American Accounting Association August 2005 Katherine Schipper

1. Required Disclosures in Financial Reports American Accounting Association August 2005 Katherine Schipper Financial Accounting Standards Board The views expressed in this presentation are my own and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation. Required Disclosures in Financial Reports

2. Overview Starting point: financial reports are communications Purpose of disclosures Theory Concepts Statement 5 Inferences from analyses of specific standards—examples from SFAS 132R, Employers Disclosures about Pensions and Other Post-Retirement Benefits Do disclosures achieve their intended purpose? Differences between disclosure and recognition Are disclosed items less reliable? Standard setter perspective Auditor/preparer perspective Analytical distinctions between disclosure and recognition Are disclosed items processed (used) differently? Required Disclosures in Financial Reports

3. Theories of Disclosure Purposes No generally accepted theory of required disclosures No agreed-upon objective function for required disclosures Logical focus of theory would be providing decision useful information Consistent with the FASB’s conceptual framework but too general to provide much guidance Example: Required disclosures might reduce information asymmetries Between investors and managers Among investors Example: Required disclosures might require the collection and dissemination of new information Key issue for standard setting: It is difficult to distinguish, analytically, between disclosed information and recognized information. Required Disclosures in Financial Reports

4. Purpose of Disclosures in the Conceptual Framework SFAC 5 describes recognized items explicitly (but not disclosed items) Recognized items meet several criteria, subject to cost-benefit and materiality considerations, and have the best combination of relevance and reliability Inference: Disclosure and recognition are not alternatives They do not serve the same purpose Items that meet the definitions of financial statement elements but fail one or more of the recognition criteria should be disclosed Observations: • Seems implausible that standard setters would not require recognition of highly reliable items unless those items utterly lacked relevance. • Some research presumes that a purpose of disclosures is to report relevant items that are less reliably measured. This inference is consistent with (for example) standards that require disclosure but not recognition of fair values as an interim step. Required Disclosures in Financial Reports

5. Purpose of Disclosures as Stated in SFAS 105 Describe recognized and unrecognized items Provide a useful measure of unrecognized items Provide alternative measures of recognized items Provide information useful for assessing risks and potentials of recognized and unrecognized items Provide interim information while other issues are studied Examples: SFAS 36 (Pensions), SFAS 47 (Long term obligations) SFAS 81 (Post retirement benefits) Observations: • SFAS 105 discussion of disclosure purposes is at least partly consistent with inference, from SFAC 5, that disclosure is reserved for less reliable information. • Examination of specific standards reveals other apparent purposes of disclosures, such as providing information on a required future cash payment (Barth and Murphy, 1994). Required Disclosures in Financial Reports

6. Purpose of Disclosures Inferred from Specific Examples: SFAS 132 and SFAS 132R Prediction Changes in benefit obligations and plan assets Long term rate of return assumption for plan assets Reconciliation of funded status with recognized amounts Components of periodic pension cost Observations: • SFAS 132R explicitly mentions assessing earnings quality and predicting earnings. • Prediction, as a purpose of disclosure, implies disaggregation. • Some disaggregation disclosures might also have as a goal displaying management’s assumptions. Required Disclosures in Financial Reports

7. Purpose of Disclosures Inferred from Specific Examples: SFAS 132 and SFAS 132R Display Management Estimates and Assumptions; Measurement Uncertainty Sensitivity of the OPEB obligation and current period costs to a 1% increase and decrease in the health care cost trend rate Observations: This type of disclosure would seem to be pertinent to any significant input to a material measurement, although it is not often observed. Example: Change in revenues for a 1% change in volume, holding all else constant. However, effects of changing one input may be nonlinear and interactive. The FASB is also considering ways to show relative measurement uncertainty Example: Proposed disclosure, in the FASB’s Fair Value Measurement Statement, to show fair values of disclosed and recognized items by category: Observed prices versus measurement techniques and models Recurring (e.g., marketable securities) versus intermittent remeasurements (e.g., impaired nonfinancial assets) Required Disclosures in Financial Reports

8. Purpose of Disclosures Inferred from Specific Examples: SFAS 132 and SFAS 132R Alternative Accounting Treatment Changes in defined benefit pension obligations and plan assets, including unrecognized gains and losses Basis for conclusions of SFAS 87 states that a preferable accounting treatment would recognize the net pension asset or liability measured as difference between the plan’s assets and the projected benefit obligation, with immediate recognition of changes in that net asset or liability Implication:Some disclosures are intended to compensate for a recognition/measurement standard that requires (or permits) a less preferred accounting treatment Question to consider: Are these disclosures effective? Required Disclosures in Financial Reports

9. Inferences about the Purpose of Disclosures, from a Standard Setting Perspective Sparse guidance in the Conceptual Framework Analysis of disclosure requirements in existing standards Inference, from SFAC 5, that disclosures are used to present relevant but less reliably measured items, seems incomplete More apparent purposes than are listed in SFAS 105 Alleviate noncomparability Inputs into measured amounts Alternative presentation, because a recognition/measurement standard does not adopt the preferred alternative Observations: • Standard setting tension between communicating a conceptually grounded measurement (i.e., recognition) and communicating information that can be used as inputs to measurement. • Example: Separately measure and recognize components of compound instruments such as convertible debt versus provide detailed disclosures to support user inferences about components. Required Disclosures in Financial Reports

10. A Pragmatic Approach to Disclosures, Based on Assumptions about Specific Judgments/Decisions Identify a specific judgment or decision that could not be made (or could not be made effectively) using recognized items only Analyze extant disclosures to determine if they are adequate for that judgment or decision. If not, require disclosures that are sufficient. Example: Determining risk exposures to interest rates, foreign currency fluctuations and commodity prices SFAS 107, SFAS 119 disclosures are not sufficient (Wong, 2000) FRR 48 disclosures are sufficient (Thornton and Welker, 2004 and Linsmeier et al., 2002) Observations: • The number of possible specific judgments/decisions is sufficiently large and variable (across users and over time) that this approach would lead to proliferating disclosures – they could grow (almost) without limit. • This approach appears to be consistent with how standard setters actually establish disclosure requirements. Required Disclosures in Financial Reports

11. Do Disclosures Achieve their Intended Purpose? Identify the purpose and choose an outcome indicator Increase ability to predict earnings or another recognized item Disaggregating revenues to identify same store sales increases ability to predict revenues and earnings (Cole and Jones, 2004) VAR (Value at Risk) disclosures predict variability of trading revenues for banks (Jorion, 2002) Numerous analyses of segment reporting show that segment disclosures improve earnings predictions (both statistical models and analysts forecasts) Provide information to undo noncomparable reporting or create an alternative accounting approach Constructive capitalization of operating leases (Imhoff et al., 1991, 1993) Numerous analyses of LIFO versus FIFO inventory accounting Reduce uncertainty FRR 48 risk disclosures reduce uncertainty/diversity of opinion about the implications for equity values of changes in certain market interest rates, foreign exchange rates and commodity prices (Linsmeier et al., 2002) Required Disclosures in Financial Reports

12. Do Disclosures Achieve their Intended Purpose? An aside on other possible consequences of disclosures • Organizational consequences • Speculation about possible changes in organizational structures because of SFAS 131 segment reporting requirements (Piotroski, 2003) • Commercial arrangements • Rearrange leases so as to qualify for operating lease treatment (disclosure only) after SFAS 13 (Imhoff et al, 1988) • Disclosed items not typically included in contracts • Disclosing (instead of recognizing) less reliable items facilitates contracting uses of accounting numbers, if efficient contracting requires highly reliable items (Espahbodi et al., 2002) • Disclosed items not always included in machine-readable commercial databases (but recognized items are) Required Disclosures in Financial Reports

13. Are Disclosed Items Less Reliable? Archival Evidence Management perspective If management can choose either to recognize or disclose, does management recognize more reliably measured items? Example: Given a choice, managers recognize revaluations for assets that are more reliably measured (e.g., land as opposed to buildings) and disclose other revaluations (Cotter and Zimmer, 2003) Example: SFAS 148 transition to voluntary adoption of fair value measurement of share based payments permits disclosure and recognition of similar items in the same period (Balsam et al., 2005) Observations: • Requires an ex ante specification of reliability of items. • Not always clear there is agreement about what is meant by reliability. • Free choice between disclosure and recognition is rare, and when it exists, the outcome is confounded by self-selection (incentives and other factors unrelated to reliability). • Questions have been raised about standard approaches used in accounting to deal with self-selection (Larcker and Rusticus, 2005). Required Disclosures in Financial Reports

14. Are Disclosed Items Less Reliable? Archival Evidence Investor perspective: Regress a market variable on disclosed and recognized items Smaller valuation weights on disclosed versus recognized items interpreted as evidence of less reliability Same firm, disclosure followed by recognition Lower valuation weights on OPEB amounts disclosed (per SAB 74) versus recognized (per SFAS 106) (Davis-Friday et al., 1999) Same firm, both disclosure and recognition for the same item Prior to SFAS 133, only derivatives in certain arrangements were recognized; others were disclosed. Within firms, lower valuation weights on disclosed versus recognized derivatives (Ahmed et al., 2005) Investor perspective: Direct estimation of measurement error Example: Investors perceive disclosed OPEB liabilities as measured with greater error than recognized OPEB or pension liabilities (Davis-Friday et al., 2004, extending techniques from Barth, 1991 and Choi et al., 1997) Required Disclosures in Financial Reports

15. Are Disclosed Items Less Reliable? Archival Evidence • Analyses based on share prices and returns require assumptions about both investors and information items • Common assumption: Investors process disclosed and recognized items the same way, so that differences in valuation weights (or any other differences) are due to reliability differences • Drawing inferences about disclosure reliability in general requires assumptions about whether there is differential reliabilityamong various types of disclosures • Results can be difficult to interpret • Sensitive to specification (e.g., Boone, 2002) • Coefficients on recognized items often differ from their theoretical values • Reasonable confidence intervals for coefficients on disclosed items can encompass both zero and the coefficients on recognized items Observations about archival analyses of investor perceptions Required Disclosures in Financial Reports

16. Are Disclosed Items Less Reliable? Experimental Evidence Auditor perspective Auditors may permit more misstatement in a disclosed item than in a recognized item (Libby et al., 2005) Possible reasons Auditing standards distinguish between misstatements in notes and on the face of financial statements My reading of these standards, plus extensive discussions with auditors, does not support this view Auditors applying SAB 99 might make different materiality judgments about recognized versus disclosed items Observation:From the auditor’s perspective, management has already developed the item (and thereby affected its properties). Evidence on whether preparers tolerate greater misstatements in disclosed versus recognized items is anecdotal and circumstantial. Required Disclosures in Financial Reports

17. Are Disclosed Items Less Reliable? Materiality SAB 99 does not formally distinguish between recognized items and disclosed items Basic principle in SAB 99 defines materiality as affecting the judgment of a reasonable person Auditors may believe that judgments of users of financial reports are intrinsically less sensitive to disclosures (because of user characteristics) Four key materiality criteria could not affect disclosures because they pertain only to recognized amounts (e.g., an item that converts a loss to income) Observation: There is a possible circularity. Users rely less on disclosures because they believe disclosures are prepared less rigorously. Preparers and auditors use less rigor in preparing disclosures because they believe users rely less on them. Required Disclosures in Financial Reports

18. Could Required Disclosures Differ in Reliability? Temporary versus (near) permanent disclosure Longstanding required disclosure, with no immediate expectation of recognition SFAS 105, 107, 119: fair values of financial instruments Unrealized inventory holding gain for LIFO users SAB 74 disclosures, before a new standard is adopted Recognition of the disclosed amount is imminent; SAB 74 requirements are very general and disclosures tend to be qualitative Discuss the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made. Have been used to compare recognition and disclosure, e.g., SAB 74 disclosures versus recognized SFAS 106 amounts analyzed by Davis-Friday et al., 1999. Required Disclosures in Financial Reports

19. Could Required Disclosures Differ in Reliability? Disaggregations of recognized amounts Disaggregation (details) of a recognized amount To the extent there are no new measurements or allocations, preparers (almost surely) incur few or no additional costs Examples: List of long term debt instruments, with terms; Inventory components Disaggregated presentation based on measurements and allocations that differ from those in recognized amounts Cost to prepare varies with the nature of the presentation Reconciliations of defined benefit plan assets and obligations Revenues, assets and income by segment Question to consider: Under what circumstances would the cost to prepare a disclosure affect its reliability? Required Disclosures in Financial Reports

20. Could Required Disclosures Differ in Reliability? Alternative measurement attribute • Mandated measurement, with disclosure of an alternative • Bank loans recognized at cost, with impairment and fair values disclosed • Free choice of measurement, with disclosure of an alternative • For LIFO users, the FIFO cost of ending inventories Observation: • This type of disclosure may become more common, because of the FASB’s proposals to permit (but not require) fair value for more measurements. Questions to consider: • With regard to the properties of the disclosed measurement, does it matter whether the recognized measurement is a free choice? • Research on LIFO users suggests they differ systematically from other firms. Is this result generalizable and if so are there implications for disclosed measurements? Required Disclosures in Financial Reports

21. Can Differences between Recognized and Disclosed Items be Modeled Analytically? Specify information properties of the item Intrinsic and exogenously specified qualities (e.g., bias, variance) Differentially affected by management and/or auditor interventions Degree to which the item is an imperfect indicator of realized cash flow. The more imperfect the indicator, the more likely the item will be required to be disclosed, not recognized Model disclosure versus recognition as two signals Recognition: Signal 1 is received by all and interpreted the same way by all Disclosure: Signal 2 is private to each investor (like something that is interpreted differently by different investors) Observations: • This approach seems to be roughly consistent with SFAC 5’s implicit distinction between recognized and disclosed items, based on characteristics of the information. • If the model treats investors as rational agents who fully understand the properties of the information, placement of the information, per se, will not matter. Required Disclosures in Financial Reports

22. Can Differences between Recognized and Disclosed Items be Modeled Analytically? Relax assumptions that investors are identical, fully rational and not subject to constraints on ability to process information Focus on investor characteristics: Separate disclosure from recognition by characterizing disclosures as harder to understand and process (Barth et al., 2003) Two pieces of information are provided, one of which is costless to use Investors must incur a cost to gain the expertise necessary to understand the other piece of information, and not all choose to do so However, it is still necessary to characterize the information with respect to its informativeness about the attribute of interest to investors Question to consider:If the hard-to-understand information is intrinsically informative about the attribute of interest, should the standard setter try to make that information easier to understand and use and if so, how can this be done? Observation: Required tabular reconciliations of items (e.g., warranties, estimated restructuring costs) are intended to make the information easier to use. Required Disclosures in Financial Reports

23. Can Differences between Recognized and Disclosed Items be Modeled Analytically? Disclosure differences based on investor characteristics Some investors use only salient (i.e., recognized) items and ignore both other (disclosed) items and price (Hirshleifer and Teoh, 2003; see also discussion by Lambert, 2003) Pricing outcomes determined by the information processing rule investors use and the relation between the salient and the ignored information Example: Predict earnings using the firm’s growth rate ignoring differential growth rates provided by segment disclosures. Pricing determined by relations among recognized and disclosed items, so no general result is possible. Observations: • Standard setters do not appear to include differential expertise among users in the decision rule for separating recognition from disclosure. • It is unclear whether commercial databases that do not capture certain disclosures affect overall use of disclosed information. Required Disclosures in Financial Reports

24. Do Users of Financial Statements Process Recognized and Disclosed Items Differently? View 1: No difference Once an item has entered the financial reports, location and presentation (face of the financial statements versus notes) have no implications View 2: Rational differences Location (that is, disclosure in the notes versus recognition on the face of the statements) has implications because the location reveals something about the decision usefulness of the item View 3: Differences due to user characteristics and not to intrinsic differences in recognized versus disclosed items Users ignore, underweight or process disclosed items differently, perhaps because they lack some combination of problem solving ability, knowledge, and ability and willingness to process disclosed items thoroughly, or perhaps for other reasons Required Disclosures in Financial Reports

25. Do Users of Financial Statements Treat Recognized Items Differently from Disclosed Items? Research design issues What user group should be studied? Investors, whose judgments and decisions are aggregated in share prices Financial intermediaries (sell-side analysts, buy-side analysts, credit analysts) Creditors, whose judgments and decisions are aggregated in lending decisions or the terms of those decisions or their lending contracts Internal decision makers (e.g., boards of directors) Imhoff, et al., 1995, provide evidence that the determination of CEO compensation appears to disregard operating lease disclosures Examples of users in accounting research Alumni of a well known business school (Frederickson et al., 2005) MBA students with business and investing experience (Maines and McDaniel, 2000; Koonce et al., 2005) Nonspecialist buy-side analysts (Hirst and Hopkins, 1998) Buy-side analysts with specific expertise in the disclosure being examined (Hirst et al., 2004) Required Disclosures in Financial Reports

26. Do Users of Financial Statements Treat Recognized Items Differently from Disclosed Items? Yes, based on results of experiments, users appear to underweight (or ignore altogether) disclosures Other Comprehensive Income, not shown on a single statement with earnings Maines and McDaniel, 2000, focus on nonprofessional investors Hirst and Hopkins, 1998, focus on buy-side analysts Explicit display of information that can be inferred from a knowledgeable analysis of information that is provided Dietrich et al., 2001, focus on students (the information pertains to oil and gas reserves). Reliability considerations do not enter. Hirst et al., 2004, focus on bank analysts (the information pertains to fair values that are either shown on the balance sheet and income statement, or can be inferred from recognized information and disclosed information). Required Disclosures in Financial Reports

27. Why Do Users Treat Disclosed Items Differently? Is it competence? Those with high levels of three attributes (motivation, subject matter knowledge and problem-solving ability) were able to adjust product costing information to take account of bias introduced by using a volume based system (Dearman and Shields, 2005) Research design requirements are considerable Many observations per subject; may not be feasible in many settings Psychometric testing of subjects to determine knowledge, problem solving ability and intrinsic motivation Those who lacked a high level of any one of the three attributes did not make the adjustment Users rely on salient, readily available information and simple heuristics. They do not make complex calculations that require more knowledge (Imhoff, et al., 1995, Dietrich et al., 2001, Hirst et al., 2004) Required Disclosures in Financial Reports

28. Why Do Users Treat Disclosed Items Differently? Is it something other than competence? Factors other than knowledge, effort and ability Judgments about risk of financial items are a function of both decision theory (probabilities and outcomes) and certain emotional or affective factors (dread and uncertainty) (Koonce et al., 2005) Dread includes worry, newness and immediacy A key link is amount of potential loss (the loss outcome) which both affects dread and affects risk directly Observations: • Certain biases in information processing (e.g., anchoring) appear to be “hard wired.” Incentives (e.g., Kachelmeier and Hobson, 2005) knowledge and ability do not seem to overcome these biases. • Using certain search-facilitating technology aids (e.g., XBRL) increases the likelihood that disclosed information will be acquired and used (e.g., Hodge et al., 2004). Required Disclosures in Financial Reports

29. Concluding Observations Existing disclosure requirements are not guided by a general theory or broad conceptual guidance Conceptual Framework may imply that disclosed items are distinguishable from recognized items by lower reliability Analysis of standards suggests some purposes appear to be derived from assumptions about specific judgments and decisions No systematic evidence that standard setters act as if they believe that users cannot understand and use disclosures as easily as they understand and use recognized items Research suggests users of financial reports process disclosed information differently from recognized information Unclear what causes this difference, and how much it matters for pricing outcomes Differences that arise because investors use heuristics, or have hard-wired biases, are difficult to model Required Disclosures in Financial Reports