Differential Market Responses to Alternative Implementation Methods of Mandated Accounting Changes

Abstract:     
The purpose of this study is to investigate whether and in what way adopting firms benefited from the pattern documented by Balsam et al. (1995) of reporting owners' equity increasing (decreasing) effects of mandated accounting changes in the income statement (balance sheet directly). If the market pays adequate attention to effects of accounting changes only when they are reported in the income statement and if managers wish to maximize firm value then the cost of adopting a new pronouncement is reduced when negative effects are reported directly on the balance sheet bypassing the income statement. We test this explanation on a sample of firms adopting major promulgations of the FASB over a seventeen year period from 1973 the year of FASB inception through the end of 1989. Consistent with our hypothesis we document significantly positive correlation between abnormal returns for a twelve month period around the end of the fiscal year in which the adoption of the mandated accounting change occurred and the income effects of mandated accounting changes when the adoption effects are reported in the income statement. Conversely we fail to find association between these twelve month abnormal returns and the effects of mandated accounting changes when the latter bypass the income statement and are reported directly in the balance sheet as a prior year adjustment to owners' equity.These results support the explanation that one reason that the FASB systematically deviates from APB No. 20 -- by not using the catch-up method for reporting the effects of mandated accounting changes -- is to reduce adopting firms' costs of implementation. They do so by allowing adopting firms to "bury" owners' equity decreasing effects in the owners' equity section of the balance sheet and thereby avoid any stock price decreases. An alternate explanation is that FASB does a good job by requiring only value relevant disclosure be reported in the income statement. This explanation however is doubtful because the amounts bypassing the income statement are predominately negative and because the underlying adoption effects whether reported in the income statement or in balance sheet directly have the same economic consequences.

JEL Classification: M41, G12

working papers series