million. Average total operating lease commitments was greater than $6.6 million. Type 4 Type 4 companies, also, had lessee finance and operating leases and lessor operating leases. Five companies were classified under this category (See Table 8).
Table 8: Type 4 No Company Lessee Profit & Loss Account Finance Lease Depreciation 1 Allan International Holdings 2 Burwill Holdings 3 Orient Power Holdings 4 S.Megga International Holdings 5 Wong's Kong King International (Holdings) Average 1974 2726 3875 971 1313 2172 Interest 307 1367 808 262 519 653 Operating Lease Rentals 3689 11083 21458 2193 8033 9291 Gross Rental Income 252 16547 N/A 4410 5937 6787 Lessor Profit & Loss Account Operating Lease Ongoings -13 -286 N/A -53 -854 -302 Net Rental Income 239 16261 N/A 4357 5083 6485

All figures shown above are in HK thousand dollars.

Again, the only difference was that for the lessee, only the term, finance lease, was used instead of both the terms, finance and hire contract. The difference is somewhat subtle. Please see discussion in introduction section. Average depreciation was $2.2 million. The average net rental income for lessor operating leases was $6.5 million. Lease balance sheet disclosures are presented in Table 9. Type 5 Only one company had only lessor finance leases. For this company, interest income was disclosed in the profit and loss statement. In the footnotes, details such as lease receivable and unearned income were provided (See Table 10). Gross rental income was $13.7 million.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

129
Table 9: Type 4 No Company Finance Lease Balance Sheet Long Term Liabilities Obligations under finance leases 1 year 1 Allan International Holdings 2 Burwill Holdings 3 Orient Power Holdings 4 S.Megga International Holdings 5 Wong's Kong King International (Holdings) Average 0 0 5667 N/A 0 1416.75 1-2 years 2-5 years 1589 3397 2856 N/A 1603 2361 2654 6327 1511 N/A 0 2623 Total 4234 9724 10034 N/A 1603 6399 1 year 0 2947 1270 2337 91 1329 Operating Lease Balance Sheet Lease Commitments 2-5 years 2506 164 5502 0 5505 2735 > 5 years 0 0 8875 0 0 1775 Total 2506 3111 15647 2337 5596 5839

All figures shown above are in HK thousand dollars. Note: For Obligations under Finance Leases 1 year Amount payable within one year 1-2 years Amount payable for more than one year, but not exceeding two years 2-5 years Amount payable for more than two years, but not exceeding five years For Operating Lease Commitments 1 year Annual commitments payable under non-cancellable operating leases which expire within one year 2-5 years Annual commitments payable under non-cancellable operating leases which expire in second to the fifth years inclusively > 5 years Annual commitments payable under non-cancellable operating leases which expire over five years

Table 10: Lessor Type 5 Company Finance Lease Balance Sheet Interest & Dividend Income Interest from Finance Lease Johnson Electric Holdings 9812 Lease Rev. 306919 Finance Lease Balance Sheet Long Term Receivables

Unearned Inc. -82264

REUFL 224655

due 1 yr. -6764

Total 217891

All figures shown above are in HK thousand dollars. Note: For Long Term Receivables Lease Rev. Lease Receivables Unearned Inc. Unearned Income REUFL Amount receivables from employees under finance leases Due 1 yr. Amount due within one year included in other debtors

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

130 SUMMARY AND CONCLUSIONS Lease accounting in Hong Kong will remain a major issue. Many companies are involved in leasing activities. At present, the accounting rules are being examined by accounting rules makers such as FASB in the US and IASC. For the US, it has been estimated that 80 percent of corporations lease assets each year and that in the aggregate, the corporations lease more than US $100 billion in plant and equipment (Nevitt and Fabozzi, 1988). Heng, general manager of AIC conferences, has stated that leasing has proven to be a very effective financial instrument in the stimulation and facilitation of new investments in the Asia area. Enormous amount of capital investments and funding is needed to keep up Asia's pace of economic growth. Ever-changing fiscal jurisdictions worldwide and increasing demands for large complex transactions will continue to offer new challenges to leasing professionals including accountants (Heng, 1997). For example, a three-day conference (Leasing & Asset Finance Asia 1997) was held in September 1997. Part of the conference was an update on the latest accounting issues for international transactions. Some of the major conclusions from this study include the following:
1 2 Most Hong Kong companies are involved in lease transactions as either lessees and lessors or both. The dollars committed to lease transactions are significant. a b 3 The average total operating lease commitments for lessees are $40.3 million. The average amount payable within one year for lessee finance leases was 12.8 million.

The profit and loss effect is, also, significant. a b c b Average depreciation for lessees is $ 4.3 million. Interest expense for lessees is on average $ 1.6 million. The average lessee annual rentals are $ 54.3 million. Net rental income for lessors is an average of $ 15.2 million

If the accounting rules are changed in the future and almost all lease transactions were to be classified as finance leases, the financial statement effect would be dramatic. Total assets and liabilities would be increased. In most cases, financial ratios such as debt and return calculations would be affected. Further research needs to be conducted to determine if the Hong Kong stock market would then be affected. It is hoped this study will provide a starting point for evaluating any future changes in lease accounting in Hong Kong. As discussed, part of the objective of this study was descriptive. Data has been collected and analyzed to provide information about existing lease accounting practices. Any classification changes would result in significant financial statement effects.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

131 REFERENCES Anonymous (1997). Board ducks leases issue. Accountancy, February, 8. Barth, M. and Murphy, C. (1994). Required Financial Statement Disclosures: Purposes, Subject, Number, and Trends. Accounting Horizons, December. Hong Kong Society For Accountants (1988). Accounting for Leases and Hire Purchase Contracts, September. Ibison, D. (1995). Tighter rules of disclosure find strong support, South China Morning Post, October 27. McConville, D. (1996). Leasing leaps forward as favored financing tool. Corporate Cashflow, January. McGregor, W. (1996). Lease accounting: righting the wrongs. Accountancy, September, 76. Miller, G. (1998). Financial Statement Disclosures- Purposes, Subject and Number The Hong Kong Experience. working paper. Nevitt, P. and Fabozzi, F. (1988). Equipment Leasing, Dow Jones, Homewood. Salameh, C. (1997). speech presented at Leasing & Asset Finance Asia '97, 10 September. Taylor and Associates (1995). Full Disclosures 1994: An International Study of Disclosure Practices, London.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

132

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

133

COMPREHENSIVE INCOME REPORTING CONCERNS


R. David Mautz, Jr., North Carolina A&T State University Ida Robinson-Backmon, University of Baltimore
ABSTRACT Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, requires presentation of comprehensive income as part of a complete set of financial statements. However, researchers, members of the financial community, and even some members of the Financial Accounting Standards Board, have expressed concerns about the effectiveness of the new standard. This article reports survey results that confirm and amplify several concerns. In particular, accounting academics and financial executives are concerned that the reporting standards allow too much latitude and are likely to lead to confusion among financial statement readers. Respondents also express concern about the cost of preparing comprehensive income disclosures and the potential for management to downplay poor results by reporting comprehensive income in the stockholders' equity statement. The Financial Accounting Standards Board is urged to reduce the reporting alternatives available to companies and to undertake a review of the burgeoning array of performance measures reported in financial statements. INTRODUCTION In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, which requires presentation of comprehensive income as part of a complete set of financial statements. The objectives of the new standard include providing a comprehensive framework for presenting all non-owner changes in equity and raising the visibility of items previously reported only as adjustments to equity. This article summarizes recent research and reports on a survey of academic accountants and practicing financial professionals. The results suggest that the FASB should consider refining SFAS No. 130 to insure that the new disclosures succeed in expanding users' focus beyond the traditional bottom line. COMPREHENSIVE INCOME: A LITTLE HISTORY Accountants, managers and standard setters have debated which items should be included in income, and which should be reported as direct adjustments to equity. At one extreme, a "current operating performance" definition of income includes only operating items. Non-operating results are reported as direct adjustments to retained earnings. Under an "all-inclusive" definition, only investments by owners and dividends are excluded from net income. The general trend among U.S. standard setters has been to favor an all-inclusive definition of income.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

134 Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, provided the foundation for SFAS No. 130 with this definition of an all-inclusive measure termed comprehensive income:
the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners (FASB, 1985, para. 70).

Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, asserted that comprehensive income should be reported as part of a complete set of financial statements. No such requirement was initially imposed. However, the list of non-owner changes in equity excluded from net income grew to include unrealized gains and losses arising from investments in marketable securities, foreign currency translation, futures contracts, and employers' pension liabilities. SFAS No. 130 was issued in 1997 to provide framework for reporting these and other unrealized gains and losses. EARLY MISGIVINGS ABOUT SFAS NO. 130 Even as the FASB required disclosure of comprehensive income, some questioned whether the reporting and display requirements of SFAS No. 130 would achieve the Board's objectives. In their dissenting opinion, Board members Cope and Foster expressed dissatisfaction that net income may be displayed more prominently in the financial statements than other components of comprehensive income. The primary objectives of reporting comprehensive income, include raising the visibility of other items of comprehensive income relative to net income and combating users' fixation on net income and earnings per share. Research findings have also raised questions about comprehensive income reporting requirements. Dhaliwal, et al. (1999) find no evidence that comprehensive income adds to the information conveyed by net income. Hirst & Hopkins (1998) report that comprehensive income can help analysts detect attempts to manage reported earnings through judicious management of the marketable equity securities portfolio. However, the disclosures are fully effective only when reported in a separate statement of comprehensive income or combined with the income statement. Maines & McDaniel (2000) report that display format display format has no apparent impact on investors' acquisition or evaluation of unrealized gain information reported as part of other comprehensive income. However, investors place significant weight on their assessments when the information is reported in a statement of comprehensive income, but not when the information is presented in a statement of stockholders' equity. The reporting practices of companies who adopted SFAS No.l30 early raise additional concerns. Campbell, et al. (1999) review the annual reports of 73 companies that adopted SFAS No. 130 before the required implementation date. They find that more than half reported comprehensive income in the statement of stockholders' equity. The impact of comprehensive income among these companies was material and negative. Companies whose comprehensive income was materially Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

135 positive were more likely to either prepare a combined statement of income and comprehensive income or present a separate comprehensive income statement. The early evidence suggests that display format matters, and that companies use format to manipulate the prominence of comprehensive income in the financial statements. These issues will affect even more companies as the application of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, gives rise to more components of other comprehensive income (Jones & Wilson, 2000). Businesses are also concerned with the potential reporting burden of SFAS No. 130. One recent article explained how companies can restructure their marketable equity securities portfolio to avoid implementing SFAS No. 130 (Godwin & Alderman, 1999). CONCERNS EXPRESSED BY FINANCIAL PROFESSIONALS The remainder of this article reports on a survey of practicing financial professionals and academic accountants. These financial professionals also express concerns about the requirements of SFAS No. 130. Survey respondents are particularly concerned that: (1) reporting requirements will prove burdensome, (2) display format alternatives permitted under SFAS No. 130 will impair usefulness, and (3) users will be confused by the growing number of alternative "bottom lines." Responses were obtained from 64 accounting faculty members and 111 chief financial officers and financial analysts. Both groups were educated in relevant disciplines, possessed considerable professional experience, and were familiar with financial reporting practices. Average experience among practitioners was 23 years. More than half held advanced degrees; most had been educated in accounting, finance or economics. Nearly half were CPAs, and many held various professional credentials including law degrees and securities licenses. All 111 responded that they analyze financial statements at least occasionally; the vast majority (86%) indicated that they do so regularly or often. The accounting faculty had similar experience-21 years on average. Virtually all reported formal education in accounting. Nearly 90% held a doctorate, and the majority were CPAs. Predictably, the faculty prepare and analyze financial statements less often. AN OVERVIEW OF OPINIONS Participants indicated agreement or disagreement with questions about comprehensive income reporting on six-point scales ranging from strongly disagree (1) to strongly agree (6). Respondents also weighed the costs and benefits of comprehensive income reporting and expressed their display format preferences. These responses are summarized in Table 1. Both groups expressed moderate familiarity with SFAS No. 130. Academics were more familiar with, and more impressed by, comprehensive income reporting. Professors generally believed that comprehensive income reporting assists in predicting future cash flows. Practitioners were less confident of predictive ability and more concerned about the potential reporting burden. Both were concerned that comprehensive income will confuse financial statement readers. With regard to overall costs and benefits, academics were again more positive. Fifty three percent of academic respondents believe that the benefits of reporting comprehensive income outweigh the Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

136 costs. Only 17% responded that costs outweigh benefits. The pattern among practitioners was exactly opposite. Forty-one percent responded that costs outweigh benefits. Only 27% believed that SFAS No. 130 makes sense from a cost/benefit standpoint.
Table 1: Overall Familiarity with and Assessments of SFAS 130 (means* and standard deviations) Prior to completing this questionnaire, I was very familiar with SFAS 130.* Reporting comprehensive income will assist in predicting future cash flows.* Comprehensive income will cause confusion among financial statement readers. SFAS 130 places an unnecessary financial reporting burden on companies.* I believe that the FASB should allow per share disclosures of comprehensive income. Asterisk indicates that difference is statistically significant at < .10. Costs v. Benefits of SFAS 130 Costs outweigh benefits Cost and benefits are approximately equal Benefits outweigh costs Total Missing/no response Preferred Reporting Format Single combined statement Separate statements of income and comprehensive income Report in stockholders' equity Total Missing/no response 49% (29) 39 (23) 12 (7) 100% (59) (5) 26% (27) 43 (46) 31 (33) 100% (106) (5) 17% (10) 30 (18) 53 (32) 100% (60) (4) 41% (10) 32 (31) 27 (27) 100% (111) (13) Accounting Faculty 4.33 (1.40) 3.45 (1.37) 3.84 (1.66) 2.39 (1.43) 3.34 (1.53) Financial Professionals 3.61 (1.84) 3.07 (1.37) 3.95 (1.56) 3.36 (1.51) 3.05 (1.68)

Differences of opinion were also evident in preferences for reporting format. Academics overwhelmingly favored reporting comprehensive income in one of the two formats preferred by the FASB, either a combined statement with net income or a separate statement of comprehensive income. Only 12% favored reporting comprehensive income in the statement of stockholders' equity. Practitioners were more evenly divided, with nearly a third preferring the stockholders' equity alternative. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

137 EVALUATING COMPONENTS OF NET INCOME AND COMPREHENSIVE INCOME To gain insight into the relative usefulness of various net income and comprehensive income components, respondents were asked to make six judgments about decision usefulness. The judgments were coded on six point scales ranging from strongly disagree (1) to strongly agree (6). The specific judgments were:
1. 2. 3. 4. 5. 6. Conveys important economic information Is relevant to many judgments and decisions Is an indicator of management performance Should be included in net income Should be reported as a separate line item Should be reported on a per share basis.

The items evaluated included four elements of net income, comprehensive income, and three of its components:
Elements of Net Income: Income or Loss from Continuing Operations Gain or Loss from Discontinued Operations Extraordinary Gain or Loss Cumulative Effect of an Accounting Change. Comprehensive Income and Its Components: Foreign Currency Translation Adjustment Unrealized Security Holding Gain or Loss Minimum Pension Liability Adjustment

Table 2 reports means and standard deviations for the resulting assessments. Responses from academics and practitioners were qualitatively similar and are aggregated. The first three questions measure usefulness without regard to current reporting standards. The latter three also measure usefulness, but responses to these questions may be influenced by knowledge of current GAAP. For example, the fact that income from continuing operations is currently reported on a per share basis may induce greater agreement with the statement that income from continuing operations should be reported on a per-share basis.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

138
Table 2: Evaluation of Individual Net Income and Comprehensive Income Items Means and Standard Deviations--Faculty and Financial Professionals*
Conveys important economic information Relevant to Indicator of Should be included in mgt judgements performance net income and decisions Should be reported as a separate line item Should be reported on a per-share basis 6-Question / 3Question**

Net Income Income from Continuing Operations Gain or Loss from Discontinued Operations Extraordinary Gain or Loss Cumulative Effect of an Accounting Change Grand Means 4.61/4.45 Comprehensive Income Foreign Currency Translation Adjustment Unrealized Security Holding Gain or Loss Minimum Pension Liability Adjustment Comprehensive Income

1 5.51 (0.84) 4.97 (1.14) 4.91 (1.15) 4.23 (1.48)

4 5.49 (1.06) 4.73 (1.52) 4.65 (1.58) 4.01 (1.74)

5 5.38 (1.05) 5.26 (1.11) 5.24 (1.13) 4.86 (1.47)

6 4.83 (1.49) 4.29 (1.63) 4.34 (1.66) 3.95 (1.79) 5.27/5.30 4.64/4.51 4.51/4.27 4.00/3.72

5.43 (0.87) 4.96 (1.10) 4.52 (1.30) 4.37 (1.42) 3.96 (1.46) 4.05 (1.36) 3.53 (1.45) 2.97 (1.46)

4.35 (1.31) 4.53 (1.24) 4.03 (1.47) 4.15 (1.55)

3.87 (1.43) 4.00 (1.35) 3.57 (1.54) 3.75 (1.54)

3.03 (1.47) 3.47 (1.50) 2.96 (1.44) 3.51 (1.57)

3.50 (1.75) 3.23 (1.79) 3.12 (1.75) 3.29 (1.80)

4.12 (1.75) 4.04 (1.82) 3.65 (1.87) 3.98 (1.85)

2.88 (1.64) 2.72 (1.75) 2.47 (1.59) 3.20 (1.88)

3.63/3.75 3.67/4.00 3.30/3.52 3.65/3.80

*Scaled responses where 1 = Strongly Disagree and 6 = Strongly Agree Grand Means **6-question = average across items 1-6. 3-question = average across items 1-3.

3.56/3.77

An overall usefulness score was computed for each item by averaging scores across all six questions. These scores are described in the "Overall" column at the right side of Table 3. The grand means leave no doubt that net income is the key performance measure. The mean score for all net income items on all six questions is 4.61. For comprehensive income and its components, the corresponding score is 3.56. Income from continuing operations (5.27) stands out from all other items. Comprehensive income (3.65) and its components receive much lower evaluations. Three-question scores are computed using only questions that could be answered independently of current reporting standards. The results are qualitatively similar. Net income (grand mean = 4.45) is more important than comprehensive income (grand mean = 3.77). Income from continuing operations (5.30), discontinued operations (4.51), and extraordinary items (4.27) are all evaluated more favorably than comprehensive income or its elements. The highest scoring comprehensive income item is unrealized security holding gain or loss (4.00). Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

139 A final analysis involved ranking the eight items, question-by-question. These results are reported in Table 3. Again, the academic and practitioner responses are combined.

Table 3: Question-by-Question Ranks of Net Income and Comprehensive Income Items Faculty and Financial Professionals
Rank Conveys important economic information 1 Net Income Income from Continuing Operations Gain or Loss from Extraordinary Gain or Loss Cumulative Effect of an Accounting Change 1 2 3 1 2 3 1 2 3 1 2 3 1 2 3 1 3 2 Relevant to judgements and decisions 2 Indicator of mgt performance 3 Should be included in net income 4 Should be reported as a separate line item 5 Should be reported on a per-share basis 6

Comprehensive Income Foreign Currency Translation Adjustment Unrealized Security Minimum Pension Liability Adjustment Comprehensive Income 5 4 8 7 6 4 8 7 6 5 8 4 5 7 8 6 5 6 8 7 6 7 8 5

Several general conclusions are evident in Table 3. First, income from continuing operations, discontinued operations, and extraordinary items dominate any assessment of usefulness. These items are ranked first, second or third on every dimension. The cumulative effect of a change in accounting principle is clearly less important, but respondents believe that it should continue to be reported as a line-item component of net income and disclosed on a per-share basis. Comprehensive income scores toward the bottom on every dimension except as an indicator of management performance. There is also support for presenting comprehensive income on a per-share basis. Unrealized security holding gain or loss consistently ranks near the net income components in terms of usefulness. There is little support, however, for reporting it as a part of net income or on a per-share basis. Minimum pension liability adjustments rank last on every question.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

140 BENEFITS, DRAWBACKS AND THE "BOTTOM LINE" The final section of the questionnaire asked open-ended questions beginning with a request to complete this statement: "If asked to identify a single 'bottom line' that would be useful for most financial statement readers, I would select __________." The responses summarized in Table 4 again confirm the dominance of net income. Over 80% named some component of net income; almost half chose operating income.
Table 4: Responses to Open-Ended Questions Accounting Faculty Single Bottom Line Operating income Net income Comprehensive income EPS Cash flow Total Missing/no response Principal Benefit Disclosure/detail Forward view Understandability Other No benefit Total Missing/no response Principal Drawback Confuse readers Time/cost to prepare Added complexity/irrelevance Other No drawback Total Missing/no response 50% (27) 15 (8) 9 (5) 20 (11) 6 (3) 100% (54) (10) 56% (55) 18 (18) 10 (10) 10 (10) 6 (5) 100% (98) (13) 34% (18) 34 (18) 9 (5) 21 (11) 2 (1) 100% (53) (11) 33% (22) 30 (20) 16 (11) 21 (14) 0 (0) 100% (67) (44) 100% (64) (9) 0.51 (28) 18 (10) 26 (14) 5 (3) 45% (33) 37 (27) 7 (5) 7 (5) 4 (3) 100% (111) (38) Financial Professionals

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

141 The principal benefits identified with reporting comprehensive income fall heavily into two categories. A third of those answering cite improvements in disclosure and detail. Typical remarks mention more detailed information for analysis, improved visibility for items that go directly to equity, and highlighting significant unrealized gains/losses on securities. A similar number assert that comprehensive income helps in understanding the economic picture sufficiently to forecast the future. Responses mention improved awareness of items that will affect income in the future, allowing better estimates of future cash flows, and obtaining a better forward view of company results. A minority assert that users, particularly sophisticated users, will understand the company's results better with the additional information. Only one response asserted that reporting comprehensive income provides no benefit. Academics and practitioners agree that the most likely drawback to reporting comprehensive income lies in its potential to confuse readers. More than half the responses make reference to this problem. Concerns include making management look better or worse due to items beyond their control, providing excessive detail, and the proliferation of competing income numbers. Practitioners are also concerned about the time and cost necessary to prepare the new disclosures. Finally, participants were invited to express thoughts that they would like to share with standard setters. The single most prevalent comment from both academics (36%) and practitioners (54%) urged the FASB to simplify reporting requirements to avoid confusing financial statement readers. Among academics, the second most common comment (27%) supported the Board's efforts, praising the comprehensive income standard. Those in practice were less enthused. Twenty-two percent asserted that SFAS No. 130 does little or nothing to improve financial reporting. A common complaint was that the final version of the standard was "watered down." One respondent asserted that reporting comprehensive income "avoids the more important issue of what should be included in net income." CONCLUSIONS Members of the financial community, accounting researchers, and even some members of the Financial Accounting Standards Board have expressed concerns about the effectiveness of comprehensive income reporting under SFAS No. 130. The alternative display formats permitted are a particular source of concern among those who fear that reporting different "classes" of income impairs the effort to broaden users' focus beyond net income. This and other studies suggest that the concern is well founded and that companies are using display format to highlight or obscure results. The current findings confirm that many practitioners favor presenting comprehensive income in the statement of stockholders' equity. There is also significant concern that users will be confused by the growing number of alternative performance measures under the umbrella of comprehensive income. For comprehensive income reporting to achieve its objectives, the FASB should consider reducing or eliminating the present latitude in display format. A comprehensive review of income reporting should also be undertaken with the goal of assisting readers in identifying appropriate performance measures for various types of decisions. Otherwise, complexity and confusion about

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

142 the bottom line are likely to increase, limiting the potential of SFAS 130 to assist investors and creditors. REFERENCES Campbell, L., D. Crawford and D. Franz (1999). How Companies are Complying with the Comprehensive Income Disclosure Requirements. The Ohio CPA Journal, 58(1), 13-20. Dhaliwal, D., K. Subramanyam and R. Trezevant (1999). Is Comprehensive Income Superior to Net Income as a Measure of Firm Performance? Journal of Accounting and Economics, 26(1-3), 43-67. Financial Accounting Standards Board (1985). Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements. Stamford, CT, FASB. Godwin, N. & C.W. Alderman (1999). Avoiding the Implementation Costs of SFAS No. 130. The CPA Journal, 69(6), 52. Hirst, D.E. & P. Hopkins (1998). Comprehensive Income Reporting and Analysts' Valuation Judgments. Journal of Accounting Research, 36, 47-75. Jones, J. & A. Wilson (2000). The Effect of Accounting for Derivatives on Other Comprehensive Income. The CPA Journal, 70(3), 54-56. Maines, L. & L. McDaniel (2000). Effects of Comprehensive-Income Characteristics on Nonprofessional Investors' Judgments: The Role of Financial-Statement Presentation Format. The Accounting Review, 75(2), 177-204.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

143

THE UK INVESTOR AND INTERNATIONAL DIVERSIFICATION


Michael E. Hanna, University of Houston-Clear Lake Joseph P. McCormack, University of Houston-Clear Lake Grady Perdue, University of Houston-Clear Lake
ABSTRACT This study describes the development of the optimum investment portfolio for a United Kingdom-based investor who seeks to utilize the major stock market index from each of the Group of Seven (G-7) industrialized countries to diversify a domestic equity index portfolio. Results of the analysis based on data from the 1990s, indicate that substantial international diversification is essential if the UK investor's objective is to obtain an optimal portfolio. INTRODUCTION In modern portfolio theory international investing is widely accepted as an efficient means to diversify a portfolio. A great body of academic literature has focused on the risk reduction enjoyed by an investor who is able to reduce risk with little or no negative impact on return. Today many modern investment strategies include international investments to take advantage of the imperfect correlation between the financial markets of an investor's home market and those of other countries. The objective is to have gains in a foreign market to offset losses in the domestic market. To what extent should United Kingdom (UK) investors in the new millennium engage in international investing? This question takes on new importance in light of the growing trend towards the use of defined contribution retirement plans in the UK. Individuals who have never considered themselves as investors and who have previously relied on the state or company-administered pension schemes (as they are called in the UK), now face asset allocation decisions and the risk and return implications inherent with those decisions. Given this new situation, it is appropriate to realize that the extent a modern UK investor should engage in international investing will be related to the degree of risk reduction or return augmentation possible when that investor adds an international asset class to the portfolio's original domestic only asset allocation. REVIEW OF THE LITERATURE Numerous academic studies have explored the virtues of international investing as an element of an asset allocation strategy. Solnik, 1974, discusses the "primary motivation in holding a portfolio of stocks is to reduce risk," and he shows that international diversification can lower the systematic risk in a portfolio. Based on historical data a long-run allocation of 20 to 30 percent in foreign equity appears correct for an investor based in the United States, according to Clark and Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

144 Tullis, 1999. Black and Litterman, 1991, conclude that international investing reduces the level of risk below that of a purely domestic portfolio. Michaud, Bergstrom, Frashure, and Wolahan, 1996, arrive at the finding that "international diversification increases return per unit of risk" While many studies have historically argued for international diversification, some contrary views have occasionally emerged. Speidell and Sappenfield, (1992, and Most, 1999, express concern that as economies and global events tie together a shrinking world, the benefits of international diversification between major markets may be fading away. Of particular importance to UK investors, Beckers, 1999, shows that "European stocks are starting to behave more similarly." Aiello and Chieffe, 1999, find that international index funds fail to deliver a high level of diversification because the market indexes for the major world economies are becoming increasingly correlated. Sinquefield, 1996, questions if it is even still correct to use the Europe Australia Far East index (EAFE) and other major indexes to diversify an S&P 500 portfolio. Sinquefield, 1996, and Eaker, Grant and Woodard, 2000, contend that actively managed emerging market portfolios may provide greater potential for diversification than investment in developed markets. Erb, Harvey and Viskanta, 1994, find that correlation coefficients appear to increase between equity markets during recessions (just when investors would want low correlation coefficients). Shawnky, Kuenzel and Mikhail, 1997, report that correlation coefficients between markets appear to increase during periods of increased market volatility. Higher correlation would imply a reduction in diversification potential and thus higher portfolio risk. Although Solnik, Boucrelle, and Le Fur, 1996, find that long-term correlation between markets have not risen significantly, they do find that the financial markets exhibit "correlation increases in periods of high market volatility." Michaud, Bergstrom, Frashure, and Wolahan, 1996, like the previous authors, find that the major market indexes have not experienced increased correlation coefficients. Melton, 1996, shows that pension funds in other countries routinely have greater international allocations than U.S. pension funds do. But Gorman, 1998, shows that U.S. pension plans are moving in the direction of including international investments in their asset allocations. Thus, the proponents of international investing for its diversification benefits have swayed many pension fund managers in other countries and appear to be swaying U.S. pension fund managers. Yet questions still remain: "How should international investment be handled?" and "How much international diversification is appropriate?" METHODOLOGY AND DATA The particular market indexes under study in this research are the Financial Times Stock Exchange (FTSE) index of London, the Standard & Poor's 500 index (S&P 500), the Toronto Stock Exchange (TSE) 300 Composite index, the Paris CAC 40, the Frankfurt DAX, the Milan MlBtel, and the Tokyo Nikkei 225. Data for the study are the 121 months of monthly equity market data from January 1990, through January 2000. The monthly observations for the FTSE and the six foreign indexes are obtained from the first joint trading day of each month, as reported in The Wall Street Journal. Data on exchange rates are also collected from the Journal for the same trading day as the market index observations, and are used to convert market return data to United Kingdom pound equivalent returns. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

145 Geometric mean returns and standard deviations are computed from the monthly return data for each of the seven indexes, after the data have been adjusted for exchange rates fluctuations. These computed values provide a basic risk-return comparison of the seven markets. Correlation coefficients are also calculated to ascertain the relationship between each foreign market index and the FTSE. The pound-adjusted variables are then utilized in the analysis to determine the efficient frontier. The study reported here analyzes the risk and return implications for a hypothetical United Kingdom investor choosing to diversify a domestic equity index portfolio by incorporating international equity index components. The study utilizes the major equity market indexes of the UK and the other G-7 countries to construct an efficient frontier of portfolios. Those other six nations were Canada, the United States, France, Germany, Italy, and Japan. Data to describe each of the seven markets is based on monthly returns on the indexes and on monthly exchange rates during the 1990s. The data is used to determine the efficient frontier of portfolios for an UK-based investor who sought to combine the Financial Times Stock Exchange (FTSE) index with an investment in one or more of the market indexes from the other G-7 industrialized nations. Ascertaining the minimum standard deviation portfolio for each of a variety of selected returns develops the efficient frontier. For each new portfolio constructed in this process, the portfolio return, standard deviation, and coefficient of variation are reported. The minimum volatility portfolio contained a relatively small UK component, and this may not be attractive to some UK investors. The minimum weighting of the UK component of the portfolio was initially set to zero and gradually increased and new efficient portfolios are developed. While the data used in this study were monthly data, the results have been converted to an annualized basis for readability. FINDINGS Presented in Table 1 are the geometric mean return and standard deviation of returns for each of the seven markets. The London FTSE produced the third best performance during this time period, and had the third best coefficient of variation. Of the European markets only Frankfurt had both a better return and a lower level of volatility. However, as is observable from the table the United States (US) index clearly dominates the other indexes during the period of the 1990s. The US market produced the highest geometric mean rate of return, and is also the least volatile (i.e., had the smallest standard deviation of returns) across this ten-year (121-month) period. The data show the Frankfurt DAX had the closest comparable pound-adjusted rate of return, but the DAX has a standard deviation of returns that is about twenty percent larger than that of the S&P 500. The standard deviation of returns for the Toronto 300 was the second smallest in this period, but the pound-adjusted rate of return in the Canadian market index was only slightly above one-third of that experienced by the S&P 500. The S&P 500 index also had the lowest coefficient of variation for this period of study, indicating it produced the lowest amount of risk relative to return.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

146
Table 1: Rates of Return, Standard Deviations, and Coefficients of Variation All Values Stated as Percentages Market London Toronto S&P 500 Paris Frankfurt Milan Tokyo Annual Geometric Mean Return 10.55 5.08 14.79 9.85 12.36 5.72 -3.63 Standard Deviation of Returns 21.75 19.06 16.04 20.51 19.20 30.46 28.92 Coefficient of Variation 2.062 3.752 1.085 2.082 1.553 5.325 -7.967

Adjusted to UK pounds, the implication of investing 1,000 in each of these markets is illustrated in Figure 1. As is clear from this figure, an investor investing in either the S&P 500 or Frankfurt DAX would have more than tripled these invested funds across this ten-year (121-month) period. Investing in the London index would have produced nearly identical results with investing in the Paris index as the funds in each more than doubled during this period. At the lower extreme, almost a third of the funds invested in the Tokyo index would have been lost.

Figure 1

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

147 Table 2 provides information on the correlation between returns in each of the seven markets. All correlation coefficients are positive, indicating a clearly positive relationship between the returns over this period in the seven financial markets. Correlation to the United Kingdom market is strongest with the US and Paris indexes and weakest with the Milan and Tokyo indexes. Given this information and all other factors being equal, one would expect the low correlation with the Tokyo and Milan markets to indicate great potential for diversification through these markets for the UK investor. However, results reported below show virtually nothing is gained for the UK investor by including the Italian market in his portfolio.
TABLE 2: Correlation coefficients for returns between indexes London London Toronto S&P 500 Paris Frank. Milan Tokyo 1 0.4541 0.4808 0.4781 0.3986 0.3630 0.2859 1 0.7832 0.5528 0.5559 0.4260 0.3278 1 0.6556 0.6035 0.3923 0.3658 1 0.7550 0.4193 0.3735 1 0.4409 0.2593 1 0.2738 1 Toronto S&P 500 Paris Frank. Milan Tokyo

Given the data from these seven equity markets, efficient frontier portfolios were developed utilizing several different minimum weightings for the UK market component of the portfolio. Efficient frontier portfolios were determined by including all seven indexes in the hypothetical portfolio. Minimization of the standard deviation of the portfolio to ascertain the frontier was performed subject to the following constraints. The portfolio must earn a given rate of return (with several rates of return used to develop the frontier). Also the weighting of the indexes must sum to one and no index could be allowed to have negative weighting. Table 3 presents the returns, standard deviations, and coefficients of variation for several possible portfolio combinations of the FTSE and other market indexes, where there is no minimum or maximum weighting preset for the FTSE. Figure 2 is a graphical representation of this table. The selected returns are six percent, eight percent, 10.07 percent, 11.26 percent, and 12 percent. The 10.07 percent return is chosen as one of the points to be determined on the frontier because that was the mean return for the UK market over the time period of this study (as reported in Table 1). The portfolio with the 11.26 percent return is the minimum volatility portfolio for the UK investor. These five portfolios are the minimum volatility portfolios for each rate of return listed in the table.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

148
Table 3: Frontier Portfolios with no constraints on weightings All values stated as percentages Portfolios Annual Return 6.00 8.00 10.07 11.26
*

Weight of each index in frontier portfolios Coefficient of Variation 2.632 1.901 1.477 1.316 1.238 S&P 500 7.23 24.84 41.96 52.15 57.57 Toronto 34.13 21.67 9.04 1.28 0 London 14.80 15.58 16.70 16.67 16.48 Paris 8.31 3.56 0 0 0 Frankfurt 14.48 17.85 21.24 21.95 21.49 Milan 1.17 0.99 0.44 0 0 Tokyo 19.89 15.52 10.62 7.74 4.46

Annual Standard Deviation 15.79 15.21 14.87 14.82 14.85

12.00

* Minimum standard deviation portfolio

The UK market across this decade had a return of 10.07 percent and a standard deviation of returns of 21.75 percent (as reported in Table 1). The frontier portfolio with the 10.07 percent return reported in Table 3 has a standard deviation of 14.87 percent, indicating nearly a 1/3 reduction in volatility as the UK component is reduced from 100 percent down to only 16.7 percent of the respective portfolio. In fact the weight of the UK component varies in each frontier portfolio from a maximum of 16.70 percent to only 14.80 percent, with the weight of each of the other indexes also being varied as required to obtain the minimum volatility portfolio for that rate of return. That the UK component of the portfolio never exceeds 16.48 percent of any frontier portfolio is an important point clearly demonstrating the significant gains from international diversification for the UK investor. Clark and Tullis (1999) have suggested that a 20 to 30 percent allocation to international equities would be appropriate for a previously domestic equity only portfolio. However, their point of view was from that of an American investor. The results reported here demonstrate that an UK investor needs to have a much larger portion of his equity portfolio allocated toward international investments. Figure 2 is a graphic representation of the return and volatility data presented in Table 3. The further importance of international diversification becomes more evident when this figure is studied. It becomes obvious that portfolios with returns below 11.26 percent (i.e., that of the minimum volatility portfolio) are not on the efficient frontier, but rather are on the inefficient portion of the frontier. Of the portfolios reported in Table 3, only the two portfolios with returns of 11.26 and 12 percent are efficient. Both the 100 percent UK portfolio and the diversified portfolio producing 10.07 percent are actually inefficient portfolios (as are the portfolios with eight and six percent rates of return). To be invested in an efficient portfolio, Table 3 makes it clear that the UK investor could have no more than 16.67 percent of his portfolio assets invested in the UK market.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

149
Figure 2

The frontier portfolio that returns 10.07 percent should be examined in contrast to the performance of the UK market. The UK investor could have earned that level of return by investing 100 percent of his assets in the UK market or by investing in the frontier portfolio that had only a 16.70 percent weighting for the UK component. The obvious difference between the two portfolios is the standard deviation of returns for each portfolio. The standard deviation for the UK-only portfolio is 21.75 percent, while the internationally diversified portfolio has a standard deviation of 14.87 percent. The internationally diversified portfolio that is located on the frontier offers the UK investor nearly a 1/3 reduction in volatility with no sacrifice in return. However, UK investors may feel the need to maintain some certain minimum amount of investing in the home market. What would be the implications of such a course of action? Table 4 reports the results of fixing the minimum weighting of the UK component of the investor's portfolio at 20 percent. In this table only the portfolios with expected returns of 11.3 and 12 percent are on the efficient frontier. The other three portfolios are on the inefficient portion of the frontier. Tables 5, 6, and 7 report the results of setting the minimum weight of the UK portion of the portfolio at 40, 60 and 80 percent, respectively. Results here are consistent with the results presented in Table 4. It should also be noted that when the UK weighting is set at a minimum of 60 percent, it is not even possible to reach the efficient portion of the frontier and the 12 percent return. With the UK weighting set at a minimum of 80 percent, it is not possible to generate portfolios producing either the six or 12 percent expected returns.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

150

Table 4 Frontier Portfolios with UK weighting set at a minimum of 20 percent All values stated as percentages Portfolios Annual Return Annual Standard Deviation 15.82 15.23 14.89 14.83 14.87 Coefficient of Variation 2.637 1.904 1.479 1.312 1.239 S&P 500 Weight of each index in frontier portfolios Toronto London Paris Frankfurt Milan Tokyo

6.00 8.00 10.07 11.30* 12.00

4.42 22.16 40.45 50.91 55.71

33.60 21.52 8.43 0 0

20.00 20.00 20.00 20.00 20.00

7.39 2.44 0 0 0

14.38 18.26 20.62 21.40 20.47

0.72 0.53 0 0 0

19.49 15.09 10.50 7.69 3.82

* Minimum standard deviation portfolio

Table 5 Frontier Portfolios with UK weighting set at a minimum of 40 percent All values stated as percentages Portfolios Annual Return Annual Standard Deviation 16.48 15.86 15.52 15.47 15.54 Coefficient of Variation 2.747 1.983 1.541 1.399 1.295 S&P 500 Weight of each index in frontier portfolios Toronto London Paris Frankfurt Milan Tokyo

6.00 8.00 10.07 11.06* 12.00

0 12.61 30.57 38.54 44.73

30.65 18.78 5.02 0 0

40.00 40.00 40.00 40.00 40.00

0 0 0 0 0

9.94 15.22 15.94 16.08 15.11

0 0 0 0 0

19.41 13.39 8.47 5.38 0.15

* Minimum standard deviation portfolio

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

151
Table 6 Frontier Portfolios with UK weighting set at a minimum of 60 percent All values stated as percentages Portfolios Annual Return Annual Standard Deviation 18.12 17.33 17.01 16.97 Coefficient of Variation 3.020 2.166 1.689 1.568 S&P 500 Weight of each index in frontier portfolios Toronto London Paris Frankfurt Milan Tokyo

6.00 8.00 10.07 10.82


*

0 3.01 20.52 25.79

16.54 15.4 1.73 0

60.00 60.00 60.00 60.00

0 0 0 0

0 10.20 11.38 11.00

0 0 0 0

23.46 11.40 6.37 3.03

12.00

* Minimum standard deviation portfolio With the UK weighting set at a minimum of 60 percent, it is impossible to generate a portfolio with a 12 percent rate of return

Table 7 Frontier Portfolios with UK weighting set at a minimum of 80 percent All values stated as percentages Portfolios Annual Return Annual Standard Deviation Coefficient of Variation S&P 500 Weight of each index in frontier portfolios Toronto London Paris Frankfurt Milan Tokyo

6.00 8.00 10.07 10.58* 12.00

19.48 19.14 19.12

2.435 1.901 1.807

0 10.03 13.22

7.85 0 0

80.00 80.00 80.00

0 0 0

0 6.44 6.07

0 0 0

12.15 3.53 0.71

* Minimum standard deviation portfolio With the UK weighting set at a minimum of 80 percent, it is impossible to generate a portfolio with a 12 percent rate of return

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

152 CONCLUSION Modern portfolio theory suggests that an UK investor's domestic portfolio should benefit by investing in other markets that are not perfectly correlated with the UK market. In this study we see that diversification reduces risk significantly as the UK investor makes the necessary allocation to foreign markets. While during the decade of the 1990s, US investors were not significantly rewarded for international diversification it held great potential of UK investors. They would have experienced significant reductions in risk coupled with no reductions in return. Data across this time period using the market indexes for the United Kingdom and its G-7 partners clearly supports the usefulness of international diversification. If the goal of the investor's investment strategy is risk minimization and offsetting domestic market losses, then the investor facing an asset allocation decision must consider the historical market patterns discussed here. The cases which are examined in this study show international diversification (based on major market indexes) over these ten years (121 months) would have been a potent tool for UK investors as has been suggested in much of the academic research. The risk reduction benefits of diversification were evident. Given this recent historical experience, the UK investor must recognize that there is sufficient reason (in terms of risk reduction) to pursue international diversification. The results of this study might be sample specific. The complete data set of the decade from 1990 through 2000 is used in describing the relationship between the United Kingdom and the remaining G-7 markets. However, it may be difficult to extrapolate the findings of this research to any other markets, specific stocks in these markets, or to other time periods. Nevertheless, investors typically obtain reasonable expectations of the potential benefits of international diversification by studying historical relationships and the results in this study should provide information that allows investors to make a more informed investment decision. REFERENCES Aiello, S. and Chieffe, N. (1999). International Index Funds and the Investment Portfolio. Financial Services Review, 8 (1), 27-35. Bailey, W., and Lim, J. (1992). Evaluating the Diversification Benefits of the New Country Funds. The Journal of Portfolio Management, 8 (3), 74-80. Beckers S. (1999). Investments Implications of a Single European Capital Market. The Journal of Portfolio Management, 25 (3), 9-17. Black, F., and Litterman, R. (1991). Global Portfolio Optimization. Financial Analysts Journal, 48 (5), 28-43. Clarke, R.G., and Tullis, R.M. (1999). How Much Investment Exposure is Advantageous on a Domestic Portfolio? The Journal of Portfolio Management, 25 (2), 33-44.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

153 Eakes, M., Grant, D., and Woodard, N. (2000). Realized Rates of Return in Emerging Equity Markets. The Journal of Portfolio Management, 26 (3), 41-49. Erb, C.B., Harvey, C.R., and Viskanta, T.E. (1994). Forecasting International Equity Correlations, Financial Analysts Journal, 50 (6), 39-45. Gorman, S.A. (1998). The International Equity Commitment, The Research Foundation of the Institute of Chartered Financial Analysts, Charlottesville, VA. Melton, P. (1996). The Investor's Guide to Going Global with Equities, Pitman Publishing, London. Michaud, R.O., Bergstrom, G.L., Frashure, R.D., and Wolahan, B.K. (1996). Twenty Years of International Equity Investing: Still a route to higher returns and lower risks? The Journal of Portfolio Management, 23 (1), 9-22. Most, B.W. (1999). The Challenges of International Investing Are Getting Tougher. Journal of Financial Planning, February, 38-40, 42-46. Shawnky, H.A., Kuenzel, R., and Mikhail, A.D. (1997). International Portfolio Diversification: A Synthesis and Update, Journal of International Financial Markets, Institutions and Money, 7, 303-327. Sinquefield, R.A. (1996). Where Are the Gains from International Diversification? Financial Analysts Journal, 52 (1), 8-14. Solnik, B.H. (1974). Why Not Diversify Internationally Rather than Domestically? Financial Analysts Journal, 30 (4), 48-54. Solnik, B., Boucrelle, C., and Le Fur, Y. (1996). International Market Correlation and Volatility. Financial Analysts Journal, 52 (5), 17-34. Speidell, L.S. and Sappenfield, R. (1992). Global Diversification in a Shrinking World. The Journal of Portfolio Management, 19 (1), 57-67. Wahab, M., and Khandwala, A. (1993). Why Not Diversify Internationally with ADRS? The Journal of Portfolio Management, 19 (2), 75-82.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

154

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

155

A NEW STOCK OPTION PLAN AND ITS VALUATION


Anthony Yanxiang Gu, State University of New York, Geneseo
ABSTRACT This new option plan allows the holder to purchase an underlying asset at a discount proportional to the asset's market price, and the proportion decreases with an employee's seniority. This option would provide strong incentives to improve executive and employee performance and loyalty. Compared to existing plans, this option would create less incentive to increase company risk or to reduce dividend payment, and it would not be too generous. We derive the value of this option for the general case of a dividend-paying stock and where the option's exercise price reflects a time-varying discount factor. The derived value incorporates the optimal exercise time. INTRODUCTION Existing stock option plans and previous research on stock option plans focus on executive compensation packages. Realizing the stronger incentives of stock options, more companies have started to offer stock options to their non-executive employees recently. Existing stock options have several disadvantages while creating incentives to increase stock price. (Smith & Watts, 1982, 1992; Agrawal & Mandelker, 1987; Lambert et al., 1989; Jensen & Murphy, 1990; DeFusco et al., 1990; Yermack, 1995; Tufano, 1996; Hall, 1998; Schrand & Unal, 1998; Core & Guay, 1998; Johnson & Tian 2000). Often, shareholders complain that some options are too generous and do not provide the right incentives to executives. Researchers find that existing stock options, traditional or nontraditional, create strong incentives to increase company risk and to reduce dividend payments. Executives compensated with stock options may take actions to increase company risk because an increase in stock price volatility increases the value of an executive stock option (Agrawal & Mandelker, 1987; Tufano, 1996; Schrand &Unal, 1998). Johnson and Tian (2000) find that five out of the six nontraditional options they examine create stronger incentives than the traditional option to increase company risk. Also, executives may reduce dividends in order to increase their option payoffs because, ceteris paribus, dividend payments reduce expected terminal stock prices and thus the value of call options that are not dividend protected (Lambert et al., 1989). Johnson and Tian (2000) report that three out of the six nontraditional options create stronger incentives to reduce dividend yield. In this paper, we present a new type of option that would create strong incentives to improve performance and loyalty of both executives and non-executive employees, while reducing the incentive to increase stock price volatility or to reduce dividend payments. We also analyze the value of the option. (For valuing traditional executive stock option plans, see Smith, 1976, and for valuing nontraditional executive stock options, see Johnson and Tian, 2000).

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

156 This option is a non-standard, American-style call option whose exercise price is a proportion of the price of its underlying asset. The option under consideration is different from existing call options in that its exercise price is not a fixed price but, rather, a proportion of the price of its underlying asset. For example, an option might give its owner the right to buy a share of common stock at a price equal to 80 percent of the stock's market price at any time prior to the option's expiration date. Since its exercise price is a portion of the underlying asset's price, the option is always in the money as long as the value of the underlying asset is greater than zero. A potential use for such an option may be for employers who wish to provide performance-sensitive compensation to their employees. Companies are increasingly issuing stock and/or conventional stock options to employees in compensation contracts. An alternative, which is a hybrid of stocks and conventional stock options, would be to compensate employees in the form of options to buy company stock at a proportional discount. Such an option is always in the money, yet its value is sensitive to the firm's performance. For a given number of underlying shares, these proportional-exercise price options would be less expensive to the company than directly issuing stock, and, unlike standard, fixed-exercise price options, they would not lose their beneficial incentive features should the company's stock decline due to exogenous swings in the stock market. Compensation in the form of proportional-exercise price options can be customized to meet a particular company's needs. The option's proportional exercise price can be based on an employee's seniority, a feature that can enhance loyalty to the company and, thereby, reduce employee turnover. An exercise price of, say, 80% of the current stock price could be set for a new hire, with the exercise price being reduced by one percentage point for each additional year of employment. Thus, a company could give an employee the right to buy a certain number of shares of stock at a price equal to 80 percent of the stock's market value if purchased during the employee's first year, 79 percent if purchased during her second year, 78 percent if purchased during her third year, and so on until she retires or leaves the company. While there would be no further reduction in the option's proportional exercise price following retirement, the option's maturity could be designed to follow the employee's retirement date at which time her tax liability on the option's capital gain may be lower due to a lower post-retirement tax bracket. The plan of the paper is as follows. In Section 2 we present a general framework for valuing an option whose exercise price equals a proportion of its underlying asset's value. We derive the optimal time at which the option should be exercised in order to determine the option's value. We discuss some implications in Section 3, and provide a conclusion in Section 4. THE MODEL Let P be the current, date 0 price of an underlying asset. An option written on this asset is assumed to have an exercise price at any future date t$ 0 equal to XPt where Pt is the price of the underlying asset at date t and 0< X < 1. First consider an option on a non-dividend paying asset, such as a non-dividend paying stock. Suppose the holder of the option decides to exercise the option at some arbitrary future date, T. What would be the present value of this option? We can value the cash flows from this option using a simple application of risk-neutral pricing developed by Cox and Ross (1976). Let r be the Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

157 continuously compounded risk-free interest rate for borrowing or lending between dates 0 and T. Then the present value of this option, V, is simply
V = erT E*[P XP ] = (1 X)erT E*[P ] T T T = (1 X)erT PerT = (1 X)P

(1)

where E* is the risk-neutral expected value of the payoff at date T. It is well-known that this expectation can be computed by assuming that the underlying asset has an expected rate of return equal to the risk-free rate, r, rather than its true expected rate of return. Note that for this very simple case, the option's value V = (1-X)P does not depend on when exercise occurs, that is, the option's value does not depend on date T. What this tells us is that it does not matter when we decide to exercise the option. The time at which the option is exercised does not affect the option's value. Let us next consider the same type of option but on a dividend-yielding asset. The underlying asset is assumed to continuously pay a dividend that yields a proportion, q, of its value. For example, if the option is written on a stock index where the portfolio of stocks underlying the index pay a 3 percent dividend, then q = .03. If we again assume that the option is exercised at some arbitrary future date, T, then the value of the option is
V = erT E*[P XP ] = (1 X)erT E*[P ] T T T = (1 X)erT Pe(rq)T = (1 X)PeqT

(2)

Here we see that E* [PT] = Pe( r-q )T is the risk-neutral expected value of the underlying asset price at date T. This means that the price of the asset is expected to appreciate, under the risk-neutral measure, at the rate (r-q). This occurs because, in equilibrium, the owner of the asset must obtain a total expected rate of return equal to r, which is the case since the dividend, q, plus price appreciation, r-q, equals q + r - q = r. Now for the case of a dividend-yielding asset, the option's value is a function of the exercise date, T. For q > 0, we see that the value of the asset is maximized when T = 0, implying V = (1-X)P. Hence, the optimal exercise strategy for this option on a dividend-yielding asset is to exercise immediately. We now consider one additional case, that being where the proportional exercise price, X, changes over time according to some deterministic function of time, X = x(t). For example, this might reflect the case in which an employee has the option to buy stock at a discount where the discount changes as a function of the employee's seniority or level of promotion. In this case, the value of the option is similar to the previous case

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

158
V = erT E*[P x(T)P ] = [1 x(T)]erT E*[P ] T T T = [1 x(T)]erT Pe(rq)T = [1 x(T)]PeqT

(3)

Depending on the specification of x(T), it may be optimal to exercise the option immediately or at some future date. For example, suppose that x(t) = Ke- gt so that the exercise price is assumed to decline at rate g from its initial value of K. Then we have

V=[1K gT]P qT =PeqT K (q+g)T] e e [ e


Taking the derivative with respect to T gives
V = P[qeqT +(q + g)Ke(q+g)T ] = 0 T

(4)

(5)

or

(q+g)K (q+g)T =qeqT e


which implies that the optimal date to exercise this option is

(6)

T* = 1 ln K q+g g q

(7)

Note that T* > 0 if K(q+g)/q > 1, which occurs if g and the original K is sufficiently large. If, instead, K(q+g)/q < 1, it is optimal to exercise the option immediately. Figure 1 shows the optimal exercise date T* with respect to different values of g, assuming q = 0.03 and K = 0.9. It would be optimal for the option holder to exercise immediately if the value of g is close to zero. T* reaches its maximum value when g = 0.02, and then declines as the value of g increases. The track of T* further implies that this option is attractive to both the employer and the employee. Companies generally allow new hires to exercise their stock options after one to six years of service (vesting), with this option, employees would delay the exercise voluntarily. In the early stage of one's employment with the company as he/she gains seniority and promotions, the employee usually does not need to exercise the option and the optimal exercise date is far away. One usually has gained the most seniority and promotions as one goes close to retirement, while the optimal exercise date is only a few years away then one would need to exercise the option.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

159 There may be other factors, such as personal taxes, which might affect the optimal exercise date. But the above analysis should clarify the most important issues regarding the valuation and optimal exercise of this option. IMPLICATIONS Employers who wish to provide performance-sensitive compensation to their employees and who are concerned with the disadvantages of existing option plans may consider the use of use this type of option. This new type of option would create strong incentives to improve performance and to increase stock price because the value of the option increases as the underlying stock's price increases. The option would promote employee loyalty because the proportional exercise price decreases as the option owner gains seniority. The new option would not be too generous because it would give its owner a proportion, not all of the appreciation in the stock price based on the owner's package. This new type of stock option would create less incentive to increase company risk (stock price volatility) and would create less incentive to reduce dividend yield. With the proportional exercise price, the executives would have to pay a higher price for greater volatility if they try to boost stock price to a temporarily high level at the time they are ready to exercise their options. They would also have to pay a higher price if they try to boost terminal stock prices by reducing dividends. With existing stock options, higher volatility and lower dividends do not cost the executives higher prices. Shareholders may further reduce the executive's incentive to increase company risk by relating the option's exercise price to stock price volatility. For example, they can tie the decline rate of the exercise price g to their market adjusted price volatility target:

g, y =* a,y +I y
where, g",y is the part of g that is related to the company's risk (g is mainly related to seniority and promotion). F* represents the market adjusted volatility target, F",y represents the actual volatility during the year, and I represents an adjustment factor at the shareholders discretion. Hence, the executives would be rewarded if they keep the company's market adjusted price volatility at or below the target level, or be penalized if they fail to do so. Shareholders can also reduce the executive's incentive to reduce dividends in a similar way, i.e., relating g to optimal dividends. The new option would reduce the incentive of early exercise. Early exercise is common for existing executive or employee options, about 90 percent of the options are exercised before expiration (Heath, Huddart & Lang, 1999). After the exercise of an option, the option and the incentive for retention it provides ceases to exist. The new option has an exercise price that declines with seniority, ceteris paribus, the longer the option owner waits while working for the company, the greater would be the gain. The company can also adjust the optimal exercise date by adjusting the declining rate g. Holding other factors constant, the optimal exercise date would be over 20 years from today when g = 2 percentage points as shown in Figure 1. In addition, this new option Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

160 can also avoid the difficulty of determining vesting periods. Currently, vesting periods range from 1 to 6 years (Huddart & Lang, 1996) among companies and it is hard to determine the optimal number of years. With this new option, the company may grant a new hire a justified number of options at a high exercise price, say 80 percent of the current market price of the underlying stock, as a sign-on bonus without working on vesting terms.
Figure 1: Optimal Exercise Date
20

Years from Today

15

10

0 0.003 0.005 0.007 0.010 0.030 0.050 0.150 0.250 0.350 0.450

Decline Rate g

It would be interesting to see companies adopt this option plan and test whether this new option is superior in satisfying stockholders, i.e., greater stock price increase with lower volatility, stronger employee loyalty, and rational dividend payments. CONCLUSION A call option having an exercise price that is a proportion of the underlying asset's price can be an attractive part of an employee compensation scheme. This type of option would create strong incentives to improve performance and to reduce turnover rates of all employees. It would reduce the incentive to exercise the option early. It would create lower incentives to increase company risk or to reduce dividend payment because the executives would have to pay a price if they increase company risk or reduce dividend payments. We show how such options could be valued using a risk-neutral pricing approach. Our model's results implies that if the exercise price of the option is a fixed proportion of the underlying asset, it will be optimal to exercise the option immediately if the asset pays dividends but is not received by the option owner. However, if the proportional exercise price declines at a sufficiently high rate, the optimal exercise of the option occurs at a specified future date.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

161 REFERENCES Agrawal, A. & G. Mandelker, (1987). Managerial incentive and corporate investment and financing decisions, Journal of Finance, 42, 823-837. Ancel, E.W. & R.K. Rao, (1990). Stock returns and option prices: an exploratory study, Journal of Financial Research, 3, 173-185. Black, F. & M. Scholes, (1973). The pricing of options and corporate liabilities, Journal of Political Economy, 81, 673-654. Boyle, P., (1988). A lattice framework for option pricing with two state variables, Journal of Financial and Quantitative Analysis, 23, 1-12. Brenner, M., Sundaram, R.K. & D. Yermack, (2000). Altering the terms of executive stock options, Journal of Financial Economics, forthcoming. Chance, D.J., Kumar, R. & R.B. Todd, (1997). The 'repricing' of executive stock options. Unpublished working paper. Virginia Tech University. Conway, J., (1998). Despite ongoing market volatility, most companies are resisting stock option repricing. Towers Perrin study finds. Business Wire, December 14. Core, J. & W. Guay, (1998). Estimating the incentive effects of executive stock option portfolios. Unpublished working paper. University of Pennsylvania. Cox, J. & S. Ross, (1976). The valuation of options for alternative stochastic processes, Financial Economics, 3, 145-66. Cox, J., S. Ross & M. Rubinstein, (1979). Option pricing: a simplified approach, Journal of Financial Economics, 7, 229-64. DeFusco, R.A., Johnson, R.R. & T.S. Zorn, (1990). The effect of executive stock option plans on stockholders and bondholders, Journal of Finance, 45, 617-627. Derman, E. & I. Kani, (1993). The ins and outs of barrier options, Goldman Sachs Quantitative Strategies Research Notes, June. French, D.W. & E.D. Maberly, (1992). Early exercise of American index options, Journal of Financial Research, 15, 127-137.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

162 Gu, Y.A. (2002). Valuing the option to purchase an asset at a proportional discount. Journal of Financial Research, 25 (1), 2002. Guay, W.R., (1999). The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and determinants, Journal of Financial Economics, 53, 43-71. Hall, B.J., (1998). The pay to performance incentives of executive stock options. Unpublished working paper, Harvard University and National Bureau of Economic Research. Heath, C., S. Huddart & M. Lang, (1999). Psychological factors and stock option exercise, Quarterly Journal of Economics, 114, 601-627. Hemmer, T., Matsunaga, S. & T. Shevlin. (1998). Optimal exercise and the cost of granting employee stock options with a reload provision, Journal of Accounting Research, 36, 231-255. Huddart, S.J., Jagannathan, R. & P.J. Saly. (1999). Valuing the reload features of executive stock options, National Bureau of Economic Research working paper no. 7020. Huddart, S.J.& M. Lang. (1996). Employee stock option exercises: An empirical analysis, Journal of Accounting & Economics, 21, 5-44. Hilliard, J.E., A.L. Schwartz & A.L. Tucker. (1996). Bivariate binomial options pricing with generalized interest rate processes, Journal of Financial Research, 19, 585-602. Jensen, M.C. & K.J. Murphy. (1990). Performance pay and top-management incentives, Journal of Political Economy, 98, 225-264. Johnson, S.A. & S. Yisong Tian, S. (2000). Indexed executive stock options, Journal of Financial Economics, 57, 35-64. Johnson, S.A. & Yisong Tian, S. (2000). The value and incentive effects of nontraditional executive stock option plans, Journal of Financial Economics, 57, 3-34. Lambert, R.A., Lanen, D.& D.F. Larcker, D.F. (1989). Executive stock option plans and corporate dividend policy, Journal of Financial and Quantitative Analysis, 24, 409-425. Lambert, R.A., Larcker, D.F. & R.E. Verrecchai. (1991). Portfolio considerations in valuing executive compensation, Journal of Accounting Research, 29, 129-149. Merton, R.C. (1973). The theory of rational option pricing, Bell Journal of Economics and Management Science, 4, 141-183. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

163 Murphy, K.J. (1999). Executive compensation. In: Ashenfelter, O., Card. D. (Eds.), Handbook of Labor Economics, 3. Amsterdam: North-Holland. Paulin, G. (1992). Resurgence of stock option popularity, Rethinking Corporate Compensation Plans, Conference Board Report no. 1015, 19-21. Rich, D.R. (1994). The mathematical foundations of barrier options, Advances in Futures and Options Research, 7, 267-311. Ritchey, R. J. (1990). Call option valuation for discrete normal mixtures, Journal of Financial Research, 13, 285-296. Ritchken, P. (1995). A multifactor model of the quality option in treasury futures contracts, Journal of Financial Research, 18, 261-279. Rubinstein, J. & Reiner, E. (1991). Breaking down the barriers. Risk, 4 (8), 28-35. Schrand, C. & Unal, H. (1998). Hedging and coordinated risk management: evidence from thrift conversions, Journal of Finance, 53, 979-1014. Smith, Jr., C.W. & J.L. Zimmerman. (1976). Valuing employee stock option plans using option pricing models, Journal of Accounting Research, 14, 193-202. Smith Jr., C.W.& R.L. Watts. (1982). Incentive and tax effects of executive compensation plans, Australian Journal of Management, 7, 139-157. Smith Jr., C.W. & R. L. Watts. (1992). The investment opportunity set and corporate financing, dividend, and compensation policies, Journal of Financial Economics, 32, 263-292. Tufano, P. (1996). Who manages risk? An empirical examination of risk management practices in the gold mining industry, Journal of Finance, 51, 1097-1137. Yermack, D. (1995). Do corporations award CEO stock options effectively? Journal of Financial Economics, 39, 237-269.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

164

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

165

THE IMPACT OF THE AMERITRADE ONLINE INVESTOR INDEX ON THE AUTOCORRELATIONS AND CROSS-CORRELATIONS OF MARKET RETURNS
Thomas Willey, Grand Valley State University
ABSTRACT This paper investigates the value of the information contained in the Ameritrade Online Investors Index (AOII) for the returns of two exchange traded funds. The AOII measures the buying and selling decisions for a group of online investors. The returns of the funds for the Nasdaq 100 and the S&P Mid-Cap 400 are examined using the quartiles of the Index. Overall, results show no influence on the returns from a broad market index and a negative impact from the lagged value of the return of the given fund. An investment strategy is suggested that incorporates short-selling when low values of the AOII are found in conjunction with negative returns of a given asset. INTRODUCTION The predictability of market returns is a topic of great interest to practitioners and financial researchers. If financial markets are truly efficient and follow a random-walk process, the cost of developing a forecast of future returns is an unrecoverable investment of time, energy and resources. At the other end of the efficiency spectrum, perhaps the future return on a market portfolio of securities is somehow linked to readily available public information and some degree of predictability is attainable. In this paper, the daily returns for two exchange traded funds, the first for the Nasdaq 100 (Ticker: QQQ) and the second for the Standard & Poors Mid-Cap 400 (Ticker: MDY), are examined to measure the role an index of online investors play in determining future market returns. The explosive growth of the Internet and online trading, in conjunction with vast amounts of financial information, are some of the major forces that shape individual investor decision making today. Recent papers by Miller (1988), Lakonishok and Maberly (1990) and Abraham and Ikenberry (1994) investigated the way investors use information in making investment choices. Their central conclusions are that there are certain time periods where it is more costly to process and use information in buying and selling choices for investors. More specifically, Abraham and Ikenberry state that increased costs to process information exist during the work week and this result leads to increased selling and lower returns of securities on Mondays. The benefits and costs of information processing by online traders are one of the primary research questions for this study. Chordia and Swaminathan (2000) employed autocorrelations and cross-correlations and found that returns on stocks with high trading volume can be used to predict returns of low trading volume stocks, regardless of the size of the firm. This paper uses a methodology implemented by Perfect and Peterson (1997) and Higgins, Howton and Perfect (2000) by investigating the Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

166 autocorrelations and cross-correlations in the returns of two exchange traded funds (ETFs) for two major market indices. While the two previous articles investigated the returns of an asset on a given day of the week, this research looks at the role a given level of buying and selling by online investors play in determining market returns. The daily autocorrelations of the QQQ will be examined first, followed by the daily cross-correlations between the QQQ and the ETF for the broader market index of the S&P 500. For comparison purposes, similar results are provided for the MDY. Finally, the relative strengths of the two statistical measures will be estimated jointly to determine if the lagged returns of a given security or the cross-correlations dominate the most recent return of the examined stock. DATA One of the major online brokerage firms, Ameritrade, has began to publish the Ameritrade Online Investor Index (AOII), a daily measure of the amount of buyer participation based on a decisions made by the firms online investors (Ameritrade Press Release, 12/1/1999). On every trading day, after the U.S. markets have closed, Ameritrade posts the Ameritrade Index page on the Internet. One of the stated goals of the index is to measure the individual investment decisions of online investment individuals. The AOII is presented as the percent of online traders that were buyers, and is found by dividing the number of buyers of equities by the sum of buyers and sellers of equities. For the initial day of the study, the AOII was reported as 37.68%, which indicated approximately 38% of all buyers and sellers would have been buying stocks and the remaining 62% would have been selling equities. The study period for the AOII data begins on February 1, 2000 and ends on September 22, 2000, a total of one hundred and sixty-four daily returns. The maximum value for the AOII of 89.03% and therefore, the strongest bull sentiment for the study period was April 12. The strongest bearish value for the index of 12.27% was on May 30, which indicates that approximately 86% of online investors were selling securities on that day. On the whole, online investors were net purchasers of securities with a median value of 51.94% for the AOII. The total observations for the sample period were further divided into quartiles to facilitate the use of indicator variables to represent the online buyers purchasing sentiments. The first quartile, from the minimum of 12.27% to 39.51%, represented the selling sentiment of the study, while the fourth quartile, which ranged from 67.48% to the maximum of 89.03%, can be thought of as the buying segment of the sample period. The data for the market returns was derived from three exchange-traded funds (ETFs) or index tracking stocks. These securities are a relatively new innovation for the financial markets, first introduced in 1995, but have gained a great amount of popularity in recent years. According to the Wall Street Journal (January 29, 2001), the astronomical compound growth rate in ETFs was about 118%, from $6.8 billion in 1997 an estimated $70 billion at year-end 2000. These assets are traded on the American Stock Exchange and have become some of the most active issues traded there. The most widely held and most active issues for the 2000 trading year were the Nasdaq 100 tracking index, known as the Cube and the mirror of the S&P 500, referred to as Spiders (ticker symbol SPY). The Cubes trading volume for 2000 was $6,973.8 million, trailed by $1,932.7 for the SPY. A related ETF that tracks the S&P Mid-Cap 400 Index was chosen as a comparison index Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

167 to the QQQ. For the entire year of 2000, the return on the MDY was 16.3% (with a volume of $212.4 million) versus annual returns of 36.2% and 10.7% for the Cube and the Spider, respectively. The primary focus of the analysis will be for the returns of the QQQ. For comparison purposes, the MDY returns will be examined separately, while the percentage change in the SPY will be used as the market return for both examined securities. METHODOLOGY The data analysis begins by examining the daily returns for ETFs for the Nasdaq 100, the S&P Mid-Cap 400 and the S&P 500 Stock Index. Results for the hypothesis test for the mean return differing from zero are also reported. After the initial analysis of daily returns, the examination of daily autocorrelations follows by estimating regression equations for each security (Higgins and Peterson (1999)). The autocorrelations are analyzed for patterns in the four trading quartiles for the QQQ returns and the MDY comparison returns. Daily dummy variables are used to segment the values of the AOII into four quartiles based on the proportion of the online investors buying percentage. Daily returns for each index tracking security are regressed on the daily dummy variables and the lagged daily returns using the following equation:
Rt = a1Q1t +a2Q2t +a3Q3t + a4Q4t + b1Q1tRt-1 + b2Q2tRt-1 + b3Q3tRt-1 + b4Q4tRt-1 + et (1)

Where: Rt = Daily returns for the sample at time t; Rt-1 = Daily returns for the sample at time t-1; Q1t,Q2t, Q3t and Q4t = Dummy variables for the quartiles of the AOII; and et = a random error term.

Equation 1 was estimated separately for the QQQ and the MDY securities. The model does not include an intercept and uses a dummy variable for each quartile of the AOII index to control for differences in daily average returns that may lead to spurious autocorrelations (Higgins, Howton and Perfect (2000)). In the first equation, the beta coefficients estimate daily autocorrelation terms. The Newey and West (1987) correction for autocorrelation and heteroskedasticity in the residual terms was used to estimate the first-order autocorrelations. The existence of cross-correlations between a broad market index, the SPY, and the QQQ index are also examined. To test this relationship, Equation 2 will be estimated by regressing daily QQQ returns on the AOII dummy variables and the lagged market returns:
Rqqq,t = a1Q1t +a2Q2t +a3Q3t + a4Q4t + c1Q1tRspy,t-1 + c2Q2tRspy,t-1 + c3Q3tRspy,t-1 + c4Q4tRspy,t-1 + et (2)

Where: Rqqq,t = Daily returns for QQQ security at time t; Rspy,t-1 = Daily returns for SPY security at time t-1; Q1t,Q2t, Q3t and Q4t = Dummy variables for the quartiles of the AOII; and et = a random error term.

The Newey and West (1987) correction was applied to the second equation and the gamma coefficients measure the daily cross-correlations. For comparison purposes, the daily crosscorrelations were also estimated for the MDY security.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

168 A final set of regression equations are estimated to measure which of the two hypothesized daily effects, autocorrelations or cross-correlations, exhibit a stronger influence on the returns of the examined securities. If the autocorrelations dominate the cross-correlations, the current returns are shaped to a greater degree by the most recent return of the security. On the other hand, conditions in the broader market would be more valuable to investors, if the cross-correlations showed a higher amount of influence relative to the autocorrelations. Equation 3 is used to measure the relative influences of the daily autocorrelations and cross-correlations on the QQQ returns:
Rqqq,t = a1Q1t +a2Q2t +a3Q3t + a4Q4t + b1Q1tRqqq,t-1 + b2Q2tRqqq,t-1 + b3Q3tRqqq,t-1 + b4Q4tRqqq,t-1 + c1Q1tRspy,t-1 + c2Q2tRspy,t-1 + c3Q3tRspy,t-1 + c4Q4tRspy,t-1 + et (3)

Where: Rqqq,t = Daily returns for QQQ security at time t; Rqqq,t-1 = Daily returns for QQQ security at time t-1; Rspy,t-1 = Daily returns for SPY security at time t-1; Q1t,Q2t, Q3t and Q4t = Dummy variables for the quartiles of the AOII; and et = a random error term.

The returns on the MDY security are also examined using Equation 3 by regressing the current return on the first lags of the securitys return and the broad market return of the SPY index shares. As in the previous two equations, the Newey and West (1987) correction is used to guard against potential biases in the estimates. The beta coefficients estimate the daily autocorrelations and the gamma values are measuring the cross-correlations with the SPY security. Three separate hypothesis tests will be performed to determine if the intercepts, autocorrelations and crosscorrelations are jointly equal to zero. RESULTS Table 1 contains the statistical characteristics for the average daily percent returns for the QQQ series, the matching MDY returns and the SPY index. All of the returns are positive and statistically different from zero on days when the AOII fell in the first quartile. This is somewhat unexpected, since the values for the online investors buying decisions in this quartile represent trading days where only a 12 % to a maximum of 40% were buying and the remaining 88% to 60% were selling. Also, during the most active buying period of the fourth quartile, when the online traders were purchasing stocks 67% to 89% of the time, the returns for each of the three assets were negative and statistically significant. Based on this initial analysis, online investors do not appear to be able to generate returns that differ from zero, instead the buying signals are associated with drops in the market and decisions to sell correspond to positive returns. The daily autocorrelation values are presented in Table 2. Section A contains the autocorrelation values for the QQQ security, the autocorrelations for the MDY matching sample are in Section B and the results for the SPY are shown in Section C. None of the autocorrelation terms are statistically significant for the broad market index of the SPY exchange traded fund. For the QQQ and the MDY returns, both of the first quartile autocorrelations are negative and statistically significant. In comparing the QQQ to the MDY, the returns for the QQQ indicate a stronger negative relationship than the returns for the MDY. Also, the autocorrelations for the second and fourth quartiles for the QQQ are negative and statistically different from zero. The joint null Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

169 hypothesis that all of the coefficients are zero is rejected with a p-values of less than 5% for both the QQQ and the MDY.
Table 1-Average Daily Percent Returns
This table presents the sample means for the daily returns of the index tracking securities for the Nasdaq 100 (QQQ), S&P MidCap 400 (MDY) and the S&P 500 (SPY). The quartiles for the Ameritrade Online Investors Index (AOII) were used to partition the returns. The AOII represents the percentage of the firms online investors who were buyers of securities on day t. The sample size is 164 observations. The p-value represents the results for the hypothesis test that the mean return equals zero. Index QQQ (p-value) MDY (p-value) SPY (p-value) All Days 0.0217 (0.9336) 0.1273 (0.3411) 0.0289 (0.7871) First Quartile 2.9618 (0.0001) 1.3945 (0.0001) 0.9422 (0.0001) Second Quartile 0.8252 (0.0181) 0.3953 (0.0732) 0.2148 (0.2049) Third Quartile -0.6605 (0.0943) -0.0431 (0.8393) -0.0741 (0.6646) Fourth Quartile -3.0396 (0.0001) -1.2373 (0.0001) -0.9671 (0.0001)

In order to investigate the possibility that online investors are incorporating other market information into their investing decisions, the daily cross-correlations between the QQQ and SPY securities are presented in Section A of Table 3. Section B contains a similar analysis for the MDY and the broader market index security. For the QQQ, evidence exists that online investors are reacting negatively to other market conditions. The cross-correlations for the first and second quartiles are both statistically different from zero. This result follows the findings for the autocorrelations, with once again the strongest negative coefficient found for the first quartile. Based on the hypothesis test results, the daily cross-correlations are not equal to each other. No statistically significant cross-correlations were found for the MDY. The final examination of the quartiles of the online investors decisions is presented in Table 4. The results for the autocorrelations and cross-correlations for QQQ are shown in Section A, while Section B has the results for the MDY. For the eight possible cross-correlation terms, only the fourth quartile for QQQ exhibited statistical significance with the SPY. For the first and fourth quartiles for both the QQQ and the MDY securities, the most recent returns are negatively related to the lagged value of each the respective securities. Also, the second quartile for the QQQ is negative and significantly different from zero. None of the three remaining autocorrelations were statistically significant. The joint hypothesis tests indicate all of the autocorrelation coefficients for both securities are not equal to zero. The practical conclusion to this result is that investors should evaluate the AOII, if the index increases (decreases), implement the contrarion decision is to sell (buy). In other words, online investors are not very accurate in predicting future returns in the examined ETFs of the QQQ and the MDY.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

170
Table 2-Autocorrelation Patterns in QQQ, MDY and SPY Daily Returns
This table presents the results for the daily autocorrelation terms. Sections A, B and C contain the QQQ returns, the MDY returns and the SPY returns. In the regression model, Rt and Rt-1 are the daily percent returns for the respective index tracking securities on day t and day t - 1. The Q1t, Q2t, Q3t and Q4t are dummy variables that equal one when the AOII falls in a given quartile and zero otherwise. Standard errors for the regression coefficients are adjusted using the Newey and West (1987) correction. The sample sizes for all regression models are 163. The Chi-Square value for the joint hypothesis test for the equality of the coefficients is also presented. Coefficient with p-value in parentheses AOII Dummy Variable Section A: Daily Autocorrelation Terms for QQQ First Quartile Second Quartile Third Quartile Fourth Quartile Joint Test of Equality Section B: Daily Autocorrelation Terms for MDY First Quartile Second Quartile Third Quartile Fourth Quartile Joint Test of Equality Section C: Daily Autocorrelation Terms for SPY First Quartile Second Quartile Third Quartile Fourth Quartile Joint Test of Equality 1.0068 (0.0001) 0.2387 (0.1231) -0.0886 (0.5892) -0.9219 (0.0001) 52.9839 (0.0001) -0.1785 (0.1761) -0.1821 (0.2518) -0.1464 (0.2172) 0.1416 (0.4658) 5.1978 (0.2676) 1.5242 (0.0001) 0.4336 (0.0292) -0.0514 (0.8028) -1.2911 (0.0001) 76.0879 (0.0001) -0.2088 (0.0067) -0.1273 (0.4359) -0.1183 (0.3455) -0.1744 (0.1228) 11.2198 (0.0242) 3.2826 (0.0001) 1.0252 (0.0004) -0.6748 (0.0663) -3.4535 (0.0001) 183.8118 (0.0001) -0.4501 (0.0005) -0.2729 (0.0151) -0.1607 (0.3101) -0.3009 (0.0459) 23.0421 (0.0001) Intercepts (ai) Autocorrelation Terms (bi)

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

171
Table 3-Daily Cross-Correlations Between QQQ and MDY Daily Returns
This table examines the predictive ability of the lagged index tracking security for the S&P 500 for the daily returns of the Nasdaq 100 and the S&P 400 Mid-Cap Index. Section A contains the cross-correlations between the QQQ returns and the S&P 500 Index. Section B presents the cross-correlations between the MDY returns and the S&P 500 Index. In the regression models below, RQQQ,t and RMDY,t are the daily percent returns on day t for QQQ sample and the MDY matching sample, respectively, and RSPY,t-1 is the return on day t 1 for the S&P 500 index security. The Q1t, Q2t, Q3t and Q4t are dummy variables that equal one when the AOII falls in a given quartile and zero otherwise. Standard errors for the regression coefficients are adjusted using the Newey and West (1987) correction. The sample sizes for all regression models are 163. The Chi-Square value for the joint hypothesis test for the equality of the coefficients is also presented. Coefficient with p-value in parentheses Intercepts AOII Dummy Variable (ai) Section A: Daily Cross-Correlations Between the QQQ and the SPY First Quartile Second Quartile Third Quartile Fourth Quartile Joint Test of Equality 3.2476 (0.0001) 0.8854 (0.0062) -0.6962 (0.0594) -3.1163 (0.0001) 153.2097 (0.0001) Section B: Daily Cross-Correlations Between the MDY and the SPY First Quartile Second Quartile Third Quartile Fourth Quartile Joint Test of Equality 1.4358 (0.0001) 0.4101 (0.0501) -0.0565 (0.7817) -1.2485 (0.0001) 74.3691 (0.0001) -0.0871 (0.5821) -0.1117 (0.6018) -0.1365 (0.4212) -0.0348 (0.8791) 1.2453 (0.8706) -0.7567 (0.0022) -0.4591 (0.0967) -0.3599 (0.1641) -0.2406 (0.5542) 14.4015 (0.0061) Cross-Correlation Terms (ci)

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

172
Table 4-Daily Autocorrelation and Cross-Correlations Between QQQ and MDY Daily Returns
This table compares the predictive ability of daily autocorrelations and cross-correlations for the QQQ and MDY indices. Section A contains the autocorrelations in the QQQ sample and the cross-correlations between the QQQ returns and the S&P 500 Index. Section B presents the autocorrelations in the MDY sample and the cross-correlations between the MDY returns and the S&P 500 Index. In the regression models below, RQQQ,t RQQQ,t-1 RMDY,t and RMDY,t-1 are the daily percent returns on day t and day t-1 for QQQ sample and the MDY matching sample, respectively, and RSPY,t-1 is the return on day t 1 for the S&P 500 index security. The Q1t, Q2t, Q3t and Q4t are dummy variables that equal one when the AOII falls in a given quartile and zero otherwise. Standard errors for the regression coefficients are adjusted using the Newey and West (1987) correction. The sample sizes for all regression models are 163. The Chi-Square value for the joint hypothesis test for the equality of the coefficients is also presented. Coefficient with p-value in parentheses Intercepts AOII Dummy Variable (ai) Autocorrelation Terms (bi) Cross-Correlation Terms (ci)

Section A: Daily Autocorrelations and Cross-Correlations for the QQQ Returns First Quartile Second Quartile Third Quartile Fourth Quartile Joint Test of Equality 3.3099 (0.0001) 1.0622 (0.0002) -0.6891 (0.0723) -3.4481 (0.0001) 189.9817 (0.0001) -0.3433 (0.0114) -0.3955 (0.0119) -0.0795 (0.7851) -0.4783 (0.0058) 20.4103 (0.0004) -0.2767 (0.2657) 0.4031 (0.3607) -0.2171 (0.6502) 0.7839 (0.0542) 5.9856 (0.2002)

Section B: Daily Autocorrelations and Cross-Correlations for the MDY Returns First Quartile Second Quartile Third Quartile Fourth Quartile Joint Test of Equality 1.5382 (0.0001) 0.4333 (0.0262) -0.0553 (0.7851) -1.2398 (0.0001) 82.8184 (0.0001) -0.5191 (0.0363) -0.1238 (0.5396) -0.0485 (0.8569) -0.2759 (0.0496) 8.6432 (0.0707) 0.4487 (0.1593) -0.0052 (0.9852) -0.0896 (0.8024) 0.2592 (0.3478) 2.9251 (0.5705)

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

173 CONCLUSION The specific purpose of this research was to investigate the influence the readily available Ameritrade Online Investor Index exerted on the returns of two actively traded exchange traded funds. For the returns of the Cube, the autocorrelations (three of the four quartiles) dominated the influence of the cross-correlations (one of the four quartiles) with the market index. These results show that current returns react inversely to the lag of the most recent value of the same return, rather than other market information. For the Mid-Cap SPDR, only the first and fourth quartiles autocorrelations were statistically significant and negative. No evidence of the influence of the returns of the broad market index was found. In a broader sense, this paper presents an extension of the tests for financial market efficiency. Unlike previously documented exceptions to this core concept, such as the January effect and the day-of-the week anomalies, the information contained in the buying and selling decisions of this group of online were not associated with positive returns in the examined assets. Instead, an active investment strategy could be devised using short-selling of the QQQ. The decision rule incorporates the interaction between a negative return on the Cube and the AOII ending between 12% to 40%, if these conditions are met, the investor should short-sell the Nasdaq 100 fund. Otherwise, holding the current position would be the correct choice. Future research is planned to test the return generating capabilities of the proposed strategy.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

174 REFERENCES Abraham, A. & D. Ikenberry (1994). The individual investor and the weekend effect. Journal of Financial and Quantitative Analysis, (June), 263-277. Ameritrade Press Release (1999). Ameritrade launches online investor index: First daily measurement of behavior of online investors. (December 1). Chordia, T. & B. Swaminathan (2000). Trading volume and cross-autocorrelations in stock returns. Journal of Finance, (April), 913-935. Higgins, E. & D. Peterson (1999). Day-of-the-week autocorrelations, cross-autocorrelations, and the weekend effect. The Financial Review, (November), 159-170. Higgins, E., S. Howton & S. Perfect (2000). The impact of the day of the week on IPO return autocorrelation and cross-correlation. Quarterly Journal of Business and Economics, (Winter), 57-67. Lakonishok, J. & E. Maberly (1990). The weekend effect: Trading patterns of individual and institutional investors. Journal of Finance, (March), 231-243. Miller, E. (1988). Why a weekend effect? Journal of Portfolio Management, (Summer), 43-49. Newey, W. & K. West (1987). A simple, positive, semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica, (May), 703-708. Perfect, S. & D. Peterson (1997). Day-of-the-week effects in the long-run performance of initial public offerings, Financial Review, (February), 49-70.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

175

LOAN PRICING: A PRICING APPROACH BASED ON RISK


James B. Bexley, Sam Houston State University Leroy W. Ashorn, Sam Houston State University Joe F. James, Sam Houston State University
ABSTRACT Loan pricing is one of the most critical decisions facing financial institution managers. Competition has forced management to continuously review loan pricing with a "sharper pencil" in light of stiffer competition for a share of the available loan pool. If the institution is to be successful and ensure continued profitable existence, there must be a balance between loan loss control and pricing to generate profitability. This study looks at the loan pricing dilemma from a risk management perspective that minimizes the number of calculations required to arrive at the risk factor. INTRODUCTION In the past, substantial lip service has been given to the impact of poor loan decisions upon a bank's profitability. In light of the substantial number of bank failures and declining bank earnings suffered across the nation during the 1980s and 1990s, this lip service obviously was not heeded. When talking of a one percent loan default rate, there is a notion that one percent is not statistically significant. However, the reality of a $100 million bank with a 65% loan-to-deposit ratio and a one percent loan loss equates to a $650,000 impact. Furthermore, a $100 million bank earning a return on average assets of 1.2% would return $1.2 million annually. Now, if there is a one percent loan loss in the $100 million bank which earned $1.2 million, it would be necessary to look at the impact of a reduction in either the loan loss reserve or the charge to earnings, to replenish the loss to the reserve. In either case, the result would be an impact on net earnings reducing the return from $1.2 million to $550,000. In this example, a one percent loss from loans could cost the bank over 50% of its normal earnings! DEALING WITH THE FOUR CATEGORIES OF RISK In looking at the loan pricing aspect of a bank from an asset/liability standpoint or risk scenario, several concepts should be instantly considered by the bank practitioner. Prior to establishing a strategy for developing a pricing model, much consideration should be given to the various means of measuring risks. Hempel, et al (1994, pp. 67-68), has developed an excellent concept of measuring risk based on four categories of risk identified as liquidity risk, interest rate risk, capital risk, and credit risk. Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

176 The element of liquidity risk addresses the bank's ability to consciously deal with shortfalls in the supply of money either through excess withdrawals or substantial commitments of the bank's funds for loans and other income-producing devices. Therefore, the liquidity of the bank is paramount to being able to stay in business given the approximate 14 to 1 leverage to capital ratio in the average bank. In considering liquidity, the following formula will give you the liquidity risk: Liquidity Risk = Short Term Securities / Bank deposits In recent years, most banks have purchased or developed sophisticated modeling packages that give a detailed picture of the various scenarios that would exist for a bank given differing economic conditions. In examining the interest rate risk, the concern lies with the assets of the bank that are subject to interest sensitivity as opposed to balancing these elements with the liabilities, which are also interest-sensitive. In a perfect world, assets and liabilities would be balanced at an equal level. Needless to say, banks do not exist in a perfect world and, as a result, we find the need to constantly look at the bank's position in each scenario. To measure interest rate risk, the following formula should be utilized: Interest Rate Risk = Interest Sensitive Assets / Interest Sensitive Liabilities In determining the make-up of interest-sensitive assets, you should include short-term securities and all variable rate loans. Transaction deposits, short-term time and savings deposits, and short-term borrowings should be treated as interest-sensitive liabilities. A risk that is often taken for granted, which is critical to the foundation integrity of a bank, is that of credit risk. In looking at credit risk, we are seeking to determine the basic exposure of the bank in all areas of credit extension. In the previous example of the bank with a one percent loan loss, it becomes very clear that credit risk evaluation is essential to the viability of the bank. The formula for credit risk is arrived at as follows: Credit Risk = Medium Loans / Assets Medium loans would be those loans having average loss potential as opposed to those loans of extremely high or extremely low quality. Although, there is an element of judgment in determining what are medium loans most banks have classified their levels of risk on the loan portfolio in order to easily establish those loans with average loss potential. Capital risk addresses how much the bank's assets may decline before the depositors, creditors, and shareholders are put at risk. The more capital the bank has, the better the cushion to absorb loss to the bank's at-risk assets. The formula associated with capital risk is as follows: Capital Risk = Capital / Risk Assets

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

177 RETURN OBJECTIVES Banks have traditionally based their pricing either on what the competition was doing or on what the market would bear. It has become obvious that, in the current competitive environment, those old methods will not work. Before setting pricing parameters, the bank should set some basic return objectives such as return on average assets, return on average equity, and net interest margin. Equally important to meeting the objectives is the establishment of a loan-to-deposit ratio. Why should the bank be concerned with return on average assets and return on average equity since these are in reality end-result or "big picture" considerations? The answer is very simple. If it is not focused on the desired end-result, the bank cannot ensure a sufficient volume of loans priced at the rate desired in order to reach its goal until it is too late to do anything about the results. In addition, if the desired goal has been established, the bank has a yardstick against which to measure results. The formulas for return on average assets and return on average equity are as follows: Return on Average Assets = Net Income / Average Assets Return on Average Equity = Net Income / Average Equity The net interest margin continues to be impacted by the competition for good loans and considers the interest earned on loans less the interest paid for the money. The formula for net interest margin is as follows: Net Interest Margin = ( Interest Income - Interest Expense ) / Earning Assets It is obvious that, as rates become more competitive, there are only so many loans to be divided up among all of the banks and the other entities that have invaded what was for years a market dominated by banks. At the same time, the investor has more options than ever before concerning where to invest his or her money for optimum return. What we see in this picture is the bank being squeezed to pay more for its deposits and charge less for its loans. This equates to a reduced net interest margin. The only way to avoid the impact of such a problem is the competitively price loans with deposit or fee requirements and to strategically price deposits in such a way to avoid being the highest bidder. For example, look at deposit pricing in the market and price at approximately 10% above the average price paid for deposits. COMPETITION AND PRICING For years the small-to middle-sized banks escaped the competitive pricing challenges facing the large, regional banks. Given the competition for quality loans from within the banking community as well as the non-banking entities, bankers everywhere must now be creative and price loans off of London Interbank Offer Rate, as well as their time-tested base or prime rates, if they have any hope of staying competitive. Gone are the days when a bank in some small market could assume that it had a "lock" on a loan merely because there was not another bank within miles. Mass Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

178 communications, computer banking, and the Internet have brought Wall Street and the world to every Main Street, U.S.A. Koch (1995, p. 763) stated, "The fact that loan losses were so high during the 1980s revealed that loans were not priced high enough to compensate for default risk, as well as other risks, and the cost of operating the bank." We agree with Koch and would point out that, since the 1980s, competition has increased. Should banks and other financial institutions fail to price their loans in such a way as to ensure compensation for all of the known risks, they stand to repeat the errors of the 1980s. HISTORICAL PRICING METHODS Banks have historically priced their loans utilizing several traditional methods. For years the primary method for loan product pricing was using a variation of a bank's prime lending rate or a regional money center bank's prime rate. This method implied that the bank's best customer (whether judged by risk or deposit balances) was given the prime lending rate. All other customers were priced either at prime or some variation of prime, plus a given percentage rate. This method dominated loan pricing until the mid-to-late 1970s when several occurrences caused the method to lose popularity. First, the competition for quality loans drove the money center banks to look to more exotic pricing methods to attract the large, blue-chip companies. This new methodology based off of LIBOR was then embraced by banks in Middle America. The second occurrence was a series of lawsuits challenging banks' use of the prime rate as the principal method for pricing loans. Today, in lieu of a prime rate, banks are utilizing the term "base rate" as the rate on which they price their loans. While many banks continue to use the base rate or prime rate (disavowing that it is the best or lowest rate), banks continue to search for a method of loan pricing that incorporates risk and at the same time allows the bank to obtain a reasonable profit index. CUSTOMER PROFITABILITY ANALYSIS In the quest for a method of lending money that would price the product being sold by the bank similar to an industrial product, large money center banks and regional banks turned to customer profitability analysis as a means to include all the costs for bank loans and services as well as a profit margin. For the most part, smaller community banks stayed with base rate pricing due to the cost and complexity of establishing and maintaining accurate costs for products and services. This method required an accurate costing of all the bank's products, which was then applied to individual customers on an activity or volume basis. At the same time, the customers were given credit for balances maintained and charged for the cost of reserves and several other items. COMPENSATING BALANCES For years, bankers have tried to recognize the deposit balances maintained by their commercial loan customers and give credit, either formally or informally, for those balances when setting a rate for a loan to the customers who maintain deposit balances. This method has been utilized by more community banks than the large money center banks or regional banks. Banks Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

179 utilizing this method would usually establish a peg or base rate and, depending on how large a balance the customer maintained, the bank would make the loan at the peg or base rate or at a rate of some percentage over the peg or base rate. Some banks would also try to allow for risk as they set the rate, but the calculation was less than scientific. FEE-BASED LENDING As competition for loans heated up, corporate financial officers saw an opportunity to play one bank against another. These corporate financiers told the banks in ever-increasing numbers that they preferred to pay a fee rather than be required to maintain what to them amounted to unproductive compensating balances. As Koch (1995, p. 771) pointed out in his discussion of fee income for banks, banks developed three distinct methods of utilizing special fees in the pricing of loans. Those methods (usually some amount less than 1%) were facility fees, commitment fees, and conversion fees. Facility fees were utilized to charge the customer a fee for making funds available, whether they were utilized or not. On the other hand, a commitment fee is charged only on that portion of the committed funds that are not drawn down. Conversion fees were charged on those loans which were converted to another type of loan. RISK-BASED PRICING With the concentration by both regulators and bankers on risk management, the time has come for banks to price their loans based on some measure of risk related to loan price or reward to the bank. Several authors support this position although they arrive at the concept in differing ways. Sinkey (1998 pp. 420-422) believes that you should score the creditworthiness of the borrower using a statistical model. Koch (1995, p. 778) is of the opinion that banks have generally underpriced loans because they have understated risk, and therefore, they should identify both expected and unexpected losses, incorporating both in the risk charge for a loan. While we certainly agree that both Sinkey and Koch have developed scholarly and workable approaches to the incorporation of risk, we are more concerned with developing a pricing mechanism that can be utilized equally well by the small community bank and the large regional bank. Our method would assign a numeric value to the various segments of the loan portfolio to be converted to a pricing factor that would be added to a pre-established loan rate based on conventional pricing methods. Possible risk categories to implement the start-up of a risk pricing scenario are as follows:
Risk Price 1 2 3 4 Defined Risk Within Category 0 +0.25% +0.45% +0.75% Cash or CD Secured, or Government Guaranteed Loan Loans Secured by Stock, Cash Value Life Insurance, or Corporate Bonds Average Risk Loans Secured by Real Estate, Receivables, etc. Above Average Risk Loans to Firms with Slightly Deteriorating Profitabilities, etc.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

180 We would then adjust the risk rates on a historical moving average basis that would be gathered from loss experience in the various grade categories (based on the grade category the loss originated from not where it went to loss). After several years, a migration analysis or historical moving average would be used, much like that currently used on calculations of historical loan loss reserve as required under Banking Circular 201. For example, let's assume that the bank had set a rate of base +0.50% for a loan with a risk category 2. In our risk pricing scenario, we would add an additional 0.25% to the conventional pricing. Assume that, instead of category 2, the risk were category 4. We would then add 0.75%, which would make the loan price out at base rate plus 1.25%. CONCLUSION Regardless of the method chosen, risk must be an integral part of the loan pricing scenario to adequately compensate the bank for credit exposure. Utilizing the risk based pricing method, a bank over several years time would have a reasonably accurate means of pricing to incorporate risk. REFERENCES Hempel, G., Simonson, D., & Coleman, A. (1994) Bank Management Text and Cases; 4th Edition. New York: John Wiley & Sons, Inc. Koch, T. (1995) Bank Management; 3rd Edition. Austin: The Dryden Press; Harcourt Brace College Publishers. Sinkey, Jr., J. (1998) Commercial Bank Financial Management; 5th Edition. Upper Saddle River, NJ: Prentice Hall.

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

181

Allied Academies invites you to check our website at

www.alliedacademies.org
for information concerning conferences and submission instructions

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

182

Allied Academies invites you to check our website at

www.alliedacademies.org
for information concerning conferences and submission instructions

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

183

Allied Academies invites you to check our website at

www.alliedacademies.org
for information concerning conferences and submission instructions

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

184

Allied Academies invites you to check our website at

www.alliedacademies.org
for information concerning conferences and submission instructions

Academy of Accounting and Financial Studies Journal, Volume 5, Number 2, 2001

You might also like