CAPITALIZATION OF INTEREST, MATERIALITY JUDGMENT DIVERGENCE AND USERS'INFORMATION NEEDS

A review of the international literature surrounding the concept of materiality yields no existing standards, no consensus of opinions, and little consistency of judgments. This study examines the initial application by auditors in the United States of SFAS No. 34 to comparative financial statements. The study finds that, relative to net income or net plant, the amount of capitalized interest judged to be material covers the same range of values as the amount judged to be immaterial. Such overlap suggests that the basis for disclosure or nondisclosure is not at all clear and that comparison of one firm's results with another may be hampered. The suggestion is made that the most immediate solution to this problem is disclosure and communication of the materiality guidelines used by the preparer of the (inancia1 statements.     

Geographic area disclosures under SFAS 131: materiality and fineness

This paper describes and evaluates certain aspects of the enterprise-wide geographic area disclosures provided by Fortune 500 companies in the implementation of SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” The first objective of this study is to determine how companies are complying with the materiality criterion of SFAS 131 for determining when an individual country is reportable. The second objective is to evaluate whether foreign operation disclosures provided by companies in accordance with SFAS 131 result in a finer set of information than was provided under SFAS 14. The results suggest that there is considerable diversity among companies in the way that materiality is defined, with a majority of companies that provide country-level disclosures using quantitative thresholds less than 10%. For a large percentage of companies, the information provided under SFAS 131 appears to be finer than the information provided under SFAS 14. However, a significant minority of companies has taken a step backward in this regard.     

Accountability and auditors’ materiality judgments: The effects of differential pressure strength on conservatism,variability, and effort

This study investigates the effects of differential accountability pressure strength on auditors’ materiality judgments. We evaluate whether incremental levels of accountability (i.e., review, justification, feedback) increase judgment conservatism, decreases judgment variability, and increases effort. One hundred sixty auditors participated in a between-subjects experiment that included a planning materiality task and a proposed audit adjustment materiality task. As predicted, auditors under higher levels of accountability pressure (i.e., justification, feedback) provided more conservative materiality judgments and had less judgment variability than auditors under lower levels of pressure (i.e., review, anonymity). The results also indicate that accountability strength was positively related to the amount of time spent on the task, explanation length, and consideration of qualitative materiality factors. Finally, the results show that use of a planning materiality decision aid influenced the accountability effects for the planning materiality judgment. These judgments were more conservative and less variable when the planning materiality decision aid was available. We consider implications for research, practice, and policy in the context of the study’s limitations.     

The materiality of country-specific geographic segment disclosures

SFAS 131 (1997) substantially changed geographic segment reporting in the United States by requiring disclosures to be made by individual foreign country when operations in an individual country are material. Although SFAS 14 (1976) provided a quantitative threshold for determining separately reportable segments, SFAS 131 provides no guidance for determining when operations in an individual country are material. In SAB 99 (1999), the SEC reminds firms that exclusive reliance on quantitative benchmarks to assess materiality is inappropriate; qualitative factors also should be considered.Using financial analysts as subjects, we conduct an experiment to examine two possible benchmarks for determining the materiality of operations in an individual foreign country: (1) the percent of total operations located in an individual country (a quantitative benchmark) and (2) the level of risk associated with the country in which the operations are located (a qualitative benchmark). The results indicate that across two regions both the magnitude of operations and the level of country risk significantly affect financial analysts’ judgments about firm risk. However, the effect that the magnitude of specific country operations has on risk assessment does not apply to countries of relatively high and relatively low risk. These results suggest that, although materiality is often evaluated in quantitative terms, the qualitative criterion of country risk may dominate in importance.     

Disclosure of contingent legal liabilities

There has long been user dissatisfaction with firm’s disclosure of contingent legal liabilities, and the FASB, IASB, and SEC have all considered compliance issues and standard amendments on this topic in recent years. This study uses a sample of employment discrimination cases to provide evidence on the extent to which current contingent legal liability disclosures provide useful contingency evaluations. Consistent with legal concerns influencing reporting decisions, I find that current disclosure practices provide limited quantitative detail regarding the magnitude of the expected loss. However, the text of the disclosures does provide qualitative indicators of the probability of loss. I find evidence that statements about the inestimable nature of the loss and statements about the firm’s willingness to consider a settlement are related to higher probabilities of loss and higher loss amounts. I also find evidence that statements regarding an existing accrual for losses and warnings about materiality reflect a higher likelihood of a nontrivial loss. These results emphasize firms’ strong resistance to quantitative disclosures of legal contingencies but suggest that existing SFAS 5 disclosures do contain qualitative information useful for evaluating the loss contingency.     

Good disclosure doesn't cure bad accounting—Or does it?: Evaluating the case for SFAS 158

This paper investigates whether the newly required recognition of the funded status of defined benefit (DB) plans under SFAS 158 is incrementally value relevant in its adoption year (2006) relative to the corresponding amounts which were previously disclosed from both equity investor and credit rating perspectives. In equity valuation models, we use a sample of 878 firms (1756 firm years) offering DB plans in 2005 (disclosure year) and 2006 (recognition year), and find no incrementally significant association with market prices of newly recognized amounts under SFAS 158 over the same information that was disclosed pre-SFAS 158. Our credit rating tests, using a sample of 428 DB firms (856 firm years) for 2005 and 2006 also show no differential impact of recognition over disclosure. Overall, we find that equity investors price the SFAS 158-imposed pension differential while credit rating agencies do not, regardless of whether such information is recognized or disclosed in the financial statements. Our results are consistent with efficiency in both equity and credit markets with respect to pension information and suggest that SFAS 158 has not changed the way market participants in aggregate use pension-related financial statement information.     

AUDITORS’ RECOGNITION AND DISCLOSURE MATERIALITY THRESHOLDS: THEIR MAGNITUDE AND THE EFFECTS OF INDUSTRY

Materiality thresholds are the dividing line between material and immaterial information. Recognition materiality thresholds are the dividing line between what is recorded and what is not recorded in the accounts. Disclosure materiality thresholds are the dividing line between what is separately disclosed in the financial statements and what is not separately disclosed. Auditors materiality thresholds are important because they have a significant influence on what information is recorded in the accounts and disclosed in financial statements and hence available for decision making by external parties. However, there are no research findings about recognition thresholds, and those in relation to disclosure thresholds show a lack of consensus. Hence the motivation for this research. The objective of the research is to study auditors’ recognition and disclosure thresholds within the context of industry, which is divided into the industry of the firm and the industry specialization (experience) of the auditor. The results of the study show that: (1) Recognition thresholds are significantly lower than disclosure thresholds. (2) The mean thresholds are 5·7% (recognition) and 8·7% (disclosure). These are in the 5% to 10% guideline provided by Australian accounting standards. (3) The thresholds appear to vary with industry market risk. (4) Auditors appear to use the thresholds from the industry in which they specialize, in an industry in which they do not specialize. The paper discusses the implications of these findings.     

Disclosure versus recognition: Evidence from lobbying behavior in response to SFAS No. 158

This study examines the lobbying behavior of firms following the release of the SFAS No. 158 exposure draft. SFAS No. 158 requires the recognition of previously disclosed net pension and postretirement benefit obligations on the balance sheet. The study documents that firms that lobbied against the pronouncement had large, underfunded plans and the decision to lobby was related to the magnitude of the SFAS No. 158 balance sheet adjustment. The findings have important implications for the recognition versus disclosure debate because they document management’s reaction to the relocation of information disclosed in the financial statement footnotes to its recognition on the balance sheet.     

Disclosure versus recognition: the case of expensing stock options

The SFAS 123R comment process generated over 6,500 comment letters, most of which were against the standard’s enactment. This outpouring of emotion indicates that many believe that disclosure versus recognition matters. Our paper provides evidence for the debate whether managers’ discretion, motivation, and accuracy of stock option estimates differ under the recognition and disclosure reporting regimes. We compare firms that are mandatorily forced to recognize stock options expense with those voluntarily choosing to do so. First we find that mandatory firms (versus voluntary) with more intensive stock option granting tend to understate option estimates, especially in the post SFAS123R period. Our results suggest that a higher recognition cost motivates firms for doing so. Second, we find that mandatory firms with lower future operating risk have better accuracy in the post SFAS123R period, as compared to themselves in the pre SFAS123R period and voluntary firms in the post SFAS123 period. Our results support the notion that the informativeness of option estimates explains the level of accuracy. The findings of this paper add to the debate on the benefits of recognizing stock option expenses.     

Improving consistency in interpreting SFAS 5 probability phrases

Statement of Financial Accounting Standard No. 5, Accounting for Contingencies (SFAS No. 5), relies on verbal probability phrases to guide recognition or disclosure decisions for loss contingencies. One of the challenges facing accountants is that verbal probability terms are vague and may have multiple meanings; thus, different accountants may interpret the same probability phrase differently. Given this background, our study addresses the difficulty of interpreting verbal probability phrases and explores a simple way to improve judgment quality. Evidence from our experiment suggests that supplementing verbal probabilities with their corresponding numerical values reduces interpersonal variability in interpreting SFAS No. 5 terms.     

Segment Disclosure Transparency and Internal Capital Market Efficiency: Evidence from SFAS No. 131

Using the adoption of SFAS 131, I examine the effect of segment disclosure transparency on internal capital market efficiency. SFAS 131 requires firms to define segments as internally viewed by managers, thereby improving the transparency of managerial actions in internal capital allocation. I find that diversified firms that improved segment disclosure transparency by changing segment definitions upon adoption of SFAS 131 experienced an improvement in capital allocation efficiency in internal capital markets after the adoption of SFAS 131. In addition, I find that the improvement in internal capital market efficiency was greater for firms that suffered more severe agency problems before the adoption of SFAS 131 and also for firms whose managers faced stronger incentives to improve efficiency after the adoption of SFAS 131. My results suggest that more transparent segment information can help resolve agency conflicts in the internal capital markets of diversified firms, thus improving investment efficiency.     

The impact of SFAS No. 141 on earnings predictability of merging firms: Evidence from the initial year of implementation

This study examines the impact of SFAS 141 on earnings predictability of merging firms. I expect a relative improvement in analysts’ earnings forecast accuracy for merging firms versus non-merging peers after SFAS 141 adoption. I restrict the post-SFAS 141 sample to the initial year of SFAS 141 implementation. This research design disentangles effects of SFAS No. 141 from those of SFAS No. 142. The evidence from analysis of 48 pairs of merging and matched non-merging firms is consistent with expectations and confirms the increase in earnings predictability for merging firms versus their non-merging peers post-SFAS 141. Results of additional tests suggest that earnings predictability improvement more likely follows from extended disclosure requirements and the other changes in the Purchase Method (“better purchase” issue) than from the elimination of Poolings-of-Interest (“purchase vs. pooling” issue).     

The Valuation of MNC International Operations During the 1990s

We investigate how international operations affected firm value during the early 1990s. We also investigate whether the disclosures of foreign operations in specific geographic regions under SFAS No. 14 provide investors with useful information beyond disclosure of aggregate foreign operations. We find that in the early 1990s, investors do not value international operations as highly as domestic operations, and that geographic region disclosures are not useful for conveying information about the specific location and magnitude of the firm's operations. This latter finding supports the recent FASB decision that eliminated the requirement that firms break out foreign operating statistics by geographic region.     

Firms' Voluntary Recognition of Stock-Based Compensation Expense

We investigate factors associated with firms' decisions in 2002 and early 2003 to recognize stock‐based compensation expense under Statement of Financial Accounting Standards (SFAS) No. 123. We find that the likelihood of SFAS 123 expense recognition is significantly related to the extent of the firm's participation in capital markets, the private incentives of top management and members of the board of directors, the level of information asymmetry, and political costs. Although recognizing firms have significantly smaller SFAS 123 expense, we find no significant incremental relation between recognition likelihood and SFAS 123 expense magnitude after controlling for other factors that we expect explain the recognition decision. We also find positive and significant announcement returns for earlier announcing firms, particularly those stating that increased earnings transparency motivates their decision.     

The Impact of SFAS No. 14 Segment Information on Price Variability and Earnings Forecast Accuracy

This study provides empirical evidence on the economic effects of Statement of Financial Accounting Standards (SFAS) No. 14 segment disclosures. Required disclosures under this standard subsume those of the Securities and Exchange Commission' (SEC) 1970 line-of-business disclosure rule both in terms of the variables to be disclosed and the degree of decomposition of the consolidated information. Consequently, this study hypothesizes that stock price variability will be greater at the time of, and security analysts' earnings forecasts more accurate following, release of these disclosures. The results of the empirical analysis support these hypotheses. They indicate that SFAS No. 14 segment disclosures convey incremental information over previously reported SEC line-of-business information that is relevant to stockholders and to security analysts.     

Information Content of Earnings and Earnings Components of Commercial Banks: Impact of SFAS No. 115

SFAS No. 115 modified classification of debt and equity securities held by firms and also modified the reporting format for unrealised gains/losses on security transactions (URGL). This study investigates whether implementation of SFAS No. 115 improved information content of earnings and earnings components of commercial banks. Improvement in the information content is measured by comparing the association between equity returns and earnings and earnings components of the post-adoption period of SFAS No. 115 with the pre-adoption period.The test results indicate that the association of equity returns with earnings components and aggregate earnings is significantly stronger in the post-adoption period compared to the pre-adoption period. The improvement is especially evident for the components of URGL and non-interest revenues. These results suggest that information provided by earnings components is considered more value relevant for investment decision after implementation of SFAS No. 115. Findings on non-interest revenues indicate that revenues from banking activities other than lending also play an important role in the commercial banks' profitability.     

Utilization of SFAS No. 14 disclosures in assessing operating risk

This paper examines the usefulness of segmental disclosures required by SFAS No. 14 in assessing the operating risk of the firm. It is shown that the segmental asset data required by SFAS No. 14 is theoretically linked to an assessment of operating risk. In addition, an empirical investigation is conducted to examine whether this new disclosure was material enough to cause a reassessment by market participants of the operating risk of the affected firms. Segmental disclosure policy implications of the findings of this study are also discussed.     

The influence of disclosure policy on analyst behavior: The case of segment data

More transparent disclosure reduces the effort required to process reported information. The adoption of Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information, increased the transparency of segment information reported by diversified firms. Using a long sample window (1988–2007) and a difference-in-difference design, this paper examines the association between corporate diversification and analysts' efforts—as reflected in analysts' idiosyncratic information precision and analyst consensus—across the old SFAS No. 14 and the new SFAS No. 131 segment reporting regime. Results indicate that SFAS No. 131 has improved segment reporting such that analysts need to invest relatively less effort generating idiosyncratic information when issuing forecasts for diversified firms. Given that analysts' information gathering efforts are costly, these findings are of interest to policy makers when assessing whether the intended reporting objectives of SFAS No. 131 are being met in a cost effective manner.     

The Usefulness of Derivative-related Accounting Disclosures

The Financial Accounting Standards Board attempts to improve reporting and disclosure of derivative transactions through SFAS Nos. 105, 107, and 119. These statements require recognition of gains or losses on trading purpose derivatives, and disclosure of notional principal amounts, credit exposures, and fair values of trading and nontrading derivatives. Using a multiple regression model, this study investigates the relevance of these disclosures to stock returns for a sample of large banks. All derivatives-related disclosures, except for notional principal amounts, are found to contain new information not incorporated in market beta and earnings. These results support the Board's derivative disclosure requirements.