Testing effectiveness
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Educational psychologist Sherrie Reynolds says it’s the teacher’s job to create an atmosphere of discovery and excitement.
When in 1997 the Financial Accounting Standards Board implemented Statement of Financial Accounting Standards (SFAS) No. 131, the goal was to press firms to reveal more about their organizational design in their segment disclosures. Under the previous rules of SFAS No. 14, managers had the flexibility — too much flexibility, argued critics — to combine unrelated or only slightly related business activities under broad industry headings. The new guidelines strive for segmentation that more accurately reflects the organizational structure that managers use to allocate resources and evaluate performance — thus providing a more detailed picture of a firm’s operations, risk exposure and overall prospects.
Unfortunately, there was no way to find out if SFAS No. 131 met its objective.
Until now.
A paper by Duncan Fellow and Professor of Accounting Mary Stanford and two of her colleagues develops measures for determining the effectiveness of SFAS No. 131 in improving disclosure. Titled “Representationally Faithful Disclosure, Organizational Design and Managers’ Segment Reporting Decisions,” the paper has very practical applications for FASB and the entire accounting profession — which is typical of Stanford’s work.
“By providing empirical evidence on how companies reacted to a new standard (SFAS 131, which changed the way companies report on segments of their businesses), she has allowed the members and staff of the Financial Accounting Standards Board to see whether companies reacted as they had expected and whether additional changes in the segment reporting rules might be necessary,” said Robert L. Vigeland, professor of accounting and chair of TCU’s Department of Accounting. “The setting of accounting and reporting standards is often highly controversial and the evidence provided by Professor Stanford and her co-authors is most useful in settling some of these controversies.”
The SFAS No. 131 project got underway in spring 2007 while Stanford taught a doctoral seminar as a visiting professor at the University of Utah.
She and two co-authors have been working on the project for about a year, with Stanford focusing on hypothesis development and some of the empirical proxies the team used.
“This paper was really an idea to bring together literature from organization design and finance to look at a different aspect of how managers are grouping operations into segments,” Stanford said, explaining that the paper is more interdisciplinary in nature than her past disclosure projects. “Because of the way the standard was written, the Financial Accounting Standards Board was really trying to induce managers to reveal their organizational design. So we started looking at the organizational design literature and said, ‘You know, we think we can actually test that aspect of the standard — did it succeed in getting managers to reveal their organization design?’ ”
Bottom line is for the standard to get managers to reveal how they view their business.
“Although we know that firms changed their reporting, we don’t have any evidence of whether or not the way they changed their segment reporting actually reveals more about their business structure,” Stanford said.
Stanford and her co-authors examined a sample of 1,081 firms that altered their segment definitions in response to SFAS No. 131, as well as a sample of 2,690 firms that did not change their segment definitions. They looked at whether segment definitions used after the new standard took effect reflected greater relatedness among operations than prior, as well as if the similarity of business units’ competitive environments and growth opportunities increased “within” each segment after the new standard.
They also tested whether the diversity of these attributes “across” segments increased. In addition, using the sample of 2,690 firms that did not change segment definitions, the team is exploring the possibility that the disclosure cost of SFAS No. 131 may prompt firms to alter their internal organizational structures or simply choose not to comply with the standard.
Stanford and her colleagues developed empirical proxies for industry relatedness, competitive environment and growth opportunities. They also identified measures of industry relatedness that reflect horizontal and vertical integration of firms as well as related and unrelated diversification in the organizational design literature. They used public data included on the Compustat segment file in the years before and after SFAS No. 131 implementation.
“We were trying to determine if after [managers] changed how they reported segments in their annual report, did they reveal more about their firms’ operations? And specifically, do they group operations in more or less similar industries into a segment for reporting purposes? The organization design literature and the finance literature suggest that grouping more similar operations is probably more efficient for the firm,” she said. “We find that firms that changed their segment reporting combined dissimilar operations under the old standard, and now, in response to the new standards, they are combining operations that are in more similar industries.”
Some of the empirical proxies produced the most challenging aspects of the project.
“We were trying to develop measures of industry relatedness, so we looked to the organization design literature, the strategy literature and the finance literature for measures of diversification and industry relatedness,” Stanford said. “Horizontal integration is fairly easy to measure. The vertical relatedness measure is something that would be new to the accounting literature. It was developed in the strategy literature, and I think that’s a contribution of the paper — that we would bring a new measure of vertical relatedness of industries to the accounting literature.”
Vertical integration occurs when a firm controls multiple steps in the production or distribution process in order to create a market advantage.
“Given the questions that accountants usually research, these are unusual measures,” she said. “Accountants are not generally looking at how the firm is organized. I think this is an interesting aspect of the project and one of the things we’ve spent a lot of time on, developing measures of horizontal and vertical relatedness, or related or unrelated diversification.”
Overall results suggest that firms that changed segment definitions after SFAS No. 131 did indeed increase the alignment of segment disclosure with their presumed organizational design.
In regard to relatedness in industry, competitive environment and growth opportunities, the research shows an increase “within” segment relatedness of operations as well as some evidence of an increase “across” segment diversity of operations following the implementation of SFAS No. 131. Firms’ reportable segments also include business divisions that share more similar competitive environments and growth opportunities than before.
In other words, SFAS No. 131 is achieving its purpose.
Stanford presented the paper at Michigan State University in the fall and plans to present it this month at the American Accounting Association’s midyear meeting for the Financial Accounting Reporting Section in New Orleans. She anticipates submitting it to a journal this summer.
While finalizing this paper, Stanford is also exploring recent strategy literature to glean ideas for comparing firms that didn’t change segment definitions to those firms that made reporting changes.
“We’d like to be able to assess the likelihood that a firm should have changed,” she said. “We would like to identify a subsample of firms that did not change their reporting but perhaps should have. This would indicate that they are continuing to take advantage of the flexibility in the standard. We want to identify the cost or benefit to firms that avoid disclosure or changes to disclosure. We haven’t quite figured out how to do that yet, but that’s the area we’re working on.”
Contact Stanford at m.stanford@tcu.edu.
Comment at tcumagazine@tcu.edu.
Mary Standford is a professor of accounting in the Neeley School of Business. She earned her undergraduate degree and master’s degree at the University of Texas at Arlington and her doctorate at the University of Michigan. Her research involves how economic trends influence accounting disclosures and how alternative accounting is reflected in stocks and bonds prices and returns. She teaches introductory to advanced accounting.
Stanford’s co-authors on “Representationally Faithful Disclosure, Organizational Design and Managers’ Segment Reporting Decisions” are Christine Botosan, a professor of accounting at the University of Utah, and Susan McMahon, is a PhD student at the University of Utah.
