FINANCIAL REPORTING OUTCOMES UNDER LOBBYING VERSUS NON- LOBBYING IN ACCOUNTING STANDARD SETTING PROCESS The Case of Lease Accounting 1 Margaret Annan Master Thesis in Accounting and Control University of Amsterdam Business School Thesis Details Draft Version: 11August 2014 Student #: 10662979 First Supervisor: Dr. Sanjay Bissessur Second Supervisor: Dr. Sander Van Triest Version: Final 1 [email protected] Accountancy and Control 2013-2014 Academic Year The author would like to thank Dr Sanjay Bissessur for his tremendous guidance and assistance throughout the thesis. MA_ Masters Thesis_2013/14 Page 1 PREFACE This thesis is submitted in fulfillment of the requirement of the University of Amsterdam to obtain my Master degree in Accountancy & Control. The experience obtained during the research process of this master thesis was a respectful one. It provided in depth knowledge and increases my market value specifically on such a crucial business relevant topic as leases. This process required extensive reading, self motivation, planning and enthusiasm and after all these dedication, I managed to accomplish my dream, which is to obtain the Master degree. First of all, I would like to thank God for the strength and enablement to achieve this goal today, without whom I would not have had the energy to complete. Secondly, I would like to Dr. S.W. Bissessur, my thesis supervisor, for his immense support, quick responses and useful thoughts during the whole process and Professor Brendan O' Dwyer for his insight into current lease issues. Last but not the least,, I would like to thank my entire family and friends for the support and inspiration throughout the entire master program, especially not forgetting my wonderful and talented daughters, Valerie and Mirabel Annan, who helped immensely with analysis and proof reading. Margaret Annan Amsterdam, 11 August 2014 MA_ Masters Thesis_2013/14 Page 2 ABSTRACT One of the major projects in the convergence of FASB US GAAP and IASB IFRS has been the change of the Current Lease Standard. The two overarching reasons why boards will add a project to their agenda is firstly, when the financial report from the incumbent standard does not give an objective and complete reflection of the underlying economics and secondly when the benefit from information improvement to users exceeds the cost to preparers for providing this information. By adding lease proposal to the agenda, it means that these two conditions have been satisfied. Since the introduction of the lease standard change in Discussion Paper DP2009, there have been reactions from different interest groups about the pros and cons of both the current and the proposed lease standards. The current standard has been criticized for allowing lease transactions to be classified as operating lease instead of capital/finance lease. Collin et al (2012) examines lease classification ratios and finds differences in their lease classification median but no difference in the dispersion of their lease classification between preparers from US GAAP and IFRS regimes. Goodacre (2003) finds the proposal significantly impacting leverage and debt covenant. The proposed standard has been branded as “the solution” to the existing challenges of the current standards but different stakeholders have concerns about whether the boards’ objective will be realized due to its administrative complexity, economic consequence and “the duck effect”. With the boards concern about the risk of being lobbied “off course”, this research uses a hybrid of qualitative and quantitative analysis to firstly, investigate whether regime or other drivers have some influence on the lobbyist position and arguments put forward by respondents. Secondly, I empirically test if ex-post financial reporting outcomes influence lobbying decision. I use comment letters submitted to the RED842 as dataset, content analysis, and matched pair design methodology for archival study. I compare financial outcomes over 1998 to 2012 (66569 observations) Lobbying decision is proxied as submission or non-submission of CL with predictors being Lease classification ratios and controlling for ROA, LEV, and MTB, Auditor and FIRM SIZE. The result of the content analysis shows that the proposed standard brings visibility in the financial statement proper of preparers, but its administration and complexity is perceived to impede the accomplishment of the two prime objectives stated above. The result of the archival study show that there is no difference in the lease utilization and classification between lobbyist and non-lobbyist but there is difference in dispersion. The results also confirm the size effect of lobbying and support the existence of free riding. It also supports the regime effect as claimed by Collin et al (2012). This suggests that the issues, reasons, effects and solutions expressed in the content analysis are a representative of a wider community. The boards are urged to undertake further consultation and engagements with stakeholder groups to redress issues flagged. Future standard should be benchmarked against set objective to ensure a balance between efficiency and legitimacy. (Prada 2013) Key Words: Lease Accounting, Lobbying, Free Riding, Taxonomy MA_ Masters Thesis_2013/14 Page 3 Contents LIST OF ACRONYMS .......................................................................................................................................................... 5 LIST OF TABLES & FIGURES ................................................................................................................................................. 6 CHAPTER 1 INTRODUCTION ................................................................................................................................................ 7 1.1 BACKGROUND .................................................................................................................................................... 7 1.2 RESEARCH QUESTION .......................................................................................................................................... 9 1.3 MOTIVATION AND CONTRIBUTION ....................................................................................................................... 10 1. 4 RESEARCH DATA SELECTION AND METHODOLOGY .................................................................................................... 12 1.5 FINDINGS AND LIMITATIONS ............................................................................................................................... 12 CHAPTER 2 LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT ...................................................................................... 13 2.1 CURRENT LEASE ACCOUNTING ............................................................................................................................. 14 2.1.1 LEASE DETERMINATION AND CLASSIFICATION ......................................................................................................... 14 2.1.2 LEASE RECOGNITION .......................................................................................................................................... 15 2.1.3 DISCLOSURE REQUIREMENT ................................................................................................................................ 15 2.1.4 CURRENT LEASE ACCOUNTING IMPACT ASSESSMENT ............................................................................................... 15 2.2 PROPOSED LEASE ACCOUNTING ........................................................................................................................... 16 2.2.1 LEASE DETERMINATION AND CLASSIFICATION ......................................................................................................... 16 2.2.2 LEASE RECOGNITION ......................................................................................................................................... 17 2.2.3 DISCLOSURE REQUIREMENT ................................................................................................................................ 18 2.2.4 IMPLEMENTATION ............................................................................................................................................ 19 2.2.5 PROPOSED LEASE ACCOUNTING IMPACT ASSESSMENT .............................................................................................. 21 CHAPTER 3 STANDARD SETTING PROCESS ..................................................................................................................... 23 3.1 LEASE STANDARD SETTING PROCESS ..................................................................................................................... 24 3.2 LOBBYING THEORY AND PRACTICE ........................................................................................................................ 25 3.2.1 INTEREST GROUP THEORY ................................................................................................................................... 26 3.2.2 IMPACT OF LOBBYING ON STANDARD SETTING IN ACCOUNTING ................................................................................. 26 CHAPTER 4 HYPOTHESIS DEVELOPMENT ....................................................................................................................... 28 4.1 REGIME EFFECT ON PARTICIPATION AND CONCERNS IN LOBBYING .............................................................................. 28 4.2 LEASE CLASSIFICATION MEDIAN EFFECT ................................................................................................................. 29 4.3 LEASE CLASSIFICATION DISPERSION EFFECT ............................................................................................................ 30 CHAPTER 5 SAMPLE IDENTIFICATION AND METHODOLOGY ............................................................................................... 31 5.1 QUALITATIVE DATA SAMPLE SELECTION ................................................................................................................ 31 5.2 METHODOLOGY FOR ANALYSIS OF COMMENT LETTERS ............................................................................... 31 5.3 ANALYSIS OF INFORMATION ON THE MESSAGE ITSELF AND CODING TAXONOMY. ....................................... 32 5.3.1 TAXONOMIES FOR ISSUES ............................................................................................................................. 32 5.3.2 TAXONOMIES FOR REASONS ......................................................................................................................... 33 5.3.3 TAXONOMIES FOR EFFECTS .......................................................................................................................... 33 5.3.5 TAXONOMIES FOR SOLUTION ........................................................................................................................ 34 5.4 QUANTITATIVE DATA SAMPLE SELECTION .............................................................................................................. 35 5.5 METHODOLOGY FOR EMPIRICAL ANALYSIS ............................................................................................................. 36 5.5.1 FINANCIAL REPORTING RATIOS AND REGRESSION MODELS ....................................................................................... 37 CHAPTER 6 RESULTS ................................................................................................................................................. 41 6.1 QUALITATIVE RESULTS ........................................................................................................................................ 41 6.2 EMPIRICAL RESULTS ........................................................................................................................................... 43 6.3 DESCRIPTIVE STATISTICS ..................................................................................................................................... 44 6.4 MULTIVARIATE ANALYSIS .................................................................................................................................... 49 CHAPTER 7 CONCLUDING DISCUSSIONS ........................................................................................................................ 53 BIBLIOGRAPHY ............................................................................................................................................................... 55 APPENDICES .................................................................................................................................................................. 59 MA_ Masters Thesis_2013/14 Page 4 List of Acronyms AASB Australian Accounting Standard Board AT Asset Turnover Ratio BDL Bundesverband Deutscher Leasing BIG 4 Deloitte & Touche, Ernst & Young, KPMG, PriceWaterhouseCoopers CL Comment Letter submitted in the RED 842 DP Discussion Paper ED Exposure Draft FASB The Financial Accounting Standards Board FLA Finance & Leasing Association G4+1 The Group of Four Plus One IASB The International Accounting Standards Board IASC The International Accounting Standards Committee KWIC Key Word in Context LEV Leverage MTB Market to Book Ratio NCL A matched sample who did not submit Comment Letters PCAOB Public Company Accounting Oversight Board RED Revised Exposure Draft ROA Return on Asset SEC U.S. Securities and Exchange Commission THE BOARDS The FASB and IASB boards UvA University of Amsterdam MA_ Masters Thesis_2013/14 Page 5 List of Tables & Figures List of Tables Table 1: Key Highlights of the Current & Proposed Standards .............................................................. 20 Table 2: Sample – Matched Dataset Per Variable & Financial Year ...................................................... 36 Table 3: Additional Proxies for Regression Model ............................................................................... 39 Table 4: Overview of Lease Utilisation and Classification Metrics ........................................................ 40 Table 5: Overview: Robustness Test Conducted to test Hypothesis ....................................................... 40 Table 6: Total Sample, Mean, Standard Deviation & Percentiles ........................................................... 44 Table 7: Subsample, Mean, Standard Deviation & Percentile CL & NCL .......................................... 45 Table 8: Pearson (below diagonal) and spearman (Above) correlation ................................................. 46 Table 9: Paired Mean t test of Lobbying and Peer Sample .................................................................... 47 Table 10: Results from Wilcoxon Ranked Sum Test ................................................................................ 48 Table 11: Regression Analysis of Lobbying Association with Lease Classification Ratios .................... 50 List of Figures Figure 1: Lease Classification Model for Leases by Lessee (IASB May 2013) ....................................... 17 Figure 2: Lease Accounting and Recognition (IASB Lease Snapshot May 2013) ................................... 18 Figure 3: Results by Coding Taxonomy – Issues .................................................................................... 41 Figure 4: Result by Coding Taxonomy - Reason .................................................................................... 42 Figure 5: Result by Coding Taxonomy – Effect ...................................................................................... 42 Figure 6: Results by Coding Taxonomy - Solution ................................................................................. 43 . MA_ Masters Thesis_2013/14 Page 6 Chapter 1 Introduction This paper compares the financial reporting outcomes of companies that lobbied on Lease Re- Exposed Draft Topic 842, in the proposed lease standard setting process, with a matched sample that did not lobby to see if there is a relationship between their ex-post financial reporting outcome and the propensity to lobby in a certain way. The paper is organized as follows: Chapter 1 gives a background to and a summary of the entire research followed by a literature review in Chapter 2. The standard setting process is discussed in Chapter 3 followed by the development of hypothesis in Chapter 4. In Chapter 5 I provide the research methodology followed by analysis of data and results in Chapter 6. I conclude with a summary, limitations and recommendation for future research in Chapter 7. 1.1 Background The increasing complexity of today’s Capital Market, the changing expectations of the actors therein, coupled with recent scandals like Enron, have mounted pressure on financial regulators (hereafter referred to as standard setters) to review and in some instances revamp accounting standards due to their “economic consequence2” (Zeff 1978).The objective of these standard setters is to develop high quality, understandable, enforceable and globally acceptable standards to ensure that the regulated firms produce transparent3 and comparable4 financial information useful for decision making, and reduce information asymmetry5.Changing accounting standards presumably create changes in the set of policy choices available to firms with implicit effect on the firms’ performance. Thus ‘the more a [proposed] standard interferes with existing contracts or reduces accounting policy choice [the more likely it is for interested and divers groups to react]’. (Scott 6e edition, p 319) or even reject the standard. Standard setters6 therefore have a challenge to weigh the cost/benefit of new standards to overcome the unwillingness of constituencies7 to accept the standard. To encourage consensus, due process mechanisms are developed and structured to engage all constituencies in a ‘delicate balancing’ act (Zeff, 1978). In other words, the responsibility of these standard setters is twofold. Firstly to find the right accounting solutions to reduce market participants asymmetry and secondly to make healthy choices among the different views of groups and individuals’ conflict of interest (Wyatt 2004, p.28). Prada (2013) describes it as balancing efficiency and legitimacy. To this end, Standard Setters “invite individual and organization to send written comments on all matters in the Exposure Draft 2Zeff (1978) defines Economic consequence as the impact of accounting reports on the decision making behaviour of business, government and creditors. Thus accounting reports can affect real decisions of managers and others rather than simply reflecting the results of these decisions. 3Transparency: When an information is a faithful representation of the underlying transactions 4Comparability: The quality of information that enables users to identify similarities in and differences between two sets of economic phenomena (FASB 1980, 9; IASB 2010, A36). 5Information Asymmetry: When parties of a business transaction or potential transaction have an information advantage. Information asymmetry is twofold in standard setting and can sometimes be conflicting. The first is the asymmetry between providers of financial capital and the regulated firms and the second is between the regulators and the regulated Firms. Standards set must reduce both asymmetries for their standard to be acceptable by all constituencies 6Standard Setters refers to Accounting Regulatory bodies International Accounting Standards Board and Financial Accounting Standard Board, specifically to their convergent project 7Constituencies here refers to all stakeholders and interested parties of a subject matter MA_ Masters Thesis_2013/14 Page 7 of a proposed standard” (Aug 2010 ED Lease Topic 840). This gives a political tweak to the standard setting process. One of such standard in the process of revamp by the FASB and IASB in their major convergence project is Lease Accounting8 . In 1996, the G4+1 published a report, Accounting for Leases: A new Approach advocating for a conceptual approach to lease accounting with all leases reflected in the Balance Sheet. In 2003 the SEC conducted a study on the adoption of principle based standards. They conjectured that whereas too much rules as in US GAAP provided an opportunity to circumvent the intent of a standard, too much principles, as in IFRS, did not give enough guidance or structure for exercising judgement by preparers and auditors, making legal enforcement difficult. In June 2004, the IASB and the FASB agreed that accounting for leases was in need of a fresh look following criticisms that the current standard failed to provide complete and transparent information. In 2005, the SEC issued a report on off-balance sheet activities and recommended that the existing lease accounting requirement be reviewed to ensure greater transparency in financial reporting. Several academic studies have made similar recommendations. According to FASB ‘there has been a widespread request from “users” (investors and analysts) of financial statements and other stakeholders to change the accounting guidance so that lessees would be required to recognize assets and liabilities arising from leases.’(Joint Lease Project update May 2014). In 2009 the Boards jointly proposed changes to Lease Accounting with the view to increase transparency and comparability among organizations and to ensure disclosure of key lease related information. With the global annual estimated value of leases signed being enormous ($640 billion in 2008 according to the World Leasing Yearbook of 2010), the proposal would affect a wide spectrum of industries and could impact on corporate behavior, making leases less attractive as a financing option (Fitch 9 Dec 2010). Barone et al (2014) document that any proposed [lease standard] change could potentially affect both preparers and users of accounting reports in terms of changes to financial ratios, assessment of risk and providing an audit of the accounting reports. So what is leasing all about? Leasing is a means by which businesses in all industries: public, private, or not-for-profit organization; can gain easy access to assets, obtain financing and reduce the organization’s exposure to the risks that comes with owning an asset. Lease financing is prevalent now because it provides easy access to capital that enables businesses to acquire the necessary assets to grow their business. It covers a wide range of assets from real estate, airplanes, trucks, ships, and construction and manufacturing equipment to other assets for administrative support. According to the latest research from the Equipment Leasing & Finance Foundation- USA, total equipment and software investment for 2012 [was] expected to reach $1.28 trillion, with total equipment finance volume estimated at $725 billion, an increase of more than 9% on 2011 figures. A similar report is given by the FLA about new asset finance business in the UK which grew by 17% to £1.93bn over a period of one year to October 2012. The German Leasing Association (BDL) reported that 2012 investment in the sector totaled €49.3bn, a marginal rise of 0.5% on 2011. The auto sector accounted for most of the new equipment business transacted. In 8 Lease Accounting standard SFAS 13 was enacted on 1st January 1976 by US FASB. Under UK GAAP accounting for leases and hire purchase contract was issued in September 1982, effective 1st July 1984 and amended in February 1997 as SSAP 21. Under International Accounting Standards it is IAS17 exposed in October 1980 (E19) and April 1997(E56), issued in December 1997 effective 1st January 1999, with 2 revisions in December 2003 and April 2009 with the last revision effective on 1st January 2010 MA_ Masters Thesis_2013/14 Page 8 Germany, ‘leasing increased its share of the overall investment market, accounting for 53% of all externally financed investments.’ (Brendan Gleeson, 2013) The proposal has received many and diverse comment letters more than during the IASC regime. This has been attributed to the directives by the European Commission for all European Union listed Companies to adopt the endorsed IFRS in Financial Reporting not later than 2005.In a recent survey by Deloitte on the perceived effect of the proposed lease accounting standards on their businesses, 284 executives reported the standards would have significant impact on debt-to- equity ratios (68%), debt covenants (44%), and the difficulty obtaining financing (40%)9. Comment Letter No. 283 puts it that ‘the proposed revised standard simply does not ensure greater transparency in the financial report for users…[and] appears to introduce a significant amount of subjectivity and judgment undermining one of the primary objective of the project.’ Assuming the perceived effects described above are representative of the leasing industry then one would expect constituents (in line with Scott p. 319) to use lobbying to influence the process and final outcome of the lease standard. Or, ceteris paribus, there will be an association between lobbying and financial reporting outcomes. Richard Watchman, an industrial editor of Exaronews (19 Jan 2013), gives a dramatic description of the perceived controversy in the proposed lease standard. He stated that ‘powerful lobby groups and regulators are at loggerheads over how companies account for leasing liabilities amounting to billions of pounds but the IASB is committed to forcing what it sees as true borrowing levels to be identified properly’. Confronted with the reality of the power of lobbying, Hans Hoogervorst (chairman of IASB), in a speech to the London School of Economics made an appeal to interest groups to help with the lease project for fear of being ‘lobbied off course’. "We will need all of the help we can get, to ensure that we do not get lobbied off course. We need national accounting standard-setters, regulators such as the SEC, investors and others to stand by their beliefs and help us to bring much-needed transparency to this important area," (Hans Hoogervorst , LSE November, 2012) Examples of a seemingly “off course lobbying” are seen in the case of PCAOB and AASB. ‘The PCAOB, a body created by Congress to police U.S. auditors in the wake of accounting scandals at Enron and Worldcom, recently dropped the idea of potentially imposing mandatory term limits on accounting firms after fierce lobbying by the industry’ (Reuter, April 2014). The release of AASB 1028 Accounting for Employee Entitlements followed a period of intense lobbying and debate, resulting in a standard that contained significantly less stringent requirements than those proposed in the preceding exposure draft.’ 1.2 Research Question There are different schools of thought about what propels Firms to lobby and there is extant research literature supporting diverse reasons why firms may indulge in lobbying during standard setting (see Chapter 3.4). Prior research on the economic consequence of lobbying examines behavior, size and leverage of the Companies. Watts and Zimmerman (1978) looks at the factors that influence management decision in the standard setting process. They conclude that with the 9 Deloitte Survey: Only Seven Percent of Companies Are Well Prepared to Comply with New Lease Accounting Standards, Press Release, February 16, 2011 MA_ Masters Thesis_2013/14 Page 9 exception of larger firms subject to political influence which will consider standards that reduce earnings, all other large firms will lobby if bookkeeping cost exceed lobbying cost. (see also Ang et. al, 2000; Francis, 1987; Schallow, 1995). Sutton (1984) attributes the size effect to the firms’ relatively lower lobbying costs, higher probability of influencing the process and greater benefits if successful and the outcome of the standard works in the favour of the lobbying firms. Dhaliwal (1982); Deakin (1989) on the other hand look at leverage and suggest capital structure of a firm as an important determinant of its management's lobbying position on an accounting standard. Sutton (1988); Schallow (1995); and Ang et al (2000) tested the effect of debt but, on the contrary, do not find any important correlation between debt and the process of lobbying. Burgstahler and Eames (2006) look at the causality from opportunistic perspective. They claim that big Corporations may lobby against a proposal either to influence the outcome or retain the ability to conceal unpleasant financial information or manage earnings. Another stream of research looks at the socio-political consequence by examining the language, culture, jurisdiction and legal settings (see Chapter 4.4). Among such authors are Jorissen et al (2013) who examine the effect of geographical representation of IASB constituents and cite language as a determinant for lobbying; Mora et al (2014) who examine cultural factors of the constituent’s country and cite regime as a determining factor (see Chapter 4.4). Overall, there is a lot of emphasis on those who lobby than those who do not lobby. What about those who do not lobby or the ‘silent participants’? Could they also hide behind those lobbying to conceal unpleasant financial information? Or could they save cost by free riding? Could the regime actually play a part? Georgiou & Roberts (2004) argue that during the process of lobbying, three categories of companies can be identified: those who lobby against the proposal, those who lobby for the proposal and those who don't lobby at all (see also Ws & Z, 1978). In light of the preceding interesting but seemingly contradictory conundrum, the aim of this research is to investigate whether there is an association between the categories of Companies identified in the lobbying process by Georgiou & Roberts (2004) and Financial Reporting Outcome. This research is timely because the proposed lease standard will change lease accounting dramatically after 30 years and obviously, the boards are concerned about the possibility of being “lobbied off course”. Five years after the discussion paper, there have been over 1700 comment letters, several stakeholder engagements and focus group meetings but still no “consensus”. As of June 2014 the boards are still deliberating on aspects of the proposal. The ensuing research questions are therefore as follows:  Does the reporting regime influence the lobbyist position in a certain way?  Do firms that Lobby differ in financial reporting outcome than those that do not lobby? 1.3 Motivation and Contribution The overarching objective of the IASB/FASB convergence project has been to eliminate the variety of differences between IFRS and US GAAP. This grew out of an agreement between the boards in October 2002 (the 'Norwalk Agreement'). Whereas some of the issues seem to fade quietly into absurdity, Leases, a major convergence projects, remains a ‘hot topic’ after years. My primary motivation for this research stems from a lecture by Professor Brendan O' Dwyer at UvA Business School on the ‘hot topics’ of the joint project. In his lecture, he discussed the MA_ Masters Thesis_2013/14 Page 10