Showing papers by "Catherine M. Schrand published in 2003"

Earnings Management Using the Valuation Allowance for Deferred Tax Assets under SFAS No. 109

Abstract: Statement of Financial Accounting Standards No. 109 (SFAS No. 109) allows firms to use their discretion to set arbitrarily high valuation allowances against deferred tax assets. Firms can then later use these "hidden reserves" to manage earnings. Our evidence indicates that most banks do not record a valuation allowance to manage earnings, but rather to follow the guidelines of SFAS No. 109. However, if the bank is sufficiently well capitalized to absorb the current-period impact on capital, then the amount of the valuation allowance increases with a bank's capital. In later years, bank managers adjust the valuation allowance to smooth earnings. The magnitude of the discretionary adjustment increases with the deviation of unadjusted earnings from the forecast or historical earnings.

Evaluating concepts-based vs. rules-based approaches to standard setting

Abstract: INTRODUCTION In its new project on Codification and Simplification, the FASB indicates its intent to evaluate the feasibility of issuing concepts-based standards rather than issuing detailed, rule-based standards with exceptions and alternatives.' Related to this project, members of the FASB board and staff asked the Financial Accounting Standards Committee of the American Accounting Association (hereafter, the Committee) to provide comments on concepts-based standards and to recast two standards as concepts-based. (2) This article summarizes comments of the Committee on issues related to concepts-based vs. rules-based standards. Comments in this article reflect the views of the individuals on the Committee and not those of the American Accounting Association. The Committee strongly supports the commitment by the FASB to evaluate the feasibility of concepts-based standards. (3) We believe that the economic substance, not the form, of any given transaction should guide financial reporting and standard setting, and that concepts-based standards represent the best approach for achieving this objective. Rules-based standards provide companies the opportunity to structure transactions to meet the requirements for particular accounting treatments, even if such treatments don't reflect the true economic substance of the transaction. We recognize, however, that the current plethora of detailed rules has been demand-driven, suggesting that companies may request more guidance than that provided by concepts-based standards. Additionally, a change from rules-based to concepts-based standards magnifies the importance of informed professional judgment and expertise for implementation of standards. Overall, however, we believe that concepts-based standards, if applied properly, b etter support the FASB's stated mission of "improving the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability...." RULES-BASED VS. CONCEPTS-BASED STANDARDS An Illustration of Rules-Based and Concepts-Based Standards In order to make our discussion of concepts-based vs. rules-based standards more concrete, we characterize the accounting standard-setting process and its products as a continuum ranging from unequivocally rigid standards on one end to general definitions of economics-based concepts on the other end. An example of the extreme left (rigid) end of the continuum is: Annual depreciation expense for all fixed assets is to be 10 percent of the original cost of the asset until the asset is fully depreciated. Such a rule leaves no room for judgment or disagreement about the amount of depreciation expense to be recognized. Comparability and consistency across firms and through time is virtually assured under such a rule. However, such a standard lacks relevance due its inability to reflect the underlying economics of the reporting entity, which differ across firms and through time. At the opposite (right) end of the continuum is a provision or rule such as the following: Depreciation expense for the reporting period should reflect the decline in the economic value of the asset over the period. (4) Such a standard requires the application of judgment and expertise by both managers and auditors. The goal is to record economic depreciation of the asset, something about which the manager arguably has more information than anyone else. Many might agree that such a rule reflects the underlying purpose of financial reporting, but argue that it is too costly to implement and would likely lead to results that are neither comparable across firms nor consistent through time. Benefits and Costs of Rules-Based vs. Concepts-Based Standards Rules-Based Standards Evidence abounds that detailed standards cannot meet the challenges of a complex and rapidly changing financial world, and that they frequently provide a benchmark for determining compliance in form but not in substance (Finnerty 1988). …

Implications of Accounting Research for the FASB's Initiatives on Disclosure of Information about Intangible Assets

Abstract: AAA Financial Accounting Standards Committee INTRODUCTION On January 9, 2002, the Financial Accounting Standards Board (FASB) added a project to its technical agenda titled Disclosure of Information about Intangible Assets Not Recognized in Financial Statements. The FASB undertook this action based on constituents' responses to the August 17, 2001 request for comments on the FASB's Proposal for a Project on Disclosure about Intangibles. Since adding the project to its technical agenda, the FASB decided to restrict the scope of the project to intangible assets that currently are not recognized in the balance sheet, but would be recognized if acquired in a business combination under Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations (FASB 200la). Such intangibles encompass those grounded in contracts or other legal rights and those that are separable from the business. The project's scope also includes in-process research and development (R&D) costs that are written off to expense on the day they are acquired under FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method. Although deliberations on the project have been temporarily suspended to allow the FASB's staff to work on higher priority projects, the FASB plans to resume the project at some point in the future. The Financial Accounting Standards Committee of the American Accounting Association (hereafter, the Committee) responded to the FASB's request for comments on a Proposal for a Project on Disclosure about Intangibles. Additionally, based on the FASB's request for information about academic research related to intangibles, the Committee prepared a document summarizing this research and its implications for the FASB's project on intangibles. The Committee and the FASB discussed this document at a meeting at the FASB offices in May 2002. This paper contains the Committee's summary of research related to intangibles and the Committee's evaluation of the implications of the research for disclosure related to and recognition of intangible assets, (1) We expand the discussion of intangibles beyond that contained in the FASB's project on intangibles in two ways. First, we discuss research that has implications for intangibles not included in the restricted scope of the FASB's project described above. Second, we examine implications of research for recognition of intangibles, in addition to implications for disclosure of information related to intangibles. RESEARCH RELATED TO INTANGIBLE ASSETS We categorize research on intangibles into three areas that we discuss in turn: (1) research related to current financial reporting for intangible assets, (2) research related to disclosures about intangible assets, and (3) research related to recognition of intangible assets. Most of this research is empirical-archival in nature and focuses on R&D-related intangibles. Overview of the Nature of Intangibles Research For pragmatic reasons, most research on intangibles focuses on those intangibles generated by R&D expenditures. Data on R&D spending are widely available because R&D expenditures must be disclosed separately under SFAS No. 2, Accounting for Research and Development Costs. Because there is no such requirement for other types of intangibles expenditures, Lev (2001, 54-55) notes that empirical-archival research on intangibles is hindered. The focus on R&D raises the question of whether the results of this research generalize to other types of intangibles. It seems to us that the answer to this question depends on whether R&D assets are economically similar to other intangibles and on how familiar investors are with information about other types of intangibles. If the economic process involved in developing these other intangibles is different from that of R&D intangibles, it is not clear that evidence based on R&D has direct implications for other types of intangibles. …

Earnings Management Using the Valuation Allowance for Deferred Tax Assets Under SFAS 109

Abstract: SFAS 109 allows firms to use their discretion to set arbitrarily high valuation allowances against deferred tax assets. Firms can then later use these "hidden reserves" to manage earnings. Our evidence indicates that most banks do not record a valuation allowance to manage earnings, but rather to follow the guidelines of SFAS 109. However, if the bank is sufficiently well capitalized to absorb the current-period impact on capital, the amount of the valuation allowance increases with a bank's capital. In later years, bank managers adjust the valuation allowance to smooth earnings. The magnitude of the discretionary adjustment increases with the deviation of unadjusted earnings from the forecast or historical earnings.

Evaluation of the FASB's Proposed Accounting and Disclosure Requirements for Guarantors

Abstract: INTRODUCTION The May 22, 2002 FASB Exposure Draft, Guarantor's Accounting and Disclosure Requirements, Including Indirect Guarantees of Indebtedness of Others (hereafter ED), addresses initial recognition, initial measurement, and disclosure issues related to guarantees. Although it undertook the guarantee project in conjunction with its project on consolidation guidance related to special-purpose entities (SPEs), the FASB addressed guarantees in a separate project because guarantees also arise in situations other than those associated with SPEs. The ED calls for recognition and increased disclosure of the liability associated with a guarantor's obligations under guarantees. It takes the position that a guarantee obligates the guarantor in two respects: (1) the guarantor undertakes a noncontingent obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur and (2) the guarantor undertakes a contingent obligation to make future payments if those triggering events or conditions occur. The noncontingent obligation occurs when the guarantor commits to the guarantee, while the contingent obligation occurs only when certain future conditions arise; for example, the entity whose debt is guaranteed defaults on payments. While the ED is not explicit on the nature of the noncontingent liability, we believe it is best characterized as deferred revenue for most guarantees. An example in the ED sets the stage for this interpretation: "if a seller-guarantor issues to its customer's bank a guarantee of the customer's loan whose proceeds are used to pay the seller for the assets being purchased, the failure to recognize a liability for the issuance of the guarantee overstates the profit on the sale." (1) Just as an insurer charges a premium as compensation for its exposure to losses, the guarantor in this example must be compensated for its guarantee commitment and resulting exposure under the guarantee--the noncontingent element. (2) This example suggests that a portion of the proceeds from the sale be deferred, and recognized over the period of time covered by the guarantee. The ED calls for the guarantor to recognize as a liability the fair value of the noncontingent element of the guarantee, (3) and confirms the applicability of FASB Statement No. 5, Accounting for Contingencies, to the contingent element of the guarantee. The ED also identities four disclosure items to be provided by the guarantor. These include: * the nature of the guarantee, including how it arose and the circumstances that require the guarantor to perform under the guarantee, * the maximum potential amount of (undiscounted) payments the guarantor could be required to make under the guarantee, * the current carrying amount of the liability, and * the nature of (1) any recourse provisions that enable the guarantor to recover from third parties any of the amounts paid under the guarantee, and (2) any assets held either as collateral or by third parties that the guarantor can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee. The ED raises issues related to valuation of contingent liabilities, financial statement recognition vs. footnote disclosure, and effects of increased footnote disclosure. This article examines academic research relevant to the issues raised in the ED and presents the views of the AAA Financial Accounting Standards Committee (FASC) (hereafter the Committee) on the ED. The Committee based these views on inferences from existing research findings, an understanding of the Conceptual Framework, and views expressed in previous Committees' communications with the FASB and IASC on guarantees related to transfers of financial assets and contingent liabilities. (4) REVIEW OF RELATED ACADEMIC LITERATURE Capital Markets (Archival) Research Valuation Implications of Contingent Liabilities Capital markets research provides evidence that contingent liabilities are relevant to capital market participants' valuation decisions. …