FASB Graded and The Grade Is Ugly

Who evaluates the FASB’s performance?  The performance of business enterprises and investment managers is closely monitored by investors, often on a quarterly basis. Such close scrutiny significantly enhances the performance of these enterprises by keeping managers and directors on their toes, and triggering needed changes (CEO turnover, board changes) by takeovers or hedge fund interventions. In contrast, public institutions (SEC, IRS, FDA, EPA, etc.) aren’t subject to formal evaluation but their top personnel and agenda are often affected by voters through the election process. Occasionally, often in the wake of crises, the performance of these institutions—the SEC’s failure to detect massive frauds (Enron, WorldCom, Bernie Madoff), or deficient reporting of financial institutions before, and during the financial crisis—is publicly discussed.

In contrast, the Financial Accounting Standards Board (FASB)—the powerful organization that sets accounting and financial reporting rules in the U.S., and whose rules are in fact the law of the land for public companies, isn’t subject to any formal and publicly available performance evaluation, and it even gets a free pass from accounting scandals. In the wake of Enron, The Economist wrote: The real Enron scandal is that so much of what Enron did was consistent with generally accepted accounting principles. Except for this slight slap on the wrist, no one blames accounting regulators for mishaps that could have been avoided by improved accounting and financial reporting, like better risk disclosure by the financial institutions which collapsed during 2007-2008. By the way, the same lack of public scrutiny applies to the IASB, the International Accounting Standards Board, responsible for setting accounting and reporting standards outside the U.S. The downside of the absence of public scrutiny is that there are no incentives to improve operations.

So, it’s a rare and satisfying occasion when a comprehensive evaluation of the FASB’s effectiveness is performed and publicly disclosed. This was recently done by four well-known accounting researchers: Urooj Khan and Shiva Rajgopal from Columbia University, Bin Li from the University of Texas, and Mohan Venkatachalam from Duke, sharing their findings in the paper titled: “Do the FASB’s Standards Add Shareholder Value?” (You can Google it.)

To avoid undue stress, here is the researchers’ answer: No! The FASB’s standards—all of them, issued during 1973 through 2009—didn’t improve investor’ lot.

First, why should good, socially beneficial accounting and reporting standards “add shareholder value”? The key point is: Investors’ uncertainty concerning the future performance and growth of companies weighs heavily on their share prices. The higher the uncertainty, the lower the share prices. Suppose a retailer which used to disclose monthly same-store-sales data (not required by GAAP) ceases this disclosure. Investors, being now in the dark about sales trends during the quarter (increased uncertainty), will obviously be willing pay less for the retailer’s shares, than they have paid before the disclosure change. A few years ago, researchers examined the effect on share prices of companies announcing that they will no longer provide earnings guidance to investors, thereby increasing investors’ uncertainty. The shares dropped, on average, by more than 5% on the announcement.

So, if the FASB’s standards improve corporate transparency and decrease investors’ uncertainty, as claimed by the FASB, its standards should “add shareholder value.” That’s what the four researchers set out to examine.

To be comprehensive, the researchers considered all the FASB’s accounting and reporting standards issued from the FASB inception (1973) through 2009: a total of 138 standards.
For each standard they identified key dates where information about the standards was publicly disclosed, and could have affected share prices (e.g., placing an item on the FASB agenda, public hearings about the standard, publication of final standard). For each standard they determined the sample of impacted companies. For example, standard No. 2, mandating the expensing of R&D, affects only companies conducting R&D. The remaining companies, unaffected by the standard, serve as control. Finally, for the affected companies, the researchers added the share price changes around the various announcements related to the standards. These cumulative share price changes indicate shareholder value added. Overall, a very sophisticated and comprehensive research design. The findings will surely surprise you:

  • 104 of the 138 standards considered (75%) had absolutely no effort on share prices. 19 standards in fact decreased share prices of the affected companies, and only 15 standards (11%) were associated with shareholder value added. Truly amazing: Almost 90% of the standards issued by the FASB during its first 35 years of operation had either zero or negative effect on the intended users of the presumably improved information—capital market investors.
  • The worst standards, those causing the largest loss to shareholders, were the various fair value standards and standard No. 2, mandating the immediate expensing of R&D. The main reason for the damage fair value standards inflict on shareholder is that they increase substantially the role of managerial estimates in financial reports. Many of these estimates—marking-to-market of non-traded assets—are sheer guesses prone to manipulation. I have written on this blog before on the adverse effects of accounting estimates on the usefulness of financial information (“Financial Reports: Facts Or Fiction”).
  • Principles-based standards add more shareholder value than rules-based standards, but much of accounting standard-setting is still heavily rules based.

So, the grade given the FASB by the four researchers is a resounding F.

For my international readers, most residing in countries using the international accounting standards (IFRS), I am not familiar with a comprehensive evaluation of the IASB like the one above, given to the FASB. There are many studies evaluating the information improvement caused by countries adopting IFRS. A meta study summarizing this research (Lourenco and Branco, “Main Consequences of IFRS Adoption…” 2014) indicates, not surprisingly, that countries with poor financial information quality saw an information improvement upon adoption of IFRS. For others, the evidence is mixed. However, given that IFRS is essentially quite similar to U.S. GAAP, my hunch is that the impact of IFRS on shareholders, beyond the initial adoption, is similar to that found for U.S. GAAP.

Finally, going back to the FASB, I asked the authors of the devastating FASB study if they were asked by the FASB to share their findings with the board, and think about ways to improve accounting standard-setting. The answer was: No! Go figure, a public institution isn’t even interested in hearing from the authors of a comprehensive study about its effectiveness.

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