Connecting Academic Research with Standard Setting

1
Connecting Academic Research with Standard
Setting
Ray Pfeiffer, FASB Research Fellow Robert
Bloomfield, FASRI Director Thomas J. Linsmeier,
FASB Member
AAA/FARS Midyear Meeting January 30, 2009
2
Presentation Overview

• Each of us will provide update on a major issue
  facing the FASB
• Ray International Convergence
• Rob Financial Statement Presentation Project
• Tom Measurement Bases and Fair Value
• and will identify areas where academic research
  can be connected
• How FASB uses research in setting standards
• Roles for academics at the FASB
• Some FASB initiatives to advance research

3
The Standard Disclaimer

• The views expressed in this presentation are
  those of the presenters and do not represent
  positions of the Financial Accounting Standards
  Board. Official positions of the FASB are
  determined only after extensive deliberation and
  due process.

4

• Moving Toward a Single
• Accounting Language

Ray Pfeiffer FASB Research Fellow and Professor,
Isenberg School of Management University of
Massachusetts January 30, 2009
5
Context

• A single set of global standards is an old idea.
• Many countries recently moved from national GAAP
  to IFRS
• SEC Concepts Release (August 2007) and Roadmap
  (November 2008) have accelerated the discussion.
• Academics contributions to date
• Effects of adoption (mandatory and voluntary,
  Daske, et al. WP 2007, JAR 2008)
• Learning from 20-F reconciliations (see FRPC
  report 9/24/07)
• Relative quality of different standards (e.g.,
  Leuz, et al. 2003 JFE)
• My role in all of this and resulting perspective

6
A Common Sense Notion?

• All companies should use the same accounting
  standards for preparing financial reports.
• Isnt it just common sense?

7
Arguments Supporting Convergence

• Globalization has increased demand for
  cross-border financial communication.
• A single set of standards will
• increase comparability,
• increase demand for U.S. securities, and
• produce cost savings for some preparers.

8
Counter-arguments

• Factors other than standards influence
  comparability
• Reporting incentives
• Auditing and enforcement regimes
• Differences in culture and institutions
• In the U.S., macroeconomic benefits are unlikely
  given existing high quality infrastructure.
• Sovereignty and political considerations

9
The SECs Roadmap

• A proposed process to a decision not a decision.
• A particular means to an agreed-upon ideal end
• A single set of high-quality global accounting
  standards.
• Developed by a high-quality global accounting
  standards setter.
• A benefit-cost approach
• A limited option for early adoption of IFRS

10
Benefits and Costs

• Benefits
• Comparability benefits are uncertain, especially
  without auditing and enforcement.
• IFRS are not better, so improvements in
  standards are needed to generate benefits from
  adoption.
• Global standard setter must be high quality.
• Cost savings are also uncertain.

11
Benefits and Costs

• Costs
• Identified in the Roadmap
• Transition costs (for everyone)
• Impacts on non-public entities and other uses of
  financial reports (e.g., tax, regulatory)
• Other costs
• A two-GAAP system
• Yielding control/influence over standard setting
• Standards that may fit less well in the long
  run (less guidance, less specificity to U.S.
  circumstances)

12
Net Benefits or Costs?

• Are the net benefits positive?
• A better question
• What work needs to be done to understand the key
  decision-relevant factors?
• How can we minimize costs and maximize benefits
  to achieve the desired end goal?

13
Should the U.S. Adopt IFRS?

• Whats likely to happen if we do?
• We have evidence from empirical research on
  other jurisdictions adoptionsbut
• The U.S. is different
• More developed existing standards
• Higher proportion of stock ownership among
  population
• More advanced regulatory structure
• Unique legal environment
• Whats likely to happen if we do not adopt?
• What alternative paths are there?
• What are their relative benefits and costs?

14
Factors maximizing the success of a single
accounting language

• An improved language (IFRS)
• Completion of the joint projects with the FASB
  (MOU, 9-11-2008)
• A mechanism for long-run continuous improvement
  of the language
• Global cooperation in
• Auditing convergence
• Enforcement convergence
• Solution(s) for non-public (private and
  not-for-profit) entities.
• Changes in mind-set (e.g., judgment framework)
• Convergence in global business culture and
  practice

15
How Can Academic Research Help?

• Synthesizing what we already know.
• Providing insight on unanswered questions
• Accounting/markets questions
• How do standards affect reporting outcomes
  vis-à-vis other factors?
• How important is comparability (e.g., De Franco,
  et al. 2008 WP)?
• How do incentives, standards, auditing, and
  enforcement interact in generating high-quality,
  comparable financial reports?
• Political economy and sociology questions
• What are key elements of well-designed
  international institutions?
• How do regulation and standards influence the
  behavior?

16
The FASB Research Fellow Position

• Objective
• To provide an in-house resource to the Board and
  Staff
• Channeling and translating relevant research to
  project teams.
• Connecting with researchers
• Providing an academic perspective
• Position description
• Fantasy camp
• We want YOU! (For 2009-10)

17
Resources

• IASB http//www.iasb.org
• FASB http//www.fasb.org
• MoU http//www.fasb.org/intl/MOU_09-11-08.pdf
• SEC http//www.sec.gov/
• AICPAs IFRS http//www.ifrs.com/
• Me rjpfeiffer_at_fasb.org

18

• The Financial Accounting Standards Research
  Initiative

Robert Bloomfield FASRI Director Nicholas H.
Noyes Professor of Management Professor of
Accounting The Johnson School Cornell
University January 30, 2009
19
FASRI

• Overview of Goals
• FASB Research Office Hours
• Financial Statement Presentation
• Key elements of Discussion Paper
• FASRI Research Activities
• Opportunities to Get Involved

20
FASRIs Charge

• Help the FASB achieve its standard-setting
  mission by
• Marshalling the existing knowledge and energy of
  academic researchers, and
• Providing those researchers with
• Guidance on the FASBs needs and goals, and
• Access to FASB constituents.
• Performing research that informs standard-setting
  deliberations

21
FASB Research Office Hours

• 2008
• CIFR (Pozen) Report (Sue Bielstein)
• Leasing (Danielle Zeyher)
• Emissions Trading Schemes (David Elsbree)
• Revenue Recognition (Jeff Wilks)
• Financial Statement Presentation (Kim Petrone,
  Bob Lipe, Denise Gomez, Aida Vatrenjak)
• Codification (Chad Bonn)
• Conference Follow-up I Liabilities and Business
  Risk
• Conference Follow-up II Leases (Christine
  Botosan, Leslie Hodder, Cathy Shakespeare)
• The Role of Financial Reporting in the Credit
  Crisis (Tom Linsmeier)

• 2009
• International Convergence (Ray Pfeiffer)
• Q A (Larry Smith)
• Upcoming
• Financial Instruments (Shea Malcolm)
• Q A (Marc Siegel)
• Researchers (YOU!)
• Getting Involved
• Web Content
• CPE Credit
• Research Follow-Ups

22
FASB Research Office Hours

• To foster communication among standard setters
  and researchers.
• Rob Bloomfield, FASRI
• Ray Pfeiffer (FASB Research Fellow)

23
FASB Research Office HoursSage Hall, Second Life
24
Picture from Office Hours
25
What You Need

• A reasonably recent computer, Second Life
  account, Second Life client
• Second Life accounts and client installation are
  free
• A good broadband connection
• Wired better than wireless
• A headset, if you want to talk
• USB recommended
• Personal assistance availablejust email Rob
  Bloomfield rjb9_at_cornell.edu

26
Financial Statement Presentation

• A FASB/IASB Joint Project
• Discussion Paper Issued, October 2008
• Comments due April 2009
• Targeted for issuance 2011

27
Financial Statement Presentation

• Financial statements should
• Portray a cohesive financial picture
• Make clear relationships between line
  items/sections across statements and that
  statements are complementary part of total
  economic picture
• Disaggregate information so that it is useful in
  assessing future cash flows
• Present information about liquidity and
  financial flexibility
• Ability to meet financial commitments and invest
  in business opportunities

28
Working Format
29
Sections Categories

• Business Operating
• Assets and liabilities used in primary revenue
  and expense generating activities
• Business Investing
• Assets and liabilities, if any, used to generate
  a return,but not part of primary activities
• Financing Assets and Liabilities
• Used to fund business activities
• Interchangeable with other sources of financing

30
Classification Guidance

• Classification of assets and liabilities drives
  classification of changes in those items in
• Statement of comprehensive income
• Statement of cash flows
• Classification based on managements view of its
  business financing activities
• Accounting policy note disclosure
• Classification at reportable segment level

31
Other Sections

• Equity
• As defined by GAAP
• Discontinued Operations
• As defined in IFRS 5 and SFAS 144
• Considering new definition in separate joint
  project
• Income taxes
• All current and deferred income tax assets and
  liabilities recognized in SFAS 109 and IAS 12

32
Schedule Reconciling Cash Flows to Comprehensive
Income

• Users want to better understand cause of changes
  in assets and liabilities
• Objectivity and Persistence
• Disaggregate
• Cash flows
• Accruals and systematic allocations
• Recurring valuation adjusts/fair value changes
• Remeasurements other than recurring valuation
  adjusts/fair value changes
• FASB separate column for unusual and infrequent
  events or transactions

33
Reconciliation Schedule
34
Research Projects

• Do categorization and detail help credit analysts
  make forecasts and judgments?
• Compare two firms, both facing demand decline
• Both have same overall operating leverage, but
  ones PPE assets are investing, the others are
  operating
• Manipulate whether F/S are categorized, detail is
  provided
• Does the reconciliation help equity analysts
  project earnings?
• Compare two firms
• Ones has more income in form of cash, other in
  accruals
• Manipulate presence of reconciliation

35

• Deviations from Historical Cost A Standard
  Setters Perspective on Measurement Bases

Thomas J. Linsmeier FASB Board Member January
30, 2009
36
Deviations from Historical Cost

• At start of work on the measurement phase of the
  Boards Conceptual Framework project, the FASB
  staff created an inventory of measurement bases
  used in current financial reporting
• To my surprise, they identified 29 different
  measurement bases only one of which is
  historical cost
• The other 28 bases represent deviations from the
  original transaction price due primarily to
• Historical cost allocations
• Remeasurements to current value
• Most of these deviations are based on judgments
  about future amounts/events (cash flows, discount
  rates, bad debts , warranty expenditures, useful
  lives, salvage values, patterns of benefit)
• Each of these judgments affect the relevance,
  reliability and comparability of reported
  information

37
Standard Setters Should Select Amongst
Measurement Bases

• Based on considerations about whether the
  resulting financial statements as a whole best
  meet the objective of financial reporting
• Our revised conceptual framework suggests the
  financial reporting objective is to help
  suppliers of capital to a firm in making rational
  decisions about
• The pricing of the capital supplied (investment
  decisions)
• Managements performance in using the capital
  (stewardship/governance decisions)
• Instead, however, standard setters generally have
  made the selection of measurement bases on a line
  item-by-line item basis

38
Facilitating Users Decisions

• In selecting amongst measurement bases, we must
  recognize that financial statements lose their
  decision usefulness as more measurement bases are
  permitted or required
• Users decisions seldom are based on individual
  financial statement line items, rather they are
  based on ratios and analyses of relationships
  among subtotals and totals within and across the
  statements

39
Facilitating Users Decisions

• Users analyses often require arithmetic
  manipulation and thus cannot be informed
  meaningfully unless the reported numbers are in
  ratio scale
• We, therefore, must evaluate carefully whether
  users decisions would be facilitated best if
• We were to limit (perhaps even to one) the
  numbers of measurement bases used in the
  financial statements as a whole
• Or, if that is not cost-beneficial, whether we
  should be striving to use the same measurement
  basis within sections of the financial statements
  that provide subtotals that users relate to each
  other in making their investment and governance
  decisions

40
A Different Perspective

• This perspective suggests that we may need to be
  thinking very differently about how and where we
  should be drawing the line (if at all) between
  items measured, for example, at current values
  versus allocated historical costs
• Besides looking at the economic characteristics
  of individual line items to decide where to draw
  the line (e.g., value from exchange vs. value in
  use or financial vs. nonfinancial instruments),
  we also should consider
• How groups of line items are being used to make
  investment and governance decisions
• Whether having groups of items measured using the
  same basis might better facilitate users decisions

41
Interaction with Financial Statement
Presentation Project

• In our joint financial statement presentation
  project, both Boards have tentatively decided
  users decisions will be facilitated by
  separating in all three financial statements
• The value creating activities of an entity
  (operating and investing) from the sources of
  financing (internal, debt and equity)

42
Interaction with Financial Statement
Presentation Project

• The disaggregation of value-creation and
  financing activities suggests potential
  considerations for selecting amongst measurement
  bases
• Will users decisions be better facilitated by
  using a single measurement attribute in each of
  the three primary subsections in all three
  statements (operating, investing, and financing)?
  
• Or if current values and allocated historical
  costs both provide benefit for investment and
  governance decisions, would it be better to
  provide two sets of complete statements under
  each major measurement approach?
• Or alternatively, if current values and allocated
  historical costs both provide benefit for
  investment and governance decisions, would it be
  better to consider ways to present separately the
  cash, accrual/deferral, and fair value components
  of income?

43
Relevance

• Answers to the questions on the prior slide,
  would appear to be driven primarily on the
  potential relevance of different measurement
  bases
• This is the appropriate starting point if the
  primary objective is to facilitate users
  decisions
• However, reliability issues also must be
  considered

44
Perspective on Reliability Issues

• Net income Cash /- accruals/deferrals /- fair
  value changes /- other remeasurements
• SEC enforcement actions demonstrate that vast
  majority of accounting manipulations are in
  accruals/deferrals and other remeasurements
  categories
• Fair values also are subject to manipulation if
  prices cannot be observed
• Each type of manipulation has caused market
  problems
• Types sometimes differ in up and down markets
• Accounting manipulation can not be focused or
  blamed on one type
• The issue needs to be addressed within broader
  context of attempting to provide (imperfect)
  financial information that best facilitates
  security pricing and governance decisions

45
Is Conservatism the Solution to
Management-Induced Error?

• From APB Statement 4 conservatism is induced by
  a general preference that measurement errors be
  in the direction of understating net assets and
  income (a unidirectional bias in reported
  numbers)
• Observations
• Is biased reporting the low cost solution to a
  governance problem?
• An alternative Could lenders protect themselves
  by writing conservative contracts, without
  requiring biased reporting that potentially
  affects decision usefulness for equity investors?
  
• Also could the system shift managements
  incentives by reducing benefits (or increasing
  cost) of introducing error?
• Conservatism in accrual/deferral model primarily
  introduced through impairments
• However, impairments often are discretionary
• Fair value remeasurements in down markets may
  result in more conservative accounting by
  requiring writedowns

46
Reasons for Increase in Use of Fair Value
Measures

• In the mid 1970s
• President Nixon broke the Bretton Woods accord
  that had pegged the value of world currencies to
  the U.S. dollar
• OPEC no longer was able to control the price of
  oil
• Black, Scholes and Merton developed option
  pricing models
• The first two of these developments created
  significant new market risks (currency, interest
  rate, commodity) with material affects on the
  profitability of businesses
• The last development provided the mechanism to
  manage these risks the market for derivatives
  and financial instruments has grown nearly
  exponentially ever since
• Huge losses in financial instruments in the late
  80s during the SL crisis and similar losses in
  derivatives in the mid 90s led to new accounting
  standards (115 133) that helped inform
  investors about those risks on a more timely
  basis
• This increased use of fair value is driven by
  market changes but it also puts additional stress
  on the reporting model, exacerbating differences
  in the timing of when economic changes hit income

47
Role of Fair Value in Current Markets

• Statement 157 received a baptism by fire by first
  being implemented in a year where trading of many
  instruments has been quite limited, potentially
  requiring many mark-to-model valuations with
  inherent reliability issues
• Accounting perspective Reliability concerns
  should result in the lesser use of fair value
• Market perspective The reason why limited
  trading is occurring is because investors are
  uncertain about the value of many instruments. To
  make markets liquid will require a reduction in
  investors uncertainty regarding current values
• To achieve this outcome, financial reporting
  should provide more recognition of the best
  estimate of current value
• In addition, to increase investors confidence in
  reported numbers it should require additional
  information about the inputs to the model
  estimates and the sensitivity of valuations to
  changes in key inputs

48
Role of Fair Value in Current Markets

• Hedge fund managers to whom I have spoken have
  said they are willing to buy stock in firms who
  provide such information
• So, in the future, the best means to avoid
  similar market problems may be more fair values
  (with additional disclosures) not less
• However to make this work, we also may need to
  re-evaluate how regulatory capital is set in up
  and down markets
• Is regulatory forebearance (increasing capital
  requirements in up markets and decreasing capital
  requirements in down markets) appropriate public
  policy to help dampen overextension of credit in
  up markets and to motivate extension of credit in
  down markets (countering natural market
  pro-cyclicality)?

49
Conceptual FrameworkImportant Next Steps

• The basis for standard setters to select amongst
  fair values, allocated historical costs and other
  measurement bases will be established in the
  measurement phase of the revised conceptual
  framework
• Development of this phase will involve careful
  analysis of the strengths and weaknesses of all
  approaches and consideration of many vexatious
  accounting issues

50
Role for Research

• Whenever possible, the Boards are seeking to base
  standard setting decisions on empirical evidence
  rather than dogmatic argumentation
• Academic research can play a significant role in
  informing the debate, especially if the analysis
  is deeply contextual and not designed to support
  only one side of the debate about current values
  and allocated historical costs
• Current values and allocated historical costs
  provide the foundation for most measurement in
  our reporting model because they both have merits
  in helping users make investment and governance
  decisions
• A contextual understanding of when one or the
  other of these approaches is the most
  cost-beneficial in facilitating users decisions
  is greatly needed

51
Role for Research

• Selection amongst measurement bases generally
  involves tradeoff between relevance, reliability
  and comparability
• However, these terms do not have precise economic
  meaning
• Research providing economic foundations for
  making these tradeoffs would add much value to
  the debate
• Nissim and Penman 2008 provide a starting point
  for providing an economic foundation for
  evaluating fair values but only from a security
  pricing perspective
• Similar analyses should be done
• For allocated historical costs and
• From a governance perspective
• The best accounting will differ depending on
  circumstances
• Research has the potential to identify the
  circumstances and conditions for standard setters
  to consider in selecting the measurement base
  that best facilitates users decisions

52
Closing

• Questions and observations
• Thanks for your attention!