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E-MailUrooj Khan is Class of 1967 Associate Professor of Business at Columbia Business School. This post is based on a recent paper by Professor Khan; Bin Li, Assistant Professor at University of Texas at Dallas Naveen Jindal School of Management; Shivaram Rajgopal, Roy Bernard Kester and T.W. Byrnes Professor of Accounting and Auditing at Columbia Business School; and Mohan Venkatachalam, R.J. Reynolds Professor of Business Administration at Duke University Fuqua School of Business.
For four decades, the Financial Accounting Standards Board (FASB) has been the designated private sector organization for setting up standards governing financial reporting for corporate America. During this time, over 160 standards have been issued along with several supporting American Institute of Certified Public Accountants (AICPA) bulletins, which are interpretations and statements of positions intended to offer implementation and supportive guidance for the standards. The FASB asserts that its standards are important to the efficient functioning of the economy because credible and understandable financial information is useful for capital allocation in the economy.
A key principle guiding the FASB’s issuance of standards is that the benefit from the expected improvement in the quality of information available to users justifies the cost of preparing and disseminating that information. However, chief financial officers (CFOs) lament that financial reporting is a lot more about compliance, resulting in deadweight costs imposed on their firms (Dichev et al. 2013). Others have noted that (i) Generally Accepted Accounting Principles (GAAP) are written using a “top-down” approach, rather than being “generally accepted” (Benston et al. 2006); (ii) the FASB seeks the conceptually right deductive answer, instead of relying on industry best practices or conventions (Institute of Chartered Accountants of England and Wales [ICAEW] 2006); and (iii) the FASB’s monopoly in creating accounting rules potentially increases firms’ cost of capital (e.g., Dye and Sunder 2001; Sunder 2002; Benston et al.; 2003; Kothari et al. 2010).
In the paper titled Do FASB’s Standards Add Shareholder Value? we investigate the impact of the promulgations of standards on capital market participants by evaluating whether standards passed by the FASB over the period 1973-2009 were cost-effective, as reflected by the stock returns of firms affected by those standards. If firms choose accounting policies ex ante to maximize firm value, then imposing binding constraints on reporting choices through standards will result in a shift in disclosure equilibrium leading to a decline in firm values. That is, if the standards impose greater costs on firms by increasing contracting costs, compliance costs, proprietary costs, estimation risk, or prospects for opportunism by managers at the cost of shareholders, we expect negative abnormal returns for affected firms when standards are promulgated. On the other hand, ex-ante managerial choices may be suboptimal and can lead to potential market failure. Promulgation of standards could then improve social welfare, particularly if the contracting costs they impose are smaller than the private contracting costs of voluntary accounting choices (Watts and Zimmerman 1986). Thus, if market participants expect the accounting or disclosure requirements mandated by a standard to produce cost-beneficial decision-relevant information, we expect positive abnormal returns for firms affected by that standard relative to returns for unaffected firms.
We use the stock market reaction across the relevant event dates to assess equity investor perceptions of cost-benefit tradeoffs. We find insignificant stock market price reactions (on average) on event dates related to the passage of 104 of the 138 standards. When we aggregate the event dates across all standards, we obtain a statistically insignificant negative abnormal return of -0.07%. From all this, we infer that, on average, a new standard is a value-neutral event for shareholders. Of the 34 standards that registered significant abnormal returns, 19 (15) are associated with abnormal negative (positive) returns. The standards associated with the most loss in shareholder value are (i) the three fair value standards (SFAS 105, 107 and 115); (ii) SFAS 2, which mandates expensing of R&D; (iii) SFAS 125, which deals with accounting for securitizations; (iv) SFAS 133 and 161, which relate to accounting and expanded disclosure of derivative instruments; and (v) SFAS 144 and 146, which deal with accounting for the impairment or disposal of long-lived assets and restructuring liabilities, respectively. The five standards associated with the greatest increase in shareholder value are (i) SFAS 134, associated with classification of mortgage-backed securities as trading securities; (ii) SFAS 119, which requires mandatory disclosure of derivatives; (iii) SFAS 92 and 152, which are industry-specific standards affecting utilities and real estate timeshares, respectively; and (iv) SFAS 138, which clarifies the ambiguous provisions of SFAS 133.
In addition to stock price reactions, we examine whether affected firms experience a decrease in estimation risk following the issuance of standards. We find a decrease in estimation risk following the issuance of 35 standards. Somewhat surprisingly, however, we find that estimation risk increases after the passage of 25 standards. In cross-sectional analysis, we find that stock returns are higher for firms with higher information asymmetry, lower contracting costs and firms that experience a relative reduction in estimation risk. We also document that principles-based standards (i.e., standards with no bright-line rules, fewer scope exceptions, less voluminous guidance) are perceived as more value-increasing than rules-based standards. Moreover, standards that involve greater use of managerial estimates (i.e., standards related to asset write-offs, fair value, stock option expensing, and pension-related issues) are associated with more negative stock price reactions.
Overall, while we find little evidence that FASB’s standard setting creates shareholder value, we acknowledge that other stakeholders might benefit. As the FASB serves multiple constituents, our research takes the first step in evaluating the value created by the FASB since its creation.
The full paper is available for download here.
