Business Ethics and Financial Accounting Standards Board - Essay Example

Running Head: Business Ethics Business Ethics of the of the Introduction Prior studies have examined whether managers lobby the U.S. Financial Accounting Standards Board (FASB) in their own economic self-interests rather than in the interests of other stakeholders. Research in this area has focused on whether managers lobby for or against standards calling for proposed financial statement recognition of an accounting item based on the economic cost to the management. Other research examines managements disclosure choices in proxy statements. This choice suggests that managers valuation choices for SBC are based on economic self-interests. Other research on lobbying behaviour and the effect of a proposed financial accounting standard on pro forma net income provides mixed results. For example, Watts and Zimmerman (1978) report that economic self-interests motivate a large firm to lobby for an accounting standard that reduces pro forma net income. Yet, other studies (Martens and Stevens, 1993; Dechow et al., 1996) find no relationship between lobbying behaviour and the effect of the proposed standard on net income. The present study extends prior research by examining whether economic self-interests affect corporate lobbying on disclosure, especially on (a) Whether to disclose similar or identical information in proxy statements versus annual reports, and on (b) The choice between disclosing via summary information in the footnotes versus disclosing via pro forma income statements. Prior to the 1993 Exposure Draft (ED) on FAS 123, Accounting for Stock-Based Compensation, corporations provided relatively little information on the value of stock-based compensation (SBC) held by top management. Essentially, corporations reported the SBC for only the top five executives and only in annual proxy statements as required by the U.S. Securities and Exchange Commission (SEC). The ED proposed recognizing for the first time in annual reports the amount of SBC for all employees. Comment letters to the FASB on FAS 123 almost exclusively opposed recognition of SBC. However, as Walker and Robinson (1993) note, a careful analysis of the substance of comment letters (i.e., analysis beyond simply counting ‘yes/no’ votes on recognition) can provide additional insights into the politics of the standard-setting process. The current analysis of the comment letters reveals that managers supported varying venues and formats of disclosure. Thus, the varying responses to the FASB on the ED for FAS 123 provide a unique opportunity to examine whether economic self-interest motivates lobbying on venues and formats of disclosure of information (Breton Wall Street Journal, 5 November 1993). . The results of this study indicate that differences in corporate lobbying positions on disclosure are related to the value of corporate SBC. In particular, the more wealth management holds in the form of stock options, the more likely managers will oppose disclosing SBC information in the annual reports, even though proxy statements already disclose SBC information for the top five executives of the firm. Further, this result holds true even when the top five managers hold virtually the entire employee SBC, and therefore already disclose most of total SBC in proxy statements. These results reflect lobbying on venue choice. The study also finds that managers economic self-interest explains lobbying on summary disclosure of SBC versus pro forma recognition of SBC. This reflects lobbying on format choice. Summary disclosure includes footnote details of SBC for all employees, similar to that reported in the proxy statement for the top five executives (including, for example, grant price and date, exercise price, number of options, and net realizable value of options). Corporations that grant relatively more SBC are more likely to lobby for summary footnote disclosure rather than pro forma recognition of SBC. MOTIVATION AND HYPOTHESIS DEVELOPMENT While it seems clear that economic self-interest and/or firm characteristics motivate managers decisions on lobbying for or against recognition of various accounting events (Deakin, 1989; Schalow, 1995; Ang et al, 2000), it is uncertain whether self-interest similarly motivates lobbying between choices of venue or formats of disclosure. Because disclosures do not affect net income (or other items possibly related to net income such as debt covenants or bonus plans), and annual proxy statements already report the SBC of the top five executives, one might expect management to be indifferent to lobbying on disclosures. However, firms in fact lobbied the FASB on the ED for FAS 123 in different manners: in opposition to any disclosure of SBC in the annual report, in favour of summary disclosure in footnotes, or in favour of pro forma income statement disclosure. Therefore, the question becomes what causes the differences in lobbying behaviour? Economic self-interest is posited to explain the differences in lobbying on venue and format of disclosure of financial information as it has been found to explain differences in lobbying on recognition of financial information. Economic self-interest is measured in three ways: total amount of prior and current SBC held by the top five executives, total amount of current SBC held by all other employees, and the percentage decrease in pro forma net income due to recognition of employee SBC. Managers will lobby against disclosing the amount of executive or total SBC in different venues and formats if they believe that stakeholders such as labour unions, shareholders or government regulators will react adversely to such disclosures. For example, disclosure of ‘excessive’ executive SBC may lead to demand from labour for higher wages or to demands from government for increased taxation and/or limitations on SBC. Further, disclosure of information of the effect of executive and/or total SBC on pro forma net income may lead to labour or shareholder demands for reduced SBC if the reduction in net income seems excessive. Arguably, securities markets would react unfavourably to mandated higher wages for labour, increased taxation, or imposed limits on SBC. Whether economic self-interest motivates management lobbying position on the venue of disclosure is examined by testing the following hypothesis: H1: Economic self-interests are related to managers lobbying on the venue of disclosure of SBC (proxy statement versus annual report). It is expected that a negative relationship exists between the amount or share of executive SBC and willingness to disclose executive SBC in the annual report, the venue choice. Similarly, it is posited that the greater the amount of other employee SBC, the less likely it is that managers would wish to disclose this additional information in annual reports. Also posited is that those firms that would experience the biggest decreases in pro forma net income should be more likely to oppose disclosure (Berton,. Whether economic self-interest motivates managers lobbying position on the format of disclosure is examined by testing the following hypothesis: H2: Within the group that favours disclosure, economic Self-interests are related to managers lobbying on the format of disclosure of SBC (summary information versus pro forma net income statement information). If economic self-interest motivates lobbying behaviour, then firms with greater levels of executive SBC and/or other employee SBC should be more likely to lobby against pro forma net income statement disclosure. Similarly, the greater the (negative) effect SBC has on pro forma net income, the more likely a firm should be to lobby against pro forma net income statement disclosure. METHOD AND RESEARCH DESIGN To test those hypotheses, comment letters to the FASB on the ED for FAS 123 were examined. The original population included 469 comment letters from industry. Thirty-three letters were excluded from representational organizations, as were 54 letters from firms which were not publicly traded, 85 letters from firms for which no proxy information was publicly available, 16 letters from firms for which no COMPUSTAT data were available, and 15 other comment letters from firms which were holding companies, Canadian-based firms, or firms not adequately identified by the comment letter. Each author independently coded the comment letters as either opposed to FAS 123, in favour of summary disclosure, or in favour of pro forma income statements. Discussions about any conflicts resulted in unanimous agreement on all but four firms that were excluded from the sample. The final sample includes 262 comment letters from firms that responded to the 1993 ED. Firms were classified as opposed to FAS 123 when comment letters opposed any changes to the existing accounting for SBC as required by APB 25. For example, Lotus Corporation states that ‘we urge the FASB to withdraw the ED and to retain the current accounting treatment for stock options’. Firms were classified as in favour of pro forma income statements when they specifically referred to and supported the enhanced disclosure outlined in Appendix E of the ED. In general, Appendix E recommended disclosing stock option information such as grant and exercise price, term, number of options granted, as well as valuation of stock options and disclosure of pro forma income statements. For example, Zenith Electronics Corporation states that ‘As an alternative to the proposed statement, the company would favour disclosure in lieu of recognition as presented in Appendix E of the Exposure Draft’. Finally, firms were coded as lobbying for summary disclosure when they supported additional disclosures but did not specifically refer to Appendix E. Typically, such firms supported disclosing information similar to that required by the SEC in the proxy statements for the five most highly compensated employees concerning stock-based compensation but expanded to include all employees in the financial statements. For example, Sysco Corporation states that ‘We would support … expanded disclosures regarding options such as those required under the [SEC] proxy rules’. One hundred and forty-eight firms (56 per cent) opposed FAS 123 entirely and favoured no disclosure beyond that already mandated by APB 25 and the SEC. Eighty firms (31 per cent) disagreed with the recognition of stock options as compensation but supported summary footnote disclosure. Twenty-six firms stated they supported pro forma income statements. Finally, eight of the sample firms supported the recognition of stock-based compensation (FAS 123). For example, Lukens, Inc. states that ‘We essentially support the theory and measurement methods proposed in the ED … financial reporting would be improved by the issuance of the proposed standard … [and] cannot find any compelling argument why compensation should not be recognized’. These eight firms were included with those twenty-six supporting pro forma income statement disclosure for a total of thirty-four firms (13 per cent of the sample).[ 8] Since the FASB issued the exposure draft in 1993, data from 1993 COMPUSTAT and information from the 1994 proxies that detail each firms executive compensation for 1993 were used. Instead of using only the value of current SBC granted to the top five executives (as followed in Dechow et al., 1996), from the proxy statements data on the value of the unexercised stock options held by the top five employees was gathered. Including the value of unexercised stock options helps mitigate the possible confounding effects of using any one years grant which may vary unsystematically and allows us to calculate total (current grants and prior holdings of) SBC for the top five executives. The amount of current stock option grants for all other employees and the percentage decrease in pro forma net income was also measured (Baker, spring 1993). The average value of the 1993 stock option grants awarded to our sample firms top five executives is approximately $4 million while the value of the unexercised options is about $14 million. Table 1 also shows the estimated dollar value of the 1993 options for all employees (on average $29.7 million) and the potential dollar decrease in pro forma net income (on average $11 million) due to the 1993 option grant. Finally, the table reports that median and mean firm sales are about $2 billion and $7 billion, respectively, which indicates that the firms responding to the ED were generally large firms. Remaining analyses, involved combining the current and prior stock-option grants and using the variable ‘total SBC for the top five executives’. Notice that the means for the value of total SBC for the top five and the value of other employee stock option grants are significantly higher for the group of firms that oppose any change in venue. In particular, the value of the total SBC for the managers that opposed a venue change are 50 per cent greater than the total SBC for the managers that support reporting SBC in a new venue. Recall that proxy statements already provide information about the SBC of the top five executives. Therefore, the firms that lobbied for disclosure of SBC in the annual report would only provide incremental information on the other employee SBC. It is argued that firms that have little or no other employee SBC to disclose should be indifferent between the two venues as both venues would report essentially the same information. A test of whether it is the amount of personal wealth (SBC) that drives managers to oppose a change in reporting venue rather than unwillingness to disclose additional information in a new venue is to hold the additional information constant. It is found that even when other employee stock-based compensation is low or non-existent, the more personal wealth (SBC) managers have, the less likely they are to support a change in reporting venue. This leads to the conjecture that a reluctance to disclose SBC in the financial statements may be similar to a reluctance to disclose ones taxable income. That is, as SBC increases, it is more likely that firms will oppose a change in reporting venue. As in the university test, the effect on pro forma net income is not significant in the logic model. These results support the hypothesis: H1: Economic self-interest as measured by SBC is related to venue choice. The mean value of total SBC of the top five is significantly higher (p < 0.01) for the group of firms that oppose presenting pro forma net income. We also find significant differences between groups for mean values of other employee stock-based compensation. These results indicate that the higher SBC is in general, the less likely firms are to lobby for pro forma disclosure of SBC. However, the impact of recognizing SBC on pro forma net income is not significant. While the university tests examine the variables of interest only in isolation, they provide some support for hypothesis 2: H2: The value of SBC is significantly related to lobbying position on the format of disclosed information. REFERENCES Ang, N., N. Gallery and B. K. Sidhu, ‘The Incentives of Australian Public Companies Lobbying Against Proposed Superannuation Accounting Standards’, Abacus, February 2000. Baker, T. A., ‘Options Reporting and the Economic Self-Interests of CEO Pay’, Journal of Accounting, Auditing and Finance, Spring 1999. Berton, L., ‘Accounting Rules Board is Under Fire as it Nears Decision on Two Key Issues’, Wall Street Journal, 6 April 1993. -----, ‘Accounting Rule-Making Boards Proposal Draws Fire — Suggested Switch on Employee Stock Options Seen Hurting Profit, Hiring’, Wall Street Journal, 5 January 1994. Berton, L., and J. S. Lublin, ‘FASB May Delay Its Plan to Require the Disclosure of Stock Options Cost’, Wall Street Journal, 5 November 1993. Black, F., and M. Scholes, ‘The Pricing of Options and Corporate Liabilities’, Journal of Political Economy, May/June 1973. Coopers and Lybrand, Stock Options: Accounting, Valuation, and Management Issues, Coopers and Lybrand, 1993. Deakin, E. B., ‘Rational Economic Behavior and Lobbying on Accounting Issues: Evidence From the Oil and Gas Industry’, The Accounting Review, Vol. 66, No. 1, 1989. Dechow, P. M., A. P. Hutton and R. G. Sloan, ‘Economic Consequences of Accounting for Stock-Based Compensation’, Journal of Accounting Research, Vol. 34 (Supplement), 1996. Delaney, K. J., and D. Wessel, ‘Lumpy Gravy: Suppose Stock Options Involved More Pain Than Financial Gain’, Wall Street Journal, 21 December 1999. Ellison, S., ‘Recruiters Look Across the Pond to Fill Ad Posts — Brain-Drain Threat Looms, but European Firms Battle to Keep Talent’, Wall Street Journal, 27 March 2000. Read More