Managerial Discretion in Accounting for Defined Benefit Obligations: An Empirical Analysis of German IFRS Statements

Transcription

1 No. 104 Managerial Discretion in Accounting for Defined Benefit Obligations: An Empirical Analysis of German IFRS Statements Marcus Salewski, Henning Zülch December 2010 A survey conducted by the Chair of Accounting and Auditing at HHL Leipzig Graduate School of Management supported by Bertelsmann Business Consulting GmbH

2 HHL-Arbeitspapier HHL Working Paper No. 104 Managerial Discretion in Accounting for Defined Benefit Obligations: An Empirical Analysis of German IFRS Statements Marcus Salewski, Henning Zülch ISSN (Online version) HHL Leipzig Graduate School of Management The sole responsibility for the content of the HHL Working Paper lies with the author/s. We encourage the use of the material for teaching or research purposes with reference to the source. The reproduction, copying and distribution of the paper for non-commercial purposes is permitted on condition that the source is clearly indicated. Any commercial use of the document or parts of its content requires the written consent of the author/s. For further HHL publications see

3 Marcus Salewski/Henning Zülch Managerial Discretion in Accounting for Defined Benefit Obligations An empirical analysis of German IFRS statements Abstract: This paper aims to make a first contribution to the determination of that proportion of the defined benefit obligation (DBO) to be disclosed in the notes which can be attributed to managerial discretion in IFRS statements by capital market oriented German companies in the period of For this, actuarial assumptions discount interest rates, the compensation growth rate and projected future pension increases are replaced by their respective industry medians. In a second step we then assess whether the thus determined discretion component raises the value relevance of the reported DBO. As a result, we can state that managerial discretion does at least not downgrade the value relevance of the DBO. In our view, this can be explained by the fact that the management possesses private information, which may become decision useful information when communicated to the capital market. For the standard setter these results imply that the regulations do not need a further standardization with regard to the actuarial assumptions. Keywords: Accounting, Defined Benefit Obligation, Earnings Management, Earnings Quality, Manipulation of Earnings, Managerial Discretion, Germany, IAS 19, IFRS, Pension Accounting, Value Relevance JEL Classification M41

4 1. Introduction One of the core tasks of the standard setters IASB and FASB is to consider how much scope for discretion the management should be allowed in the drawing up of a company s financial statement. On the one hand it is argued that such managerial discretion could lead to the manipulation of earnings by the management. Thus a significant part of the literature about international accounting deals with the questions if and why managers manipulate earnings, how they do it and what the consequences of this behavior might be. The results of research in this area are very well summarized in the survey articles of Schipper (1989), Healy and Wahlen (1999), and Dechow and Skinner (2000). Other authors believe that managerial discretion serves to communicate the management s internal information to the statement addressees (Healy and Palepu (1993)). Thus, the question if the management should be allowed a certain scope of discretion is mainly a question of whether the advantages of private information being communicated outweigh the disadvantages created by the management s opportunistic behavior (Dye and Verrecchia (1995)). In the present paper we examine this question by means of a specific accounting parameter - the defined benefit obligation (DBO). On an international level, the accounting of pensions, which often have a significant influence on the balance sheet structure of companies, is covered by IAS 19: Employee Benefits. Fundamentally, this regulation differentiates between defined contribution plans and defined benefit plans, a crucial factor being the economic content of the obligation caused by the company s pension promises. Regarding defined contribution plans, the economic obligation resulting from the pension promise is limited to the payment of a specific sum to an external social security body, such as a pension fund. These expenses are recorded in the profit and loss statement with no further balance sheet recognition. In contrast, defined benefit plans, which are 1

5 the subject of this research, have to be recognized in the balance sheet and also actuarially evaluated. These plans oblige the employer to make payments to the employee after the occurrence of the insured event. Due to the uncertainty of future events, the sum of the obligations has to be assessed considering a number of parameters. According to IAS 19.72, it is imperative to differentiate between demographic and financial assumptions in this context. Amongst the main demographic assumptions relating to defined benefit plans, IAS (a) lists assumptions regarding the employee turnover and the mortality rate. The financial assumptions essentially comprise, according to IAS (b), assumptions regarding the discount rate and the rate of compensation growth and future pension increases. IAS prescribes that the discount rate is to be determined using the return of high-class, fixed interest bearing corporate bonds. If there is no liquid market for such corporate bonds, the market returns of government bonds should become the basis for calculation. According to IAS 19.79, the discount rate only reflects the time value of money it does not, per definition, contain any risk component. In general it has to be considered that the different benefit promises have different durations, which means that different discount rates have to be applied. However, according to IAS 19.80, companies can instead use a single, weighted discount rate reflecting the settlement dates, the sum and the currency of the benefits to be paid. Regarding the evaluation of obligations, IAS (a) demands that expected future income raises are to be considered, taking into account inflation, the duration of employment at the company, promotions, and the structure of supply and demand on the labor market. Furthermore, adjustments need to be taken into account, which are ascribed to legal or factual obligations. This is, for example, true if a company has in the past regularly adjusted pension payments by a compensation for inflation. As the determination of both the discount rate and the rates of compensation growth and future pension increases are very complex and hardly comprehensible to outsiders, there exists a significant scope of discretion for the management. This can either be used to communicate decision useful, 2

6 internal information about the nature of the obligation to the statement addressees, or to manipulate both the balance sheet structure and the earnings of the company. Due to extensive criticism of the accounting of pension promises, the IASB incorporated the project post-employment benefits (including pensions) into its agenda in July However, the managerial discretion examined in this paper has so far not been discussed by the standard setter. Accordingly, we examine the question whether managerial discretion during the determination of financial assumptions increases or lowers the value relevance of the disclosed DBO. To this aim, we identify the proportion of the DBO which is not to be ascribed to managerial discretion by replacing the company specific assumptions with their respective industry values. The difference between the disclosed DBO and the identified non-discretionary component constitutes our estimator for that proportion of the DBO which can be ascribed to managerial discretion. By means of various fixed-effects regressions of our samples, comprising the IFRS statements of capital market oriented German companies in the period of , we examine the value relevance of this discretion component. More precisely we examine (1) whether the discretion component increases the value relevance of the DBO, (2) whether there is a difference between the periods of the voluntary and the mandatory (from 2005 onwards) application of IFRS, and (3) whether the funded status of the pension plans influences the practice of discretion. Accordingly, this paper is structured as follows: chapter?? provides an overview on the relevant literature, while chapter 3 introduces our research approach. Chapter 4 presents our research results followed by a final conclusion in chapter 5. In summary, it appears that the discretion component does at least not downgrade the value relevance of the DBO. The benefit of communicating private information to the 1 Meanwhile, both a discussion paper and an exposure draft have been published on this topic (see International Accounting Standards Board (IASB) and International Accounting Standards Board (IASB)) 3

7 capital market obviously outweighs the possibility of opportunistic behavior on the part of the management. This result has on the one hand considerable implications for the process of standard setting in general: Accounting should contain a certain degree of flexibility, allowing for the management to communicate private information. On the other hand our result is linked to the IASB s revision of pension accounting: In the context of this important project, the standard setters should take care that managerial discretion is only limited with regard to those aspects in which opportunistic behavior is proven to predominate. 2. Literature Survey The literature on international accounting generally subsumes a management s opportunistic behavior in form of manipulation of the published earnings under the key word earnings management (a good introduction is provided by the survey articles of Schipper (1989), Healy and Wahlen (1999), and Dechow and Skinner (2000)). Earnings management is referred to whenever managers apply discretion during financial reporting to either deceive the statement addressees about the company performance or to influence specific accounting parameters, which could for example affect performance-based payment components (Healy and Wahlen (1999), p. 368). On the other hand, this discretion might also serve to communicate company internal, private information to the statement addressees (Schipper (1989), Healy and Palepu (1993), Sankar and Subramanyam (2001)). This research paper aims to contribute to the debate on how much scope of discretion should be allowed to the management. This principally means weighing the benefits of discretion (communication of private information) against their costs (opportunistic behavior by the management) (Dye and Verrecchia (1995)). 4

8 The majority of works dealing with this subject is based on the model of Jones (1991), differentiating the accruals by a discretionary and a non-discretionary component. 2 Subramanyam (1996), for instance, demonstrates that the practice of discretion on average increases the value relevance of earnings, whereas Tucker and Zarowin (2006) show that discretionary income smoothing on the part of the management increases the information efficiency of stock prices. However, Guay, Kothari, and Watts (1996) note that such a differentiation of accruals tends to be defective, which principally renders the above statements unreliable. One possible way of avoiding such defects is to examine specific managerial decision processes (McNichols (2000)). Some authors, for example, look at the proportion of loan loss provisions of banking institutions, or alternatively loss provisions of insurance companies, which can be ascribed to managerial discretion (Wahlen (1994), Beaver and Engel (1996) und Beaver and Venkatachalam (2003) bzw. Petroni, Ryan, and Wahlen (2000) und Beaver and McNichols (2001)). The advantage of such an approach is that the authors can use their expertise in a specific subject area to model the discretionary component in a more realistic way. In this present contribution we take a similar step by examining a specific accounting parameter: the defined pension obligation (DBO). Glaum (2009) offers an overview of previous research on the subject of pension accounting. The DBO presents itself as suitable for our analysis due to various factors: On the one hand it has a significant influence on the companies balance sheet structure, on the other hand there exists an enormous scope for managerial discretion in the determination of its amount. Furthermore, companies have to disclose specifications of the essential parameters determining the amount of the DBO in the notes of an IFRS statement. Various studies have proven 2 Accruals are defined as the difference between payment surpluses (i.e. incoming payments less outpayments) and profit (i.e. revenues less expenditures). See Jones (1991). 5

9 that these parameters can vary significantly between companies and that their determination is influenced by the management (Blankley and Swanson (1995), Gopalakrishnan and Sugrue (1995), Godwin, Goldberg, and Duchac (1996)). Based on Hann, Lu, and Subramanyam (2007), we thus first determine the non-discretionary proportion of the DBO by replacing the actuarial assumptions of the management with their respective industry values. The discretionary proportion of the DBO is then deduced by the subtraction of this sum from the DBO disclosed in the balance sheet notes. One disadvantage of this approach is inherent in the fact that the amount of the DBO is only disclosed in the balance sheet notes. Thus our study cannot practically be subsumed under literature about earnings management, but should rather be seen as a contribution to accounting management in general. In this context, we must ask ourselves whether statement addressees appreciate the notes at all, or whether the capital market appraises them equally to the specifications made in the earnings statement or the balance sheet. Barth (1991), however, demonstrates that specifications regarding pension obligations are perceived by the market in a similar way to specifications about other obligations reported in the balance sheet. We thus believe that our approach is a valuable method to exploring the question whether the benefit of managerial discretion in accounting pension obligations outweighs the inherent costs. 3. Research Approach 3.1. Determining the discretion component of DBO The determination of that proportion of the DBO which can be ascribed to managerial discretion (henceforth DBO D ) is based on Hann, Lu, and Subramanyam (2007), who derive the discretionary component DBO D from the difference between the DBO disclo- 6

10 sed in the notes and that proportion of the DBO which is explicitly not to be ascribed to discretion (DBO X ). DBO X is determined by replacing company specific actuarial assumptions with their respective industry medians, as in the following equation 1. 3 We thus suggest that the DBO can be defined as 4 DBO = P i,r,l( KW ˆ (1 + g) N ) (1 + i) N. (1) In this context, P i,r,l describes the present value factor of a pension which geometrically progresses over a period L with an annuity factor r and a discount rate of i, formally expressed by P i,r,l = (1+i)L (1+r) L (i r)(1+i) L (in contrast to our approach, Hann, Lu, and Subramanyam (2007) do not take into account the projected future pension increases in their segmentation of the DBO, which must be considered a weakness of their model). L defines the average life expectancy of an employee after retirement, K indicates the proportion of the current wage level W, which is to be paid as a pension in N years. The factor (1 + g) N is used to anticipate future salary increases. It should be noted that N has to be equally applicable both to employees and to pensioners - it thus represents the average, weighted years to retirement of the complete labor pool. In other words, the DBO is the present value of the predicted pension paid over a period of L years after retirement. ˆ KW (1 + g) N, which has to be Determining the evaluation parameters i, g and r is uncomplicated, as these can be extracted directly from the notes. This is not possible for L and N, meaning that various assumptions have to be made: 3 We base our classification of industry on the industry sector specifications of the German stock exchange, see German Stock Exchange (2010). 4 For reasons of clarity, we suppress both the time index and the company index. 7

11 Assumption regarding L: In the mid-2000s, the average life expectancy of 65-year-old men was ca years, that of 65-year-old women about 20 years. 5 Thus we assume an average remaining life time of L = 18 years. Assumption regarding N: The average age in Germany in the mid-2000s was about 42 years 6, while the average age of retirement was at ca. 62 years 7. This would mean 20 years to retirement N. Since N refers to both employees and pensioners, however, we first determine an estimator to identify which proportion of each DBO is allotted to pensioners. For this purpose, the benefit payments V Z, which were due in a specific period and disclosed in the balance sheet notes, are multiplied by annuity present value factors RBF gained from the Professional Association of Mathematics Experts of the Commission for Company Pension Schemes Inc. (Arbeitsgemeinschaft für betriebliche Altersversorgung e.v.). The proportion of the DBO allotted to pensioners can thus be defined as λ = V Z RBF DBO. (2) The proportion allotted to the employees thus amounts to ϕ = 1 λ. This is multiplied by the original 20 years to retirement, providing a company- and period specific estimator for N in dependance to ϕ. Apart from ˆ KW, all elements of equation 1 are thus either known (i, r and g) or assumed (L and N). Accordingly, ˆ KW can be determined as follows: 5 See specifications of the Federal Statistical Office, to be viewed at: jetspeed/portal/cms/sites/destatis/internet/de/content/statistiken/bevoelkerung/ GeburtenSterbefaelle/Tabellen/Content50/LebenserwartungDeutschland,templateId= renderprint.psml. 6 See German Federal Statistical Office (2007), S See Deutsche Rentenversicherung Bund (German pension fund Bund), S

12 KW ˆ DBO(1 + i)n = P i,r,l (1 + g) N. (3) If we now replace the actuarial assumptions of the management (i, r and g) in equation 1 by their respective industry medians (i, r and g ), the result is DBO X, the nondiscretionary proportion of the DBO. DBO X = P i,r,l( KW ˆ (1 + g ) N ) (1 + i ) N. (4) By subtracting DBO D = DBO DBO X (5) we determine the discretionary proportion of pension obligations DBO D Value relevance tests Preliminary remark For the purpose of determining the value relevance of managerial discretion in the identification of the DBO, we execute a variety of regressions in which the market capitalization as of December 31st serves as the dependent variable. The use of this variable 9

13 (in contrast to using returns) is suitable for our study, since we examine the value relevance of a balance sheet item. Furthermore, such a model is in accordance with other contributions dealing with pension accounting (Hann, Lu, and Subramanyam (2007), Landsman (1986), Barth (1991), Barth, Beaver, and Landsman (1992)). Such a specification, however, suffers from a number of econometric difficulties, mainly those created by heteroscedasticity and economies of scale. To account for these problems, all variables are standardized by the revenues. In addition, we apply time fixed effects panel regressions with White (1980) adjustment Influence of discretionary component First we examine the relative value relevance of the pension obligation with and without discretion. For this we compare the corrected coefficient of determination R 2 as well as the coefficients of the following models I. and II. MARCAP it = 2008 t=2000 α t I t + β 1 DBO it + β 2 P A it + β 3 NI it + β 4 EMP it +β 5 RD it + β 6 T A it + u t (I.) MARCAP it = 2008 t=2000 α t I t + β 1 DBO X,it + β 2 P A it + β 3 NI it + β 4 EMP it +β 5 RD it + β 6 T A it + u t (II.) 10

14 MARCAP it defines the market capitalization as of December 31st, DBO it the defined benefit obligation, DBO X,it the non-discretionary proportion of the DBO and P A it the present value of plan assets to be enclosed. I t indicates the time fixed effects. In addition, we incorporate the following control variables into our model: NI it defines the income before extraordinary items, RD it the research and development expenses, EMP it identifies the average number of full-time employees during a fiscal year, and T A it the total assets. We have incorporated NI it because Ohlson (1995) has shown that a correct specification of such a price equation must also consider the profit for the period. EMP it and RD it are used to account for the service cost anomaly 8, while T A it serves to accommodate the aforementioned economies of scale. In a second step we examine the additional explanatory power of the discretionary component by estimating model III.: MARCAP it = 2008 t=2000 α t I t + β 1 DBO X,it + β 2 DBO D,it + β 3 P A it + β 4 NI it +β 5 EMP it + β 6 RD it + β 7 T A it + u t (III.) In this case, DBO D,it indicates the proportion of the DBO which can be ascribed to managerial discretion. All other variables are as defined above. 8 The service cost anomaly refers to the unexpectedly positive relation between service costs and stock price (Barth, Beaver, and Landsman (1992)). Subramanyam and Zhang (2001) demonstrate that the inclusion of EMP it and RD it into the regression equation disposes of this anomaly. 11

15 Transition to mandatory application of IFRS The number of companies included in our sample increases dramatically with the transition from a voluntary application of IFRS until 2004 to the mandatory IFRS application for capital market oriented companies from the year 2005 onwards. As it seems likely that companies make a significantly higher use of discretion in their first application of IFRS to allow for a good start into the accounting by IFRS standards, we estimate the following model IV. and examine whether a difference between these two periods can be observed: MARCAP it = 2008 t=2000 α t I t + β 1 DBO X,it + β 2 DBO D,it + β 3 DBO D,it P ost β 4 P A it +β 5 NI it + β 6 EMP it + β 7 RD it + β 8 T A it + u t (IV.) P ost2004 in this case indicates a dummy variable with the value of 1 for all years from 2005 onwards, and 0 for all others. All other variables are as defined above Influence of funded status Companies whose plans are strongly underfunded have, under otherwise equal conditions, stronger incentives to reduce the DBO by a careful choice of actuarial assumptions. This is why, in a final step, we examine in accordance with Hann, Lu, and Subramanyam (2007) whether there is a difference with regard to the funded status of the obligations. We define the extent of underfunding as the non-discretionary proportion of the obligations DBO X less the present values of plan assets to be enclosed (P A), divided by the 12

16 disclosed DBO. In the following estimation equation V., UF UND indicates a dummy variable by the value of 1 if the extent of underfunding is above its median, and 0 if otherwise: MARCAP it = 2008 t=2000 α t I t + β 1 DBO X,it + β 2 DBO D,it + β 3 DBO D,it UF UND + β 4 P A it +β 5 NI it + β 6 EMP it + β 7 RD it + β 8 T A it + β 9 UF UND + u t (V.) 3.3. Data description The empirical analysis is based on a sample which consists of the 160 companies from the main indexes DAX, MDAX, TecDAX and SDAX of the German capital market. These indexes comprise the largest and most traded German capital market oriented companies (by market capitalization), which often serve as benchmarks for smaller entities regarding the application of IFRS regulations. These companies also offer themselves for an analysis as they are both in the public focus and under observation of analysts. The limitation to the German capital market offers the advantage that all companies under consideration come from the same institutional and regulatory environment and are governed by the same enforcement mechanisms (Ernstberger (2008), p. 14). Furthermore, latest since the late 1990s, sufficient companies have been accounting according to IFRS, so that there are ample observations to be gathered for the sample. Glaum (2009) additionally notes that studies about pension accounting have up to this point almost exclusively been based on US-American data and regulations. We aim to close this research gap with the present contribution. 13

17 First of all, in accordance with other studies (see for example Leuz, Nanda, and Wysocki (2003), Francis and Smith (2005) or Pronobis, Schwetzler, Sperling, and Zülch (2008)), we eliminate all banking institutions and insurance companies from the sample, as their balance sheet structure differs fundamentally from the balance sheet structure of other companies, which would seriously affect the comparability of the various entities. The basic data of balance sheets and profit and loss statements of the remaining 123 companies were extracted from the Hoppenstedt balance sheet data base, while data about market capitalization was taken from Thomson Reuters Datastream. However, the relevant specifications made in the balance sheet notes concerning the DBO, the discount rates, the rates of compensation growth and future pension increases, etc., had to be handpicked. Our sample is restricted to the period of Since not all of the observed companies were accounting by IFRS during all these years, we first gain a basis of 973 firm-years for our analysis. In a next step, all those observations are eliminated, in which either the respective company was not capital market oriented or no (alternatively insufficient) specifications were made regarding the pension obligations. We then determined the industry medians i, g and r for the years , keeping to the sector classification provided by the German stock exchange. 9 We decided to exclude all those sectors to which less than five companies could be counted 10, since such a small number of companies cannot provide for the determination of reliable medians. In all other branches, i, g and r are determined for those years in which observations could be gathered for at least five companies. All observations to which this does not apply were also eliminated. 9 The German stock exchange classifies each of the listed companies as belonging to one of the following sectors: Automotive, basic resources, banking institutions, chemicals, construction, consumer, financial services, food & beverages, industrial, insurance, media, pharma & healthcare, retail, software, technology, telecommunication, transportation & logistics, utilities. For further information see?. 10 These are, apart from the already excluded sectors banking institutions and insurances: Basic resources, food & beverages, software, technology, telecommunication and utilities. 14

18 Our sample was thus reduced to 100 companies and 482 firm-years. To account for the effects of outliers, both the 0.5-percentile and the 99.5-percentile were winsorized (Tukey (1962), p. 18.). 4. Results 4.1. Descriptive analysis Companies can influence the total sum of the DBO by choosing actuarial assumptions, with higher (lower) interest or a lower (higher) rate of compensation growth and future pension increases respectively, resulting in a lower (higher) DBO. According to IAS A (n), each company is obliged to specify the evaluation parameters they applied. Table 1 provides an overview on the development of the discount rate, the rate of compensation growth and of future pension increases on the whole. As the development pictured in table 1 is aggregated for all industry sectors, observations are also considered here which were later excluded from the study due to the marginal representation of individual sectors in the sample. It becomes apparent that the development of actuarial assumptions is certainly taking place in dependance of economic conditions. However, both the standard deviation and the spread indicate that there are significant differences between individual companies. [Table 1 about here] Table 2 presents the mean value of evaluation parameters differentiated by industry sectors. It must be noted that for the majority of sectors, the number of companies sufficient for the determination of the median could only be obtained after the transition to mandatory IFRS accounting in

19 [Table 2 about here] Table 3 provides an overview on the main characteristics of our sample. The variables are defined as follows: M ARCAP indicates the market capitalization as of December 31st, T A the total assets, DBO the defined pension obligation, DBO X the non-discretionary proportion of the DBO, and DBO D that proportion of the DBO which can be ascribed to discretion. N I identifies the income before extraordinary items, RD indicates the research and development expense, EM P the average number of full-time employees during a fiscal year and N the weighted, average years to retirement of the complete labor pool. All variables apart from EMP and N are divided by the revenues to obtain standardization. [Table 3 about here] 4.2. Influence of the discretionary component Table 4 summarizes the results of the estimations of models I. and II.. The only difference between these two estimations is that the DBO functions as an exogenous variable in the first estimation, being replaced by the non-discretionary proportion of the DBO (DBO X ) in the second estimation. All variables in model I. point in the expected direction and are significant on the level p = 0.02%. This is similarly true for model II., except that P A is only significant on the level p = 0.1%. The coefficient of DBO (-2.149) is slightly lower than that of DBO X (-1.964). [Table 4 about here] 16

20 Comparing the two models, the R 2 offers itself for consideration. At 54.59%, it is marginally higher for model I. than it is for model II. at 54.47%. The three outlined information criteria also tend to support the strength of model I., which may be seen to indicate that the capital market actually rewards managerial discretion. However, there are various econometric difficulties inherent in the simple comparison of the R 2 of two models (Greene (2003), p and Kennedy (2008), pp ). We thus controlled whether the difference between the R 2 is significant on a common level by applying the Vuong (1989) test, the results of which are summarized in table 5. Clearly positive values in Vuong s Z-statistics indicate the superiority of model I., while clearly negative values point to a superiority of model II.. Accordingly, on a common level of significance we cannot assume that model I. is superior to model II. (p = 0.203). [Table 5 about here] In summary, the results show that managerial discretion does at least not downgrade the value relevance of the DBO. A superiority in a statistical sense is, however, not observable. In a next step, we examined the additional explanatory power of discretion by model III. The results of this estimation are shown in table 6. Again, all coefficients point in the expected direction and are significant on the level p = 0.01%. At , the coefficient in front of DBO D is about three times larger than the coefficient in front of DBO X. This result is not unexpected, however, if we look at the dimensions of these two variables (see table 3). Corresponding to the results of the comparison of model I. and II., this estimation also demonstrates that the capital market does not punish managerial discretion in the determination of pension obligations, but on the contrary rather tends to reward it. In this context it should be noted that the capital market 17

21 evaluates the component of pension obligations ascribed to discretion similarly to the non-discretionary component. [Table 6 about here] 4.3. Transition to mandatory application of IFRS With the transition from a voluntary to the mandatory accounting by IFRS in the year 2005, our sample increases significantly. To examine whether the management of companies accounting by IFRS for the first time made more use of discretion in the determination of pension obligations, we estimated model IV.. Table 7 summarizes the results of this estimation. Neither the coefficient for DBO D ( ) nor the coefficient for DBO D P ost2004 (-2.521) are significant on a common level. The sum of these coefficients (-6.186), which indicates the coefficient for the whole period of , is slightly higher than the DBO D coefficient of model III.. However, due to the lack of significance, these results do not allow the deduction that the coefficient had changed after the introduction of mandatory IFRS accounting. Overall, we cannot observe that companies accounting by IFRS for the first time are making a stronger use of discretion. [Table 7 about here] 4.4. Influence of funded status The incentives to (downwardly) manipulate the total sum of pension obligations by a careful choice of actuarial assumptions increase directly in correspondence with the underfunding of plans. We used model V. to verify this hypothesis, the results being 18

22 shown in table 8. The coefficient for DBO D is the one indicating the companies with the least underfunded plans. It is significant at The joint coefficient for DBO D and DBO D UF UND is also highly relevant (23.678). This represents the effect on those companies whose plans are the most underfunded. The capital market takes a perceivably stronger notice of the managerial discretion wielded by these companies. In this case, the prefix points to the opposite direction, which suggests a positive relation between the scope of discretion and market capitalization. [Table 8 about here] 4.5. The functional determination of DBO D : Opportunities and limitations It needs to be stressed that the validity of our results is strongly dependent on the functional determination of the discretionary component of the DBO, which is certainly not altogether free of mistakes. We are forced to make assumptions that influence the amount of DBO D, particularly the fundamental assumption that the scope of discretion might be determined by a deviation from the industry median, as well as the assumptions regarding life expectancy (L) and the average years to retirement (N). Thus, estimating the life expectancy after retirement to a general 18 years is an extreme simplification. Insofar as there are differences between the various companies under observation (and undoubtedly there are), DBO D must be flawed. Also, the estimator of the years to retirement N is based on assumptions, again distorting the determination of the true discretionary component. For this reason we estimate another regression equation, identifying the proportion of DBO D which can be deduced from the basic deviation between the disclosed actuarial assumptions and the respective industry medians: 19

23 DBO D,it DBO it = α + β 1 (i it i it) + β 2 (g it g it) + β 3 (r it r it) + u t (VI.) Table 9 below summarizes the results of this estimation. The coefficients are significant and point in the expected direction. Furthermore, the R 2 value of 97.9% is meaningful. It indicates that the significantly largest part can be ascribed to deviations between the disclosed i, g and r and the industry medians of i, g and r. The results demonstrate that in this context flawed assumptions about L and N have less influence on the determination of DBO D. DBO D is mainly driven by the deviations between the companies actuarial assumptions and the respective branch values. [Table 9 about here] To further verify the fault tolerance of our models, we estimated all models for a sample limited to the years , and also conducted the estimations with and without winsorizing the upper and lower percentile. For all the tested specifications we received results of equal quality. However, we do not want to conceal two further simplifications, which may lead to erroneous measurements and flawed specifications: In the case of companies providing both domestic and foreign pension plans, we assumed that the foreign pension plans may be neglected. Thus the determination of the scope of discretion in the DBO is only based on domestic actuarial assumptions, regardless of the fact that foreign assumptions might also play a certain role. We justify this means however by the observation that only a very small proportion of companies has foreign pension obligations, and that these are significantly lower than the domestic ones. Regarding the specifications disclosed in 20

24 the balance sheet notes, it should be stressed that interest rates as well as the rates of compensation growth and future pension increases are, contrary to the regulations of IAS A (n), not always provided in absolute percentages. We are confronted in a few cases with specifications of a certain (if little) spread. In these cases we simply assume that the mean of this spread represents the true value of the respective assumptions. This then is incorporated in the determination both of the industry values and of DBO D. 5. Conclusion There is a lot of disagreement as to the scope of flexibility a management should be allowed in their drawing up of IFRS statements. On the one hand it is argued that discretion might be used to manipulate the balance sheet structure and the earnings. Others believe that discretion may serve to better communicate company internal information to the statement addressees. In this present study we take a specific balance sheet item i.e. the defined pension obligation (DBO) to identify that proportion which can be ascribed to managerial discretion. In doing so, we replace the essential actuarial assumptions discount rate, rate of compensation growth and projected future pension increases by their respective industry medians. We examine whether the thus determined discretion component increases or decreases the value relevance of the DBO disclosed in the balance sheet notes. As a result we can state that the application of managerial discretion at least does not lower the value relevance. In fact, the capital market seems to even reward the use of discretion. The option to adapt actuarial assumptions to company specific conditions is generally welcomed by the capital market. This can partly be explained by the fact 21

25 that the management has access to private knowledge about the respective obligations and that the communication of this knowledge to the statement addressees may relay decision useful information. In addition, our research results demonstrate that there is no difference in the application of managerial discretion before and after the introduction of mandatory IFRS accounting for capital market oriented companies from 2005 onwards, and that, furthermore, companies with distinctly underfunded pension plans tend to influence their actuarial assumptions to lower the amount of pension obligations more than others. These results carry significant implications for the process of standard setting by the IASB: Accounting should allow for a certain degree of flexibility, granting the management the opportunity to communicate private information to the statement addressees. Additional implications arise for the revision of pension accounting carried out by the IASB project post-employment benefits : In the course of this project, the standard setter should take care to limit managerial discretion only with regard to those aspects in which opportunistic behavior is proven to predominate (such as in the treatment of actuarial profits or losses in the balance sheets). 22

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31 A. Appendix i Mean Median Standard deviation Minimum Maximum g Mean Median Standard deviation Minimum Maximum r Mean Median Standard deviation Minimum Maximum Table 1: Development of i, g and r 28

32 i Automobile Chemicals Construction Consumer Financial Services Industrial Media Pharma & Healthcare Retail Transp. & Logistics g Automobile Chemicals Construction Consumer Financial Services Industrial Media Pharma & Healthcare Retail Transp. & Logistics r Automobile Chemicals Construction Consumer Financial Services Industrial Media Pharma & Healthcare Retail Transp. & Logistics Table 2: Development of i, g and r differentiated by industry sectors 29

33 Mean Median Sd. Minimum Maximum M ARCAP T A P A DBO DBO X DBO D N I RD EM P (in thousands) N (in years) Table 3: Sample characteristics 30

34 Dependent Variable: MARCAP Method: Panel Least Squares Sample: Periods included: 9, Cross-sections included: 99 Total panel (unbalanced) observations: 449 White cross-section standard errors & covariance (d.f. corrected) Model I.: MARCAP it = 2008 t=2000 α ti t + β 1 DBO it + β 2 P A it + β 3 NI it +β 4 EMP it + β 5 RD it + β 6 T A it + u t Variable Coefficient Std. Error t-statistic Prob. C DBO PA NI EMP 1.69 e e RD TA Period fixed (dummy variables) R-squared Mean dependent var Adj. R-squared S.D. dependent var S.E. of regression Akaike info criterion F-statistic Schwarz criterion Prob(F-statistic) Hannan-Quinn criter Model II.: MARCAP it = 2008 t=2000 α ti t + β 1 DBO X,it + β 2 P A it + β 3 NI it +β 4 EMP it + β 5 RD it + β 6 T A it + u t Variable Coefficient Std. Error t-statistic Prob. C DBO X PA NI EMP 1.70 e e RD TA Period fixed (dummy variables) R-squared Mean dependent var Adj. R-squared S.D. dependent var S.E. of regression Akaike info criterion F-statistic Schwarz criterion Prob(F-statistic) Hannan-Quinn criter Table 4: Relative value relevance of discretion 31