Corporate investment and changes in GAAP

Abstract

This paper investigates whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. Using a sample containing forty nine changes in GAAP, I find that changes in accounting rules affect investment decisions. I then examine two mechanisms through which changes in GAAP affect investment. First, I find that changes in GAAP affect investment, particularly R&D expenditures, when firms have financial covenants that are affected by changes in GAAP. Second, I find evidence suggesting that the process of complying with some changes in GAAP alters managers’ information sets and consequently changes their investment decisions, particularly their capital and R&D expenditures and, to a weaker extent, their acquistion expenditures. This paper contributes to the literature on the real effects of accounting by providing evidence that accounting rules affect investment decisions even when the rule change does not concern the measurement and reporting of investment, and by documenting specific mechanisms through which the relation manifests.

Appendices

Appendix 1: Identifying changes in GAAP that are likely to inform managers

Hypothesis 3 predicts that some accounting changes can inform managers and facilitate their investment decisions. A crucial component of this test is identifying which changes in GAAP are more or less likely to inform managers. I discuss my identification choices for the 13 standards that were adopted by at least 25 firms in my sample. Collectively, these 13 standards comprise more than 95% of my sample. To identify standards more likely to inform managers, I examine whether the change in GAAP increased the amount of accrual accounting estimates and judgments that managers are required to make, and whether compliance with the standard is likely to require the services of an outside expert (e.g., actuary or appraiser). Managers require information to arrive at reasonable estimates of the numbers reported in public financial statements. Therefore, standards that require managers to compute more estimates and exercise more judgment are more likely than others to require managers to collect and process additional information, and thus more likely to inform managers.²⁷

Reporting rule	Classification	Discussion of the accounting standard classification choices
SFAS No. 106: accounting for postretirement benefits other than pensions	Informative	SFAS 106 establishes accounting standards for employers’ accounting for postretirement benefits other than pensions. Prior to SFAS 106, accounting for postretirement benefits was primarily accounted for on a pay-as-you-go (cash) basis. SFAS 106 required firms to accrue the expected cost of providing future benefits to an employee over the years that the employee renders service. The change required firms to compute the expected duration for which an employee will serve the company, the future cost of providing promised benefits, the expected life of the employee post retirement, etc.a These calculations likely provided managers with richer and more accurate information about the cost of promised benefits and, more generally, the cost of an employee’s service. Any re-evaluation of employee costs is likely to have been factored into investment decisions, as it directly affects the net present value of the investment. Anecdotal evidence supports the argument that managers hired outside experts and learned new information about the cost of postretirement benefits. For example, a Business Week article entitled “First Thing We Do is Kill the Accountants” quotes FASB project manager Diana J. Scott as saying, “We are absolutely appalled. They [employers] honestly weren’t measuring this. In some cases they didn’t even know whom they were covering as dependents. Employers are finding they promised much more than they can give” (September 12, 1988, p. 4)
SFAS No. 109: accounting for income taxes	Informative	SFAS 109 required firms to recognize deferred tax liabilities (assets) for all taxable (deductible) temporary differences (and operating loss and tax credit carry forwards). Further, based on the available evidence, deferred tax assets should be reduced by a valuation allowance to amounts more likely than not to be realized in future tax returns. The realization of deferred tax assets depends primarily on the existence of sufficient taxable income of appropriate character. Such taxable income is generated from (1) reversal of existing taxable temporary differences, (2) any future taxable income exclusive of reversing temporary differences, (3) taxable income in carry back years, and (4) tax-planning strategies (see Miller and Skinner 1998). Considering future economic events in assessing the likelihood of realizing the deferred tax asset is a unique provision of SFAS 109, and Ayers (1998) shows that this information is value-relevant to investors. The information necessary to estimate future tax consequences of current transactions could potentially provide managers with better estimates of marginal tax rates and, hence, affect investment decisions
SFAS No. 112: accounting for post-employment benefits	Informative	SFAS 112 establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement. This statement requires firms to recognize the cost of postemployment benefits on an accrual basis (when it can be reasonably estimated). Prior to this statement, employers’ accounting for the cost of postemployment benefits varied. Some employers accrued the estimated cost of those benefits over the related service periods of active employees; other employers recognized the cost of postemployment benefits when they were paid (cash basis). Employers using the cash basis of accounting for postemployment benefits likely required more information to obtain reasonable accrual estimates. Hence, this statement potentially created information for firms who used the cash basis of accounting for postemployment benefits.b The arguments parallel that for SFAS 106
SFAS No. 115: accounting for certain investments in debt and equity securities	Not informative	SFAS 115 addresses the accounting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. This standard did not require the collection of any new information; rather, it required firms to classify securities into three groups—held-to-maturity, available-for-sale, and trading securities—depending on the intent of purchase
EITF 97-13: accounting for consulting contracts, business process reengineering and IT transformation	Not informative	EITF 97-13 concerns accounting for costs incurred in connection with a consulting contract or an internal project that combines business process reengineering and information technology transformation. Prior to this rule, the reporting practices of various firms were mixed. Some firms capitalized the cost associated with business process reengineering, while other firms expensed them. This accounting change required firms to expense the cost of business process reengineering activities as incurred. Expensing the cost of an activity is unlikely to require additional information collection. Rather, in most cases, expensing an item that was previously capitalized simply amounts to removing the item from the balance sheet and including it in the income statement. Hence, the adoption of this rule is unlikely to generate decision-facilitating information for managers
SOP 98-5: reporting on the costs of start-up activities	Not informative	Prior to SOP 98-5 some companies were expensing start-up costs, while other companies were capitalizing them, using a variety of periods over which to amortize the costs. The disparate treatment of these costs diminished the comparability of companies’ financial statements. This standard sought to bring uniformity to the treatment of start-up and organization costs by dictating that these costs be expensed as incurred. Similar to the reasoning discussed for EITF 97-13, expensing such costs is unlikely to provide managers with information to facilitate investment
SAB 101: revenue recognition in financial statements	Not informative	This statement required that revenue should not be recognized until it is realized or realizable and earned. For revenue to be realized or realizable and earned, there should be persuasive evidence that an arrangement exists, delivery should have occurred or services should be rendered, the seller’s price to the buyer should be fixed or determinable, and collectability should be reasonably assured. The primary result of this statement was to postpone revenue recognition until a higher verifiability threshold had been met. Since managers are less likely to gain knowledge about the cash flow stream from a higher verifiability threshold, this standard is less likely to provide managers with new information. In fact, Altamuro et al. (2005) find that the associations between earnings and future cash flows and between unexpected earnings and earnings announcement period returns declined after the adoption of SAB 101, suggesting that there might have been a loss in earnings informativeness
SFAS No. 133/138: accounting for derivative instruments and hedging activities	Not informative	This statement requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge. When an entity applies hedge accounting, changes in the fair value of the derivative instrument can be offset with changes in the fair value of the asset/liability being hedged. Before the issuance of this statement, many derivatives were “off balance sheet” because, unlike conventional financial instruments such as stocks and bonds, derivatives often reflect at their inception only a mutual exchange of promises with little or no transfer of tangible consideration. Although SFAS 133 and 138 substantially changed accounting for derivatives, I do not expect this rule change to provide managers with new information. First, derivative instruments often have readily available market prices that are used to determine the value of the derivative assets or liabilities and do not require managers to make any estimates. Further, choosing the appropriate derivative instrument, whether for speculation or for hedging, requires reasonable prior understanding of the associated risks and payoffs. Recognizing derivatives on financial statements is unlikely to change a manager’s ability to assess the risks and payoffs from investing in derivative instruments
SFAS No. 142: goodwill and other intangible assets	Informative	This standard addresses accounting for acquired goodwill and other intangible assets. Prior to this standard, goodwill and other intangibles were amortized over an arbitrary period, with an arbitrary ceiling of 40 years even if the asset had an indefinite life. This standard required firms to do away with amortization of assets with indefinite lives and to conduct impairment tests at least annually. Impairment tests require firms to compare the book value of net assets to the fair value of the related operations. To get a reasonable estimate of the fair value, firms are likely to need information about the expected future cash flows generated from the assets and the risk associated with those expected cash flows (as outlined in Statement of Financial Accounting Concepts 7, Using Cash Flow Information and Present Value in Accounting). Such an activity has the potential for providing managers with new information useful for evaluating investment decisions. Although number of studies show that managers use the discretion allowed by SFAS 142 opportunistically (e.g., Ramanna and Watts 2012), such behavior is not indicative of whether the internal estimates of the value of goodwill used by managers improved or worsened. To the extent managers fear litigation risk, they are more likely to back their estimates of the value of goodwill with more information after the adoption of SFAS 142 than before, even if they do not disclose the information in financial statements. Further, anecdotal evidence suggests that firms often hire appraisers to conduct impairment tests and comply with this standard
SFAS No. 143: accounting for asset retirement obligations	Informative	SFAS 143 established accounting standards for the recognition and measurement of obligations attributable to the removal of assets as well as to their associated restoration costs. Since the obligation must be recorded at fair value and an active market for these obligations generally does not exist, the company must use the expected present value technique outlined in Statement of Financial Accounting Concepts 7, Using Cash Flow Information and Present Value in Accounting, which results in measuring the asset’s and related liability’s present value by using each company’s credit-adjusted rate. Inherent in the calculation of the obligation and its related asset cost are numerous assumptions and judgments, including the estimated life of the property to be retired, settlement amounts, inflation factors, credit-adjusted discount rates, timing of settlement, and changes in the legal, regulatory, and environmental landscapes. These assumptions and judgments require the assimilation of information that likely also helps firms re-evaluate investment decisions. And anecdotal evidence indicates that compliance with this standard usually requires the help of outside experts
FIN 47: accounting for conditional asset retirement obligations	Informative	This interpretation clarifies the term “conditional asset retirement obligation” as used in SFAS 143. Many companies concluded that SFAS 143 did not apply to “conditional” asset retirement obligations (AROs). “Conditional” is defined by the FASB as “the legal obligation to perform an asset retirement activity in which the timing and/or method of settlement is conditioned on a future event that may not be in the control of the entity.” FIN 47 was promulgated to clarify the term “conditional,” as used in SFAS 143. FIN 47 makes it clear that if a company has sufficient information to reasonably estimate the fair value of an ARO, it must so recognize at the time the liability is incurred, even if the timing for the retirement of the asset remains uncertain. For example, if a building is purchased by an entity that eventually must meet certain environmental cleanup regulations, the entity must record those cleanup costs when the asset is acquired and as soon as the costs for cleanup may be estimated. Effectively, FIN 47 requires that companies disaggregate their environmental liabilities by placing these liabilities on the balance sheet before they become certainties, so that shareholders can get a better sense of the company’s value. According to FIN 47, an asset is reasonably estimable if: (1) it is evident that the fair value of the obligation is embodied in the acquisition price of the asset; (2) an active market exists for the transfer of the obligation; or (3) sufficient information exists to apply an expected present value technique. There is “sufficient information” available to reasonably estimate the cost of an ARO when a settlement date is known or the date or method of settlement is reasonably estimable. If there is not sufficient information available, an ARO is not recognized, but the entity still must submit a report with its financial statement detailing why there is not sufficient information available. Given the amount of judgment and estimation required by this pronouncement, I classify this interpretation as providing information. In essence this statement expanded the scope of SFAS 143, and the arguments for why this statement might be informative to managers parallel those for SFAS 143
FIN 46/46r: consolidation of variable interest entities	Not informative	Accounting Research Bulletin (ARB) 51—Consolidated Financial Statements—requires that an enterprise’s consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest. That requirement has usually been applied to subsidiaries in which an enterprise has a majority voting interest, but in many circumstances the enterprise’s consolidated financial statements do not include variable interest entities with which it has similar relationships. This statement was issued because the voting interest approach is not effective in identifying controlling financial interests in entities that are not controllable through voting interests or in which the equity investors do not bear the residual economic risks. This statement spells out the conditions under which an entity should be consolidated. Since the specific criteria to consolidate do not require extensive information collection, managerial judgments, or estimates, I do not expect this standard to inform managers about investment
SFAS No. 123R: share-based payment (revised)	Not informative	This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost is recognized over the period during which an employee is required to provide service in exchange for the award—the requisite service period (usually the vesting period). This statement eliminates the alternative to use Opinion 25’s intrinsic value method of accounting that was provided in Statement 123 as originally issued. Under Opinion 25, issuing stock options to employees generally resulted in recognition of no compensation cost. Since SFAS 123 already required firms to disclose the fair value of equity-based compensation, implementation of SFAS 123R is unlikely to provide managers with information to facilitate investment decisions. Choudhary (2011) argues that the manners in which fair value estimates of stock option expense are computed under SFAS 123 and SFAS 123R are very similar. Specifically, she states that “[t]he valuation method of fair value (Black–Scholes) is applied consistently across both regimes.”

1. ^aAmir (1993) shows that investors underestimated the full consequences of postretirement benefits promised by firms prior to the introduction of SFAS 106. He goes on to shows that disclosures required by SFAS 106 are value-relevant and help investors compute a more accurate value of the cost of postretirement benefits
2. ^bFirms already using the accrual basis of accounting for postemployment benefits are likely to have smaller transition obligations from adopting this standard. Since I use the transition obligation to measure the impact of a standard on the firm, the fact that some firms already used the accrual method is unlikely to be a cause for concern

Appendix 2: Stock returns-based test to validate the classification of accounting standards into “informative” and “uninformative” groups

Hypothesis 3 predicts that some accounting changes can inform managers and facilitate their investment decisions. A crucial component of this test is identifying which changes in GAAP are more or less likely to inform managers. In order to validate my classification of which changes in GAAP are more or less likely to inform managers, I perform the following test: I regress annual stock returns on the change in annual earnings and the cumulative effect of an accounting change, split into those arising from accounting standards that are likely to be informative and uninformative to managers. RET is the 12-month cumulative stock return for fiscal year t. The 12-month interval begins three months following the end of fiscal year t − 1 and ends three months after the end of fiscal year t. ΔEARN is defined as the change in earnings before extraordinary items (IB) for fiscal year t, scaled by market value of equity at the end of fiscal year t − 1. CUMU_EFF (ACCHG) is the cumulative effect of an accounting change as reported in the income statement, scaled market value of equity at the end of fiscal year t − 1. INFO is an indicator variable that takes on the value of one for observations in which the firm adopted an accounting standard that is likely to inform managers. It takes on the value of zero otherwise. The accounting standards classification is described in “Appendix 1”. NO_INFO is an indicator variable that takes on the value of one (zero) if Information equals zero (one).

1. In this table, the t-statistics are computed using heteroskedasticity robust standard errors and are reported in parentheses. All continuous variables are winsorized at the 1 and 99% of their empirical distribution
2. ***,**,* Statistical significance at the two tailed 1, 5, and 10% levels, respectively

Appendix 3: Variable definitions

Variable name	Variable definitions with Compustat or CRSP codes in parentheses
ACQ	ACQ (AQC) is the costs incurred during the year that relate to acquisitions, deflated by average assets in period t and t − 1
AGE	AGE is the natural logarithm of the difference between the first year the firm enters Compustat and the current year.
CAPEX	CAPEX (CAPX) is the cash outflow or the funds used for additions to the company’s property, plant, and equipment, excluding amounts arising from acquisitions, reported in the Statement of Cash Flows, deflated by average assets in period t and t − 1
CASH	CASH (CHE) is cash and all securities readily transferable to cash, deflated by average assets in period t and t − 1
CFO	CFO (OANCF) is cash flows from operations reported in the statement of cash flows, deflated by average assets in period t and t − 1
COVENANT/NO_COVENANT	COVENANT is an indicator variable that takes on the value of one (zero) if the observation has (does not have) at least one financial covenant that is likely to be affected by the cumulative effect of an accounting change. NO_COVENANT is an indicator variable that takes on the value of one (zero) if COVENANT equals zero (one).
CUMU_EFF	CUMU_EFF (ACCHG) is the cumulative effect of an accounting change as reported in the income statement, deflated by average assets in period t and t − 1. It represents the effect of company adjustments due to accounting changes on prior period earnings.
DEALSCAN	DEALSCAN is an indicator variable that takes on the value of one (zero) if the firm has (does not have) data available in the Dealscan database for year t.
DISCLOSE_RECON	Indicator variable that equals one (zero) if the debt contract requires the firm to reconcile and disclose differences in financial ratios after changes in GAAP while renegotiating covenants.
FIXED_GAAP_CONT, HYBRID_GAAP_CONT, FLOATING_GAAP_CONT	FIXED_GAAP_CONT (HYBRID_GAAP_CONT; FLOATING_GAAP_CONT) is an indicator variable that takes on the value of one (zero) if the debt contract is based on Fixed GAAP (Hybrid GAAP; Floating GAAP). The Fixed GAAP practice excludes all changes to GAAP including mandatory accounting changes once the debt contract is signed. The Hybrid GAAP gives lenders and borrowers a mutual option to freeze GAAP at any point in time. The Floating GAAP practice uses the most up-to-date version of GAAP to determine compliance with the terms of the contract.
FLOATING_GAAP/NO_FLOATING_GAAP	FLOATING_GAAP is an indicator variable that takes on the value of one if the debt agreement has a covenant and uses the Floating GAAP practice or requires the firm to disclose reconciliations between the old and new accounting practice while renegotiating covenants to adjust for the change in GAAP. NO_FLOATING_GAAP is an indicator variable that takes on the value of one (zero) if FLOATING_GAAP equals zero (one). I hand collect this information from the debt contracts of my sample firms. Firm-years without debt contracts in the Dealscan database are assumed to have no private debt contract and thus FLOATING_GAAP (NO_FLOATING_GAAP) equal to zero (one).
GROWTH	GROWTH is the change in total assets (AT) from period t − 1 to period t scaled by total assets (AT) in period t − 1
INFO/NO_INFO	INFO is an indicator variable that takes on the value of one for observations in which the firm adopted an accounting standard that is likely to inform managers about current or future investment opportunities. It takes on the value of zero otherwise. The accounting standards classification is described in “Appendix 1”. NO_INFO is an indicator variable that takes on the value of one (zero) if INFO equals zero (one)
LEVERAGE	LEVERAGE is the sum of short-term debt (DLC) and long-term debt (DLTT), deflated by average assets in period t and t − 1
MVE	MVE is the natural logarithm of the stock price (PRCC_F) times the number of shares outstanding (CSHO) measured at the end of the fiscal year
POST	An indicator equal to one for the fiscal years following SFAS 106 adoption
POST [−2]	An event time indicator equal to one for the fiscal year ending two years preceding the period in which a firm adopts SFAS 106
POST [−1]	An event time indicator equal to one for the fiscal year ending immediately preceding the year in which a firm adopts SFAS 106
POST [0]	An event time indicator equal to one for the fiscal year in which a firm adopts SFAS 106.
POST [1]	An event time indicator equal to one for the fiscal year ending immediately following the year in which a firm adopts SFAS 106
POST [2]	An event time indicator equal to one for the fiscal year ending two years following the period in which a firm adopts SFAS 106
POST [3+]	An indicator equal to one for the fiscal years ending three or more years following the period in which a firm adopts SFAS 106.
R&D	R&D (XRD) is the costs incurred during the year that relate to the development of new products or services, deflated by average assets in period t and t − 1
RETIRE OBLIGATION	RETIRE OBLIGATION is the present value of future benefits attributed to employee services performed up to a given yearly date, measured in the year in which the firm adopted SFAS 106 (as a result this variable is time invariant)
TOBIN’S_Q	TOBIN’S_Q is measured as the sum of market value of equity (PRCC_F × CSHO), short-term debt (DLC) and long-term debt (DLTT) divided by total assets (AT)
TOTAL INVEST	The sum of acquisition expenditures (ACQ), capital expenditures (CAPX), and research and development expenditure (XRD), deflated by average assets in the period t and t − 1