Discussion of: Market reactions to mandatedinterest capitalization

LAWRENCE D. BROWNUniversity at Buffalo - State University of New York

IntroductionHughes and Ricks (1985), hereafter HR, examined the impact of SFAS No. 34,in terms of the security market's reaction both prior to policy announcementsleading up to the statement, and eamings numbers prepared in accordance withthe statement. HR found: (1) little evidence of capital market reaction leadingup to promulgation of the statement, (2) little evidence of capital market reactionto eamings prepared in accordance with the statement, and (3) a bias by analystsin predicting eamings prepared in accordance with the statement.

HR conducted a careful analysis and presented some interesting findings, butas is true with virtually all empirical studies, certain questions regarding theo-retical framework, research method, and interpretation of findings can be raised.I shall discuss each of these areas in turn.

Theoretical frameworkThe HR study is not motivated on the basis of an explicit economic theory; itis best described as a descriptive analysis of the capital market reaction tomandated accounting changes. Foster (1980) discusses the advantages of havingan explicit theory of why a capital market reaction should be associated withmandated accounting changes. He maintains that an exphcit theory facilitatesthe design of more powerful tests by, inter alia: (1) enabling a determination ofwhat are likely to be first versus second order effects, (2) aiding the selectionof test and control groups, (3) determining appropriate partitionings of the sam-ple, (4) estimating the expected direction, magnitude, and timing of the capitalmarket impact, (5) determining the critical event(s) to investigate, and (6) choos-ing the appropriate confounding event(s).

Mandated interest capitalization was substantially different from that of mostother mandated accounting changes in the sense that prior to the promulgationof most other mandated accounting changes, firms' managers were able to chooseamong GAAP as to how to account for a specific event. In contrast, prior to theeffective date of SFAS No. 34 (December 16, 1979), firms not capitalizinginterest prior to June 1974 (SEC moratorium date) could not capitalize interest

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Discussion of "Market FLeaction" 253

after that date. Thus, whereas most other mandated accounting changes reducedthe choices available to firms' managers, SFAS No. 34 did nof reduce the choicesavailable to managers of the affected firms; it forbade one method (expense) andmandated another method (capitalize).'

Bowee, Noreen, and Lacey (1981) provided evidence that firms that wereclose to violating their debt covenant restrictions were more likely to havecapitalized interest prior to the SEC moratorium than did those firms that wereDot close to violating (or did not have) bond covenant restrictions. During thefive year moratorium on interest capitalization (1974-79), it is likely that somefirms, in order to reduce the probability of violating their debt co-venants, wouldhave preferred to (but could not) capitalize interest. This (agency cost) argumentsuggests that HR could have considered the impact of the accounting change onfirms' debt covenants. Firms close to violating their debt covenants may havebeen favorably affected by mandated interest capitalization. Other firms, pre-ferring to report iower eamings (e.g., in an effort to reduce political costs - seeWatts and Zimmerman (1978)), may have been unfavorably affected by mandatedinterest capitalization. If the above contention is accurate, HR's failure to segmenttheir sample on the basis of the bond covenant variable may have preventedthem from rejecting the null hypothesis of no capital market effect.^

MethodSeveral aspects of the HR method are briefly discussed in this section: (1) useof calendar-year firms, (2) procedure of estimating the effect of SFAS No. 34on affected firms' EPS, (3) event selection, (4) assignment of priors, (5) cross-sectional tests of association between interest capitalization effects and excessretums, (6) univariate versus multivariate analyses, and (7) a proposed altemativemethod.

Use of calendar-year firmsBy confining their sample to calendar-year firms, HR considerably reduced theirsample (to 84 firms) and introduced "event date clustering" problems.^ Theclustering problems arose because most annual eamings reports for calendar-year firms are announced during the two month period, February-March. ThisphcDomenon was exacerbated by the fact that the sample firms implemented the

1 By reducing altematives available to managers, most mandated accounting changes areexpected to reduce the affected firms' share prices. As stated by Collins, Rozeff, and Dhaliwa!(1981, p. 44.): "any change which restricts the altematives available to management ishypothesized to reduce expected cash flows to stockholders because of increased bonding andmonitoring costs [Jensen and Meckling (1976)] and via a reduction in expected wealth transfersfrom bondholders to stockholders".

2 Numerous other theoretical constructs may pertain to SFAS No. 34. My purpose here is not tosttggest theoretical constmcts, but rather to illustrate how an explicit theory could have enabledHR to conduct more powerful tests and enhance the reliability of inferences drawn from theirfindings.

3 Although HR offered no justification for this sample selection criterion, it did facilitate theirdata collection.

254 Lawrence D. Brown

interest capitalization policy in one of three years. Thus, most of the 84 firmswere confined to six month/year categories.

Estimating the effect of SFAS No. 34 on affected firms' EPS numbersOnly 29 (30) of the 84 firms disclosed the effect of SFAS No. 34 on EPS (netincome). As only 29 firms disclosed the effect of the statement on eamings pershare, HR estimated the EPS effect for the remaining 55 firms by eliminatingthe estimated tax benefit on income before taxes and dividing by shares out-standing.'* HR assumed that the marginal tax rate equaled the statutory tax rate.Zimmerman (1983) has shown that: (1) the marginal tax rate does not generallyequal the statutory tax rate and (2) the marginal tax rate is positively related tofirm size. Thus, the HR estimation procedure had two effects: (1) it introducedmeasurement error into their primary independent variable and (2) it may haveaffected the results they obtained when they removed firm size effects from theirdependent variable, excess retums.

Event selectionHR selected ten events, several which related to the SEC moratorium on interestcapitalization (e.g., 1 and 3) and several which related to the FASB pronounce-ment mandating interest capitalization (6.g., 6, 9, and 10). Perhaps the absenceof an explicit theory caused HR to: (1) study such a large number of events, (2)fail to discriminate between those events which were likely to have primaryeffects from those likely to have secondary effects, and (3) fail to identify thoseevents which were likely to increase the probability that firms must (cannot)capitalize interest. Suppose, however, that HR theorized as follows; (1) events1 (SEC proposes moratorium) and 6 (FASB issues discussion memorandum)were primary events and (2) these events affected firms in opposite ways. HRcould then have used the "reversal methodology" introduced by Noreen andSepe (1981) to test whether interest capitalization significantly impacted affectedfirms' shareholders equity.^

Assignment of priorsHR maintained that shareholders of some firms may be better off as a result ofmandated interest capitalization, while shareholders of other firms may be worseoff by conforming with SFAS No. 34. Nevertheless, they did not assign priorsas to which firms were likely to be better/worse off, because they felt they were

4 While not stated by HR, the divisor was presumably shares outstanding as of the calendar-yearend. Firms which disclosed the effect of the pronouncement on EPS undoubtedly used thisprocedure (rather than a weighted average of shares outstanding during the year). Thus, thedivisor used by HR probably did not introduce measurement error,

5 These assumptions and the reversal methodology are not without their drawbacks. Forexample, events 1 and 6 were three and one-half years apart. As many firm-specific factorschange over such a long time span, it is unlikely that these two events affected all firms inopposite ways. Another obvious problem is the appropriate time period over which to measureexcess retums (i.e., were these events anticipated and if so, when?).

Discussion of "Market Reaction" 255

able to do so, "only if shareholder preferences remained unchanged since themoratorium was imposed." (p. 226). However, if HR had an explicit theory(e.g., bond covenant argument), they could have assigned priors, conductedmore powerful tests, and perhaps obtained more definitive results.*

Cross-sectional testing proceduresIn Table 2, HR reported results of cross-sectional tests of association betweenexcess retums arouod the ten event dates and the interest capitalization effectsassociated with SFAS No. 34. The ten events were chronologically distributedas follows: 1974 (events i-4), 1975 (event 5), 1977 (event 6), 1978 (events 7-̂8), and 1979 (events 9-10). The interest capitalization effects in accordance withSFAS No. 34 were disclosed, at the earliest, in 1980.' Thus, some of the table2 test results were based on the assumption that capital markets possessed perfectforesight (i.e., unbiased expectations) with regard to the terms and effects ofSFAS No. 34 more than five years in advance of initial disclosures conformingto that statement's requirerD,ents. Given the considerable amoutit of measuremen,terror associated with the capital market's expectation of the effects of SFAS No.34, it is not surprising that HR found "no support for the hypothesis that theaccounting change induced economic consequences for firms affected by thatRiling at the times of policy announcements leading up to that change" (p.229).

Univariate vs. multivariate analysesWith the exception of the test results reported in Table 9, the other analyses ofearnings announcements "to determine if the interest capitalization componentof eamings constituted news that was priced by the market at that time" (p.229) were univariate in nature. More specifically, these analyses focused uponthe relatioHship betweeo standardized excess retums and analyst forecast errorseither adjusted or unadjusted for the effects of interest capitalization. An alter-native procedure would have been to decompose the analyst forecast en'or intotwo parts: (1) that due to interest capitalization effects and (2) that due to othersources, and include both variables in a multiple regression."^

6 According to the "bond covenant argument", the probability that a firm is better offconforming with SFAS No. 34 is directly related to how close the firm is to violating its debtcovenant constraints. According to Foster (1980, p. 35), one can ascertain the empiricalvalidity of the bond covenant e.xplanation by partitioning the sample into firms with/withoutiong term debt with covenants written on financial statement variables. HR included debt/equityratios and obtained no significant results for this variable (see their fn. 12). However, the debt/equity ratio is unlikely to be a good proxy for the bond covenant variable suggested by Foster(1980). Furthermore, based on the testing procedures which underlied their Table 2 results, HRwere unlikely to have found the bond covenant (or any other) hypothesis to be descriptivelyvalid.

7 Recall that firms in the HR sample implemented SFAS No. 34 during a three year period(effective date of SFAS No. 34 was fiscal years beginning December 16, 1979).

8 The decomposition procedure requires an assumption as to how much of the interestcapitalization effect was anticipated by analysts. Based oc the HR evidence that analysts'

256 Lawreoce D. Brown

A suggested alternative research methodAn altemative method would have been to use the firm as its own control, andexamine whether the "mapping" of unexpected eamiogs ioto abnormal retumswas different in the implementation year than in nonimplementation years.'Rejection of the null, that the "mapping" in the implementation year was atleast as pronounced as in nonimplementation years, suggests that capital marketsprice the effects of interest capitalization differently (lower) than they do theunanticipated results of firms' production/investment/financiog activities. Theadvantages of allowing each firm to act as its own control are: (1) that test resultscan be presented that are based on individual firms (rather than averages) aod(2) that the problems associated with cross-sectional analyses (e.g. cross-correiatiooof the residuals) are alleviated.

Interpretation of resultsIn this section, I briefly consider a few interpretations by HR of their results,and offer altemative interpretations. First, HR observed that analysts' eamingsforecasts were biased (unbiased) io implementation (nonimplemeotation) years,and attributed this to the assumption that "Analysts, aware of the accountiogchaoge, simply did oot update their forecasts" (p. 239). I believe that thereare two problems with this ioterpretation: (1) it is unrealistic and (2) if it wasvalid, HR could not have determined whether (how) the market priced theeamiogs effects of interest capitalization with the research method they adopted.The HR cooteotion presumes that aoalysts do oot seek to obtaio the best (mostaccurate) estimates of firms' future eamiogs numbers. As iovestors desire ac-curate eamings forecasts, aod as aoalysts sell eamings forecasts to iovestors, itis unlikely that aoalysts will generate biased forecasts iotentionally. If, however,the HR contention was correct, an analysis of whether (how) capital marketsprice interest capitalization effects would require an examination of share pricemovements when analysts first become aware of the chaoges. As this date issometime prior to the eamings announcement date, HR could not expect to findany reaction on the eamings announcement date even if capital markets do priceinterest capitalizatioo effects in the same way that they price other effects onfirms' reported eamiogs numbers.

Second, HR reported the results of one multivariate aoalysis (Table 9) andobtained sigoificaot (oegative) results for the interest capitalization effect. Yet

forecasts were unbiased in nonimplementation years but biased in implementation years, itappears that analysts did not (on average) anticipate the entire effect of SFAS No. 34. Forsimplicity, HR could have assumed that analysts did not anticipate any of SFAS No. 34'seffect on EPS. One advantage of this assumption would be that the effect of the mandatedchange would be observed on (or shortly before) the eamings announcement date, rather thanon the (unknown) date that analysts first became aware of the impact of the change.

9 With the alternative method, it would be necessary to check for other contemporaneous events,possibly including other accounting changes. Also, the proposed method is based on theassumption that analysts did not anticipate any (most) of the interest capitalization effect.

Discussion of "Market Reaction" 257

the authors concluded that there is "little evidence of an information content ininterest capitalization effects resulting from the accounting change" (p. 239).As their multivariate analysis was presumably their most powerful test, and asthey found the interest capitalization effects to be significant, it is unclear whyHR concluded that SFAS No. 34 did not possess information content. Perhaps,HR viewed these results as anomalous, but given that they were conductingclassical (rather than Bayesian) tests, it is unclear why HR did not conclude infavor of the altemative hypothesis of information content.

Third, in attempting to reconcile the HR results to those of Ricks and Hughes(1985), HR maintained that the best explanation was the relative ease of esti-mating the income effects of interest capitalization vis-a-vis thait of estimatingthe income effects of changing from the cost to the equity method of accountingfor business combinations (i.e.. Ricks and Hughes examined APB No. 16).Although not tested by HR, this is a testable hypothesis. Assuming that analystsrevise their eamings expectations when they receive inform.ation regarding ac-counting changes, HR could have tested the null hypothesis that analysts' fore-casts for firms affected by APB No. 16 were at least as accurate as they werefor those firms affected b)̂ SFAS No. 34. Rejection of the null would haveprovided evideace consistent with HR's contention. A more definitive expla-nation for the differing findings of HR and Ricks and Hughes (1985) awaitsexplicit theories of capital market reaction to the different accounting changesexamined by these studies,

ConctaslonResearchers must make several choices when conducting empirical research.These choices include a theoretical framework and a research method. My dis-cussion comments relate to the HR theoretical framework and several aspectsof their research method: (1) use of calendar-year firms, (2) estimating the effectof SFAS No. 34 on affected firms' EPS numbers, (3) event selection, (4) as-signmeHt of priors, (5) cross-sectional testing procedures, (6) univariate vs.multivariate analyses and (7) a suggested alternative research method. In addi-tion., three alternative interpretations of the HR results are offered.

ReferencesBowea, R.M., E.W. Noreeti, and J.M. Lacey, "Determinants of the Corporate

Decision to Capialize Interest," Journal of Accounting and Economics (August1981) pp. 151-179.

Collins, D.W., M.S. Rozeff, and D.S. Dhaliwal, "The Economic Determinants of theMarket Reaction to Proposed Mandatory Accounting Changes in the Oil and GasIndastry: A Cross-Sectional Analysis." Journal of Accounting and Economics(March 1981) pp. 37-71.

Foster, G., "Accouttting Policy Decisions and Capital Market Research." Journal ofAccounting and Economics (March 1980) pp. 29-62.

Hughes, J.S., and W.E. Ricks, "Market Reactions to Mandated InterestCapitalization." Contemporary Accounting Research (this volume).

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Jensen, M.C., and W.H. Meckling, "Theory of the Firm: Managerial behavior,agency costs, and capital structure." Journal of Financial Economics (September1976) pp. 305-360.

Noreen, E.W., and J. Sepe, "Market Reactions to Accounting Policy Deliberations:The Inflation Accounting Case." Accounting Review (April 1981) pp. 253-269.

Ricks, W.E., and J.S. Hughes, "Market Reactions to a Non-Discretionary AceountingChange: The Case of Long-Term Investments." Accounting Review (January 1985)pp. 33-52.

Watts, R.L. and J.L. Zimmerman, "Towards a Positive Theory of the Determinationof Accounting Standards." Accounting Review (January 1978) pp. 112-134.

Zimmerman, J.L., "Taxes and Firm Size." Journal of Accounting and Economics(August 1983) pp. 119-150.