As described in Section 2, financial reporting of DB plans took a significant step
towards full fair-value recognition in the new millennium due to:
. the issuance of FRS 17 in the UK in 2000;
. an endorsement of the UK rules by FASB Chairman Robert Herz in public
comments; and
. an increasing momentum towards integration of US GAAP with international
accounting standards.
The UK regulatory moves were subsequently echoed in the FASB’s regulatory
initiatives as well. Therefore, we examine the freeze decision in a period which is
characterized by clear and significant shifts in ideology relating to DB plan accounting
regulation.
Implicit in our research question is the assumed perception that recognition relative
to disclosure of pension accounting information matters. In an efficient, frictionless
market, the particular accounting treatment – recognition or disclosure – should be
irrelevant. However, the accounting choice can matter in the presence of increased
contracting costs due to recognition, non-trivial information processing costs,
systematic biases in how information is processed, and the perceived greater reliability
of recognized information over disclosed information (Ahmed et al., 2006). Therefore,
the potential threat of additional market-related costs due to the required recognition of
the DB plan funded status on the balance sheet is a credible motivating factor for the
freeze decision resulting from an imminent change in the pension accounting standard.
While research on recognition vs disclosure has largely focused on valuation
implications, we examine whether the differential accounting treatment is a significant
driver of managerial decisions regarding employee retirement plans. Regulatory
changes requiring accounting recognition of previously disclosed information can
provide incentives for managerial decisions such as pension freezes if they are
expected to affect the firm’s cash flows or contractual relationships either directly or
indirectly (Watts and Zimmerman, 1986).
Consistent with Mittelstaedt et al. (1995), we argue that firms reduce their employee
benefits in anticipation of accounting regulation even though such accounting
regulation may not directly affect firms’ cash flows. Therefore, to consider the
impending DB plan accounting regulation as a plausible motivation for the freeze
decision, we must assume that firms expect the new regulation to affect cash flows
indirectly. Requiring full balance sheet recognition of the DB plan funded status could
potentially have such indirect cash flow effects if the new accounting standard results
in increased cost of capital due to, for instance, market corrections for inefficient equity
contracting. If we suppose that DB plan balance sheet reporting under SFAS 87 is
deficient, an inefficient allocation of resources in the capital markets may result[13]. In
such a case, many firms with underfunded DB plans may be overvalued; and the
change in accounting guidance requiring a fair-value balance sheet reporting of
the funded status can result in a significant increase in cost of capital for such firms as
the markets begin to impound the newly reported information. As a result, the
impending change in pension accounting regulation can provide an incentive for the
pension freeze decision[14].
Accordingly, we expect that the anticipation of the impact associated with SFAS 158
may have driven many firms to freeze their DB plans. Therefore, we hypothesize that
firms with a potentially stronger negative impact from proposed accounting changes
As described in Section 2, financial reporting of DB plans took a significant step
towards full fair-value recognition in the new millennium due to:
. the issuance of FRS 17 in the UK in 2000;
. an endorsement of the UK rules by FASB Chairman Robert Herz in public
comments; and
. an increasing momentum towards integration of US GAAP with international
accounting standards.
The UK regulatory moves were subsequently echoed in the FASB’s regulatory
initiatives as well. Therefore, we examine the freeze decision in a period which is
characterized by clear and significant shifts in ideology relating to DB plan accounting
regulation.
Implicit in our research question is the assumed perception that recognition relative
to disclosure of pension accounting information matters. In an efficient, frictionless
market, the particular accounting treatment – recognition or disclosure – should be
irrelevant. However, the accounting choice can matter in the presence of increased
contracting costs due to recognition, non-trivial information processing costs,
systematic biases in how information is processed, and the perceived greater reliability
of recognized information over disclosed information (Ahmed et al., 2006). Therefore,
the potential threat of additional market-related costs due to the required recognition of
the DB plan funded status on the balance sheet is a credible motivating factor for the
freeze decision resulting from an imminent change in the pension accounting standard.
While research on recognition vs disclosure has largely focused on valuation
implications, we examine whether the differential accounting treatment is a significant
driver of managerial decisions regarding employee retirement plans. Regulatory
changes requiring accounting recognition of previously disclosed information can
provide incentives for managerial decisions such as pension freezes if they are
expected to affect the firm’s cash flows or contractual relationships either directly or
indirectly (Watts and Zimmerman, 1986).
Consistent with Mittelstaedt et al. (1995), we argue that firms reduce their employee
benefits in anticipation of accounting regulation even though such accounting
regulation may not directly affect firms’ cash flows. Therefore, to consider the
impending DB plan accounting regulation as a plausible motivation for the freeze
decision, we must assume that firms expect the new regulation to affect cash flows
indirectly. Requiring full balance sheet recognition of the DB plan funded status could
potentially have such indirect cash flow effects if the new accounting standard results
in increased cost of capital due to, for instance, market corrections for inefficient equity
contracting. If we suppose that DB plan balance sheet reporting under SFAS 87 is
deficient, an inefficient allocation of resources in the capital markets may result[13]. In
such a case, many firms with underfunded DB plans may be overvalued; and the
change in accounting guidance requiring a fair-value balance sheet reporting of
the funded status can result in a significant increase in cost of capital for such firms as
the markets begin to impound the newly reported information. As a result, the
impending change in pension accounting regulation can provide an incentive for the
pension freeze decision[14].
Accordingly, we expect that the anticipation of the impact associated with SFAS 158
may have driven many firms to freeze their DB plans. Therefore, we hypothesize that
firms with a potentially stronger negative impact from proposed accounting changes
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