Anticipatory and implementation effects of FIN 46 on the behaviorof different market participants

Umit G. Guruna*, Alina Lermanb and Joshua Ronenc

aUniversity of Texas, Dallas, TX, USA; bYale School of Management, New Haven, CT, USA;cNew York University, New York, NY, USA

We examine whether Financial Accounting Standards Board (FASB)-mandated mod-ifications of the consolidation rules (FIN 46 and FIN 46R) resulted in perceptiblechanges in market participants’ decisions as manifested in a variety of financial indi-cia. We find that financial analysts’ idiosyncratic precision of information decreasedand equity market participants acted as if they perceived higher information risk, asevidenced by reduced earnings response coefficients, in anticipation of guidance. Weattribute these effects to a perceived increase in information risk and decrease inaccounting information quality. We find that the actual implementation of the newrules reversed some, but not all, of these effects. On the other hand, we find thatinformation users that likely had access to information regarding the off-balance-sheet debt structures prior to 2001 did not exhibit a similar reaction to the apparentchange in information risk either in anticipation or upon implementation of the newguidance. Specifically, we find that banks did not increase the loan spreads for FIN46 firms and credit rating agencies lowered the ratings of these firms only marginallymore than those of other firms. This finding is consistent with our conjecture thatthese entities were aware of the fundamentals of FIN 46 firms even under the priorlimited disclosure regime.

Keywords: consolidation; FIN 46; FIN 46R; variable interest entity; informationrisk

JEL Codes: G14; G21; M41

1. Introduction

In this paper, we examine the empirical question of whether equity market participantsand other sophisticated financial information users are sensitive to the information riskinherent in corporate consolidation choices.1 Specifically, we ask whether FinancialAccounting Standards Board (FASB)-mandated modifications of the consolidation rulesresulted in perceptible changes in market participants’ decisions as manifested in avariety of financial indicia.

The high-profile corporate failures in the United States in 2001 and 2002 have ledto the Sarbanes-Oxley Act of 2002 (SOX) and to various amendments to the stockexchanges’ regulations. Perhaps one of the most publicized accounting problems thatled to the downfall of Enron was its use of special purpose entities (SPEs), allegedlyallowing it to leave significant amounts of debt off its balance sheet and hide losses offits income statement. In response to widespread concerns about this business practice,

*Corresponding author. Email: umit.gurun@utdallas.edu

Asia-Pacific Journal of Accounting & EconomicsVol. 19, No. 1, April 2012, 30–55

ISSN 1608-1625 print/ISSN 2164-2257 online� 2012 City University of Hong Kong and National Taiwan Universityhttp://dx.doi.org/10.1080/16081625.2012.668054http://www.tandfonline.com

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FASB began deliberations on this topic in early 2002. It issued FASB InterpretationNo. 46 (FIN 46) Consolidation of Variable Interest Entities in January 2003, a RevisedInterpretation (FIN 46R) in December 2003, and on 12 June 2009 a revised amendmentto FIN 46R (SFAS 167).2 The interpretation elaborates on and significantly expands thenumber of entities subject to consolidation under Accounting Research Bulletin (ARB)No. 51 Consolidated Financial Statements. This interpretation covers the accountingtreatment of any entity in which the firm has an interest, which up to the issuance ofSFAS 167, was deemed to exist by virtue of bearing a portion of potential risks and anentitlement to potential rewards. In other words, even in the absence of a voting inter-est, a firm’s exposure to the assets’ risks and rewards is seen as representing the bestevidence of financial control.3 When an enterprise maintains a controlling position in avariable interest entity (VIE), it is considered the primary beneficiary and must consoli-date that VIE into its financial statements. The goal of this guidance is to improve com-parability among enterprises by imposing more consistent consolidation practices and toallow for better assessment of the enterprise’s risk and profitability. The adoption ofFIN 46 and FIN 46R (henceforth referred to as FIN 46 unless noted otherwise) providesus with a controlled setting within which to observe instances when relevant assets andliabilities and revenues and expenses previously kept off the financial statements aremandated to be consolidated into the parent entity.

What are the economic consequences of the purportedly improved transparency offinancial statements as a result of FIN 46? Under the new guidance the explicit andimplicit risks and profitability of off-balance-sheet structures are revealed as the com-pany acknowledges that the economic structure of the VIE is such as to warrant consol-idation. Presumably, consolidation of VIEs makes visible the previously hidden assets,liabilities, revenues and expenses. It also mitigates the earnings management opportuni-ties associated with VIE use: Feng et al. (2009) find evidence that special purpose vehi-cles are often arranged for financial reporting (vs. economic) purposes and as such playa role in managing accruals and earnings. This should enable users of the financialstatements to more completely incorporate the hitherto-hidden risk and profitability intotheir lending and investing decisions. We assess whether FIN 46 accomplished thisobjective by examining the anticipatory and the implementation impact of the guidanceon a variety of metrics manifesting investment and lending decisions. In other words,we seek to assess the reaction of market participants to the revelation of such previ-ously hidden and newly disclosed information risk. The results of such an examinationnot only reveal how changed rules of consolidation and related disclosures such asthose of FIN 46 affect capital markets, but may also contribute to our understanding ofhow mandated accounting rule changes which lead to greater disclosure of risk andprofitability would be assimilated by various market participants.

In conducting our examination, we formulate two sets of hypotheses. The firstrelates to users of financial statements that are not likely to possess non-publicly avail-able information. This group includes equity investors and information intermediariessuch as financial analysts. The second set includes lending banks and debt-rating agen-cies. The latter group is likely to have access to superior information as a result of theirprivileged access to company information and their right to demand such informationas a condition for lending or rating. While we expect FIN 46 to impact the decisions ofthe first set of users, we predict little or no impact on decisions of lending banks andrating agencies by virtue of their pre-FIN 46 privileged access to information.

Investigating diverse reactions of different sets of market actors to an accountingstandard change (such as FIN 46) and to subsequent changes in financial statements

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content contributes to our understanding of the role of accounting information in chang-ing beliefs and decisions. Our study complements and extends the examination of FIN46 effects on aggregate market metrics as it informs about the workings of differentsegments of the market.4 Documenting how accounting events differentially affectbeliefs or decisions of various segments of the market conditional on different informa-tion sets they likely process is of interest to understanding the effect of existinginformation endowments on the assimilation of new accounting information.

We infer the first set of information users’ reactions to changing information uncer-tainty by observing two measures. Within the equity markets we examine: (1) the earn-ings response coefficient (ERC), which, among other things, reflects the assessment ofthe information risk that is manifest in financial statements measures, and (2) the char-acteristics of analyst forecasts. With respect to the second set of financial statementusers, lending banks and rating agencies, we examine as a measure of perceived infor-mation risk: (3) the spreads required by banks on private loans, and (4) the ratings ofsecurities by credit rating agencies. We examine two significant break points related tothe disclosure of VIE information and the promulgation of the new guidance. First, weconsider whether the perception of information risk changed subsequent to 2001 to cap-ture the effects of accounting scandals, the expectation of a change in accounting guid-ance, the increased press coverage and voluntary firm disclosures. Second, we examinewhether the perception of information risk changed after a firm’s disclosure of consoli-dation information to capture the effects of the implementation of FIN 46 and FIN 46R.To control for other contemporaneous regulatory events, notably the SOX and regula-tion fair disclosure (FD), we employ a difference-in-difference approach against anindustry and size matched sample.

Overall, we conclude that equity market participants reacted to the increased infor-mation uncertainty of FIN 46 firms in anticipation of the mandated disclosure and theconsolidation of VIEs (and to some extent to the reduced information uncertainty fol-lowing actual implementation of the new guidance). Specifically, we find that overallequity market participants acted as if they perceived higher informational risk or lowerquality of accounting information as evidenced by reduced ERCs after 2001 but beforeimplementation for FIN 46 firms. We also find that financial analysts experienced areduction in the idiosyncratic precision of information relied upon, consistent with theargument that FIN 46 increased the noisiness of their idiosyncratic information. We seesome of these effects reverse upon implementation (although with no statistical signifi-cance for the analyst results). This suggests that implementation of the guidancereduced the uncertainty of the anticipation period as well as possibly improving thequality of accounting information (due to a reduction in earnings management opportu-nities). On the other hand, we find that sophisticated information users that likely hadaccess to information regarding the off-balance-sheet debt structures prior to publiclymandated disclosures do not exhibit as much of a reaction to changes in apparent infor-mation risk either in anticipation or with the adoption of FIN 46. Specifically, we findthat banks did not increase the loan spreads for FIN 46 firms at a greater rate than thespreads for other firms and credit rating agencies raised the ratings of FIN 46 firms onlymarginally as compared to other firms. This finding is consistent with our conjecturethat these entities were either fully or partially aware of the true fundamentals of FIN46 firms even under the prior limited disclosure regime. We observe a continuum of thedegree of informativeness with banks exhibiting the lowest information uncertainty,investors and equity analysts the highest and credit rating agencies falling somewherein between.

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Overall, we conclude that the perceived information risk of firms that have struc-tured a part of their operations in separate entities increased significantly after theybecame likely to be required to bring the previously off-balance-sheet assets, liabilities,and results of operations into their financial statements. We interpret these results as evi-dence that, to the extent these firms assumed responsibility for the liabilities, assets andresults of operations of the separate entities, they have successfully withheld informa-tion from the market by hiding their debt and/or managing their earnings previouslyand that relative to their peers were associated with lower information risk within theequity market. We conclude that FIN 46 was instrumental in changing the behavior ofmarket participants who lacked prior access to relevant information, namely equityinvestors and analysts.

The rest of this paper is organized as follows. Section 2 reviews the accountingguidance and the relevant literature as well as motivating our hypotheses. Section 3describes our sample selection procedures and the sample. Section 4 presents and dis-cusses our empirical results and Section 5 concludes.

2. Background and hypothesis development

2.1. Accounting guidance

In December 2003 the FASB issued the revised FASB Interpretation No. 46 Consolida-tion of Variable Interest Entities. FIN 46R replaces FIN 46 issued earlier that year andis an interpretation of ARB 51 Consolidated Financial Statements. It requires publiccompanies to consolidate VIEs which do not effectively disperse risks among the par-ties involved. The goal of the standard is to improve comparability among enterprisesby imposing more consistent consolidation practices and to allow for better assessmentof the enterprise’s risk by providing more complete information about the relevantresources, obligations and opportunities.

To better understand the expected and actual impact of FIN 46 and FIN 46R weconsider the prior accounting guidance, the motivation for the new standard and thetransition process. ARB 51, issued in 1959, required the consolidation of the assets, lia-bilities and results of operations of subsidiaries in which a firm has a controlling finan-cial interest, which has commonly been interpreted to mean a majority voting interest.The voting interest approach does not identify controlling relationships executedthrough other means or arrangements where voting equity investors do not bear theresidual economic risks. Thus, while VIEs and similar mechanisms became increasinglycommon throughout the last two decades of the twentieth century, the relevant account-ing guidance was incomplete and inconsistently applied. FASB has attempted to pro-mulgate a stricter set of consolidation guidelines at various points in time in the 1980sand 1990s but have repeatedly been thwarted by intense lobbying. However, the col-lapse of Enron, due in large part to cavalier off-balance-sheet arrangements, has bothstrengthened FASB’s resolve to rectify the inadequacies of the accounting guidance andmade firms and accountants more receptive to these amendments.

FASB has initiated discussions regarding identification and treatment of special-purpose entities as early as February 2002 with the initial draft of FIN 46 distributedfor comments in July. FASB issued FIN 46, by placing the interpretation on its website,shortly after the 15 January 2003 Board meeting. The mandatory implementation ofFIN 46 started immediately with respect to new VIEs and from 15 July 2003 withrespect to existing VIEs. Throughout 2003 FASB “learned that certain provisions of

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[FIN 46] were not being interpreted as the Board intended”5 and issued a revised inter-pretation to address technical corrections and implementation issues in December 2003.

FIN 46R (the final revised version of FIN 46) states that business entities (sponsors)must consolidate VIEs which by design have one or more of the following characteristics:

(1) the VIE does not have sufficient equity investment at risk;(2) the equity investors lack essential characteristics of a controlling financial

interest;(3) the equity investors have disproportionate voting and economic interests.

The first condition to avoid consolidation requires that the VIE be able to finance itsactivities without additional subordinated financial support from any parties. The quanti-tative benchmark for sufficiency is set to be at least 10% of the VIE’s total assets, butsupplementary qualitative analysis to determine sufficiency is encouraged.6 The secondcondition mandates that the holders of equity have the rights to make significant operat-ing decisions, are obligated to absorb the losses of the VIE and have the right to receivethe expected residual returns. The third condition states that if substantially all of theVIE’s activities are conducted on behalf of equity investors whose voting rights are dis-proportionately small (given their obligations to absorb expected loss and rights toreceive expected residual returns) then consolidation is in order. Besides redefining thecharacteristics of a controlling financial interest, FIN 46R makes several other notableamendments to FIN 46 including increased disclosure requirements, mandated for fiscalperiods ending after 15 December 2003 for entities that have VIEs and fiscal periodsending after 15 March 2004 for all entities.7 Certain disclosures are mandated even ear-lier for entities with a possibility of consolidation of VIEs. Implementation aspects forFIN 46R remain similar to prior consolidation guidance. In the consolidation of newlycreated VIEs the entity must record the assets, liabilities and non-controlling interests attheir fair values with a goodwill adjustment or an extraordinary loss recorded as neces-sary. In the consolidation of VIEs created before 31 December 2003 the assets, liabili-ties and non-controlling interests are to be recorded at carrying amounts with acumulative effect of accounting change recorded.

FASB issued SFAS 167 in 2009 to amend and enhance certain guidance in FIN46R. The three main areas of focus in SFAS 167 are: a requirement for an ongoingassessment to determine VIEs, emphasis on qualitative analysis in determining a pri-mary beneficiary, and enhanced disclosures regarding an entity’s involvement withVIEs. Thus, consolidation of off-balance-sheet entities is likely to remain a pertinentand significant issue in the near future. This was made further evident by the lobbyingefforts of the financial services industry to delay the issuance of SFAS 167.

2.2. Literature and hypothesis development

The literature discussing FIN 46 and FIN 46R has been largely limited to practitioneroriented implementation aids (see, e.g. Agosta 2004, Ciesielski and Soroosh 2004,Reinstein et al. 2005). Several papers present notable exceptions but are limited to spe-cific types of assets or structures. Bens and Monahan (2008) examine the investmentdecisions undertaken by US Banks which were sponsors of highly leveraged assetbacked commercial papers (ABCP) in response to promulgation of FIN 46. They findinterest in ABCPs waning with the introduction of the guidance and provide evidencethat parent banks have proceeded to enter into costly restructuring arrangements to

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avoid FIN 46 required consolidation. Beatty (2006) examining issuances of Trust Pre-ferred Securities finds that financial institutions modify their economic behavior inresponse to accounting changes (those being a combined effect of SFAS 150 and FIN46R) even when their regulatory capital ratios are not impacted. Several papers discussthe impact of FIN 46 within the synthetic lease setting. Callahan and Spencer (2008)examine the valuation and disclosure impact of FIN 46 on firms disclosing a syntheticlease with a VIE. They find that disclosed future minimum lease payments are signifi-cantly valued by the market both pre and post adoption of FIN 46, while recognizedlease liabilities are valued with substantially more weight post FIN 46. Altamuro (2006)finds that firms are less likely to engage in synthetic lease financing after the issuanceof FIN 46, consistent with the conjecture that the primary benefit of such transactions isthe off-balance-sheet treatment, made exceedingly difficult subsequent to the passage ofFIN 46. Lastly, Zechman (2010) shows that consolidation of synthetic leases vs. thedecision to purchase the assets or to restructure the contract in order to retain off-bal-ance-sheet reporting is more prevalent for firms with more informative prior disclosures.One study, Dickinson et al. (2010), examines the short-window market reaction to theregulatory actions resulting in the promulgation of FIN 46 and FIN 46R and concludesthat the market overall exhibits a negative price reaction at the release of a first expo-sure draft proposing FIN 46.

While there is limited existing literature addressing the new VIE guidance, we canrely on a range of prior studies to formulate our hypotheses regarding the behavior ofvarious capital market participants in response to the new consolidation requirements.VIEs enable a company to remove underperforming or risky assets and debt from itsbalance sheet. However, explicit or implied performance guarantees may essentially bur-den the sponsoring firm with the losses and the obligations to pay off liabilities of theVIE.8 If these vehicles are not disclosed in the financial statements, then capital marketparticipants are not able to accurately estimate the company’s true earnings risk profile.Similarly, VIE use may enable earnings management which will lower the quality ofaccounting information and hence increase information risk (Feng et al. 2009, Dechowet al. 2010). The consolidation of previous off-balance-sheet entities would be expected,at least partially, to eliminate the earnings management opportunities of such firms.Moreover, the disclosure of retained losses and leverage of VIEs will reveal previouslyhidden information, thus improving the quality of accounting information and reducinginformation risk generally. As a result we expect that the market will adjust its behavioraccordingly. Niu and Richardson (2006) find that for firms that disclose their off-balance-sheet securitization information, the off-balance sheet debt is treated by thecapital markets in the same way as on-balance sheet debt in the determination of sys-tematic risk. Under the FIN 46 guidance the explicit and implicit losses and risks ofoff-balance-sheet structures are revealed as the company acknowledges that the eco-nomic structure of the VIE is such as to warrant consolidation. Thus, we expect thatthe disclosure of consolidation information, or anticipation of such consolidation, willevoke significant reaction from capital market participants.

Several inferences may be drawn from the literature noted above. One, as indicated inthe Zechman paper, is that the firms in our sample, i.e. firms consolidating VIEs and dis-closing such consolidation, may have had relatively informative disclosures regardingthese entities prior to FIN 46 promulgation. This would bias against us finding results thatsupport the hypothesis that the perceived information risk of these firms is impacted byFIN 46 disclosures; on the other hand, Zechman’s paper implies that investors were ableto anticipate which firms were likely to be impacted by the implementation of FIN 46,

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thus making possible the detection of the effects of such anticipation as manifested ininvestors and financial intermediaries’ reactions. The second implication is that FIN 46and FIN 46R may have impacted the actual financing decisions of the firm. Hence weaddress the contrast between information risk and fundamental risk below.

We focus in this paper on information risk, or the likelihood that firm-specificaccounting information used by investors and other market participants is of low quan-tity or quality. We suggest that information risk includes not only quality of the infor-mation itself, but also the users’ perception of uncertainty associated with it. In otherwords, even if the underlying information does not change, the perception of its preci-sion or usefulness may change due to revelations regarding its quality or impendingchanges. Thus, after off-balance-sheet entities are brought to light in early 2002 butbefore the implementation of the new guidance, the information risk should increase forfirms suspected to be associated with such structures. We expect that market participantswould be able to identify firms potentially subject to consolidation – those who sponsorVIEs – from information coming to light because of the accounting debate and firms’responses to it (Section 3 contains further discussion regarding this assumption). Forfirms thus identified, investors and others perceive a lower accounting information qual-ity (including higher earnings management opportunities) or higher information risk.This information risk is reduced once FIN 46 is implemented and the required consoli-dation information is revealed (because of availability of new information, the reductionin the perception of uncertainty, and the mitigation of earnings management opportuni-ties). For these reasons the impact of the anticipation of the new consolidation guidanceand its implementation may differ in direction.

Of course, the fundamental business risk of FIN 46 firms could change as well inreaction to the anticipated rule. But as the literature we had cited earlier indicates, themost likely reaction is a decrease in business risk – a decrease in the number or achange in the structure of VIEs. Such a decrease would bias against finding our hypoth-esized effects. In effect, our focus is on changes in the information uncertainty sur-rounding the inherent profitability and business risk, not on changes in inherentbusiness risk or in profitability themselves. Below we formulate specific hypothesisregarding the four market participants/effects examined.

2.3. Earnings response coefficients

Prior research has frequently used returns–earnings relations to investigate the weightattached to financial accounting items. Empirical tests in such studies are often based oncomparisons of ERCs, which are slope coefficients from regressions of unexpectedreturns on unexpected earnings. The rationale is that firm values are equal to the presentvalues of their expected dividends and present values are based on firm-specific discountrates, which are increasing in informational risk. Because FIN 46 elicits consolidationand/or disclosures regarding risks and revenues or losses not revealed by firms previ-ously, capital market participants that did not have privileged access to firm informationprior to FIN 46 are hypothesized to use a higher discount rate and thus to attach lowerweight to earnings surprises during the anticipation period. We expect this because of theinformation risk that can lead investors to value FIN 46 firms less reliably than in priorperiods when they did not suspect the existence of VIEs (Imhoff and Lobo (1992) showthat uncertainty or noise in the earnings signal reduces ERC). Similarly, the recognitionof the potential earnings management facilitated by VIEs in suspected FIN 46 firmsbefore implementation likely reduces ERC in the anticipation period. As to the post-

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implementation period, we expect an increase in accounting information quality and cor-respondingly an increase in ERC. However, it is not clear what the extent of the increasewould be. The lingering residual uncertainty about the quantum of losses (or gains) andrisks borne by the consolidating firms may limit the extent of improvement in the ERC.This remains an empirical question. We note that Easton and Zmijewski (1989) and Col-lins and Kothari (1989) use the dividend discount model to show that when unexpectedearnings cause corresponding revisions in expectations, ERCs are decreasing in system-atic risk. However, as we discussed above, it is not clear whether consolidation would infact result in increased systematic risk and thus our hypothesis development regardingERC is rooted in expectation of information risk change only. Our hypothesis in nullform regarding the earnings returns relationship is as follows:

Hypothesis 1a: ERCs will not change for FIN 46 firms under the newconsolidation guidance (or in anticipation of it).

2.4. The precision of analysts’ information

While analysts may be more sophisticated than equity investors in their analysis of pub-licly available information, they were similarly unlikely to have access to confidentialinformation regarding off balance sheet activities. Furthermore, prior research has foundthat analysts are in fact not sophisticated in adjusting financial statements for off-bal-ance sheet items – for example, Hirst et al. (2004) show that commercial bank equityanalysts are able to analyze banks’ exposure to interest rate risk when the fair valuegains and losses on all financial assets and liabilities are recognized in financial state-ments but not when they are only disclosed in the notes to the financial statements. Weexamine two characteristics of analyst forecasts: the estimated precision of public andprivate information relied upon.9

During the anticipation period, when analysts identify the “suspects” sponsoringVIEs that might be consolidated upon implementing FIN 46, they face greater informa-tion uncertainty. This enhanced information uncertainty before the consolidation islikely to manifest in lower private information precision. That is, in the face ofenhanced information uncertainty analysts acquire private information with greaternoise, leading to higher dispersion of posterior information – i.e. lower idiosyncraticprecision.10 Upon implementation, once the decisions about consolidation are made andthe resulting VIEs’ information about assets, liabilities, revenues and expenses is incor-porated into the primary beneficiaries’ financial statements, at least some of the priorinformation uncertainty is resolved. Prior literature shows that, in general, disclosure ofrelevant information leads to more accurate forecasts (Lang and Lundholm 1996, Hope2003). However, it has also been shown that disclosure of difficult information whichcomplicates the forecasting or valuation process reduces analyst precision (Botosan andStanford 2005). As many commentators responding to the 46R exposure draft and tothe most recent exposure draft that culminated in SFAS 167 noted, the criteria for con-solidation and the computations necessary to apply them are highly complicated andsubjective. The ambiguity surrounding the precise quantum of risk to which the enter-prise is exposed as a result of involvement with VIEs as disclosed under the exposuredraft is expected to render the analysts’ task more difficult. Indeed, as the comments onthe SFAS 167 exposure draft indicate, there is a concern about over-consolidation: theinclusion in the financial statements of assets and revenues dedicated to the satisfactionof the liabilities of the consolidated entity, and, liabilities and losses for which the

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consolidating entity bears no responsibility. Thus, the resolution of information uncer-tainty may not be complete. Consequently, while one would expect an improvement inthe quality of information post-implementation, the extent of such improvement remainsan open question. For this reason we offer no prediction of the post-implementationimpact on idiosyncratic precision.

We also offer no predictions regarding the change in the precision of public infor-mation either in anticipation or upon implementation of FIN 46. The precision of public(common) information reflects the extent to which analysts rely on the public informa-tion in generating their forecasts and the quality of such information. In the anticipationperiod the public information environment has not yet experienced a significant change,although the perception of its quality may have changed. While greater levels of disclo-sure subsequent to the implementation may contribute toward increasing the precisionof public information, if the FIN 46 information is difficult to interpret the extent ofsuch increase is limited. Similarly, while reduction in earnings management opportuni-ties improves the quality of earnings in the long term, it may also make them less per-sistent, and thus more difficult to forecast, in the short term. Overall, our hypothesis innull form regarding the behavior of equity analysts is as follows:

Hypothesis 1b: The precision of equity analysts following FIN 46 firms will notchange under the new consolidation guidance (or in anticipation of it).

2.5. Bank loans and credit rating agencies

Both of the above hypotheses deal with market participants who prior to the com-mencement of the debate on FIN 46 did not have detailed knowledge of VIE activities.However, several participants in the capital market, namely commercial banks andcredit rating agencies, likely had significant knowledge due to unique relationships withsponsoring institutions.

A large body of finance literature indicates that banks possess superior informationdue to the existence of unique lender-borrower relationships (see Boot (2000) for a surveyof this literature). Banks obtain information about the company at the loan initiation andinitial screening and subsequently they have the ability to monitor both the firm’s perfor-mance and management’s behavior over the duration of the loan. Such access to proprie-tary information means that banks know more about a company’s prospects and risks thanother stakeholders. Yu (2007) finds evidence that banks have superior information evenwhen the public information environment of borrowers is rich and that this superiorinformation is obtained through more efficient ex ante private information production.Consistent with prior literature we do not expect to reject the following null hypothesis:

Hypothesis 2a: Bank loan spreads will not change for FIN 46 firms under thenew consolidation guidance (or in anticipation of it).

Relationships also play a critical role in the activities of other financial intermediaries.Jorion et al. (2005) provide evidence that credit analysts at rating agencies have access toconfidential information that is not available to other securities professionals. Earlierresearch on the information content of rating agency announcements has shown thatdowngrades have a significant impact on daily stock prices, indicating that rating agen-cies, at least in some instances, are leading the market in information procurement. (seee.g. Dichev and Piotroski 2001). In the context of off-balance-sheet assets and liabilities,

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there is evidence that the rating agencies were explicitly concerned with the disconnec-tion between economic substance and legal form of transactions before the promulgationof FIN 46. For example Standard and Poor’s (2001) Corporate Ratings Criteria state thatin the case of securitization transactions with either explicit or implicit recourse:

There is no rating benefit that is deserved because there is no significant transfer of riskand there is no point analyzing such a company differently from the way it would beanalyzed if it had kept the receivables on the balance sheet.11

Consistent with prior literature and the rating agencies’ guidance we do not expect toreject the following null hypothesis:

Hypothesis 2b: Credit ratings for securities of FIN 46 firms will not changeunder the new consolidation guidance (or in anticipation of it).

3. Data and descriptive statistics

To obtain our sample of firms we carried out an automated search using the Securitiesand Exchange Commission’s (SEC) Electronic Data Gathering, Analysis, and Retrievalsystem. We searched 10-K filings of all US firms from January 2002 through June2006 for references to FIN 46, FIN 46R, and VIEs. The first relevant reports identifiedare for the period ending 30 November 2002. Overall we found 1251 10-K filings, rep-resenting 882 distinct firms, which mention FIN 46 or FIN 46R. The relevant portionsof these filings were read and analyzed and each filing was assigned to one of the fol-lowing six categories: (1) 46 or 46R are discussed and the disclosure indicates orimplies that appropriate consolidation was carried out; (2) it is specified that the firmintends to adopt 46 or 46R and expects some impact from consolidation; (3) 46 or 46Rare discussed but the effect on the firm is specified to be minor and few details are pro-vided; (4) 46 or 46R are discussed and the disclosure indicates or implies that appropri-ate deconsolidation was carried out;12 (5) 46 or 46R are mentioned but the disclosurespecifies that the guidance does not apply to this firm or that the impact is immaterial;and (6) 46 or 46R are mentioned but the disclosure specifies that the firm is still assess-ing any impact, with no other details provided. See Appendix A for examples of disclo-sures in each of the six categories. Of interest to us are category 1 and 2 disclosers,firms revealing actual or expected substantial impact resulting from the adoption of newconsolidation requirements. Any errors in classification, i.e. classifying a non-46 firm asa 46 firm and vice versa would bias against us rejecting the null hypotheses of nochange in perceived information risk as they would attenuate the strength of found rela-tionships between hypothesized variables. Because we expect to reject hypotheses 1aand 1b such potential bias is not troubling for analysis related to equity investors andanalysts. However, because ex ante we do not expect to find changes in the perceivedinformation risk in the analysis of banks and credit rating agencies, we acknowledgethat failure to reject hypotheses 2a and 2b may be due to improper classification. Over-all, we classify 163 distinct firms, as category 1 or 2 disclosers – this is our sample ofFIN 46 firms. The firms that form our sample must have deemed the events disclosedas material: otherwise they would not have needed to consolidate or disclose (perwording in FIN 46R itself).13 See Panel A of Table 1 for the full distribution of identi-fied firms among the six categories.

The distribution of the 163 FIN 46 firms across various industries (by 2 digit SICcode) is presented in Panel B of Table 1. Finance, Insurance, and Real Estate is the

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Table 1. Descriptive statistics.

Panel A: categories of disclosureDisclosure category Firms Percent

FIN 46 { 1 Consolidation 139 16firms 2 Plan of consolidation 24 3

3 Consolidation (immaterial) 15 24 Deconsolidation 77 95 No impact 555 636 Impact still assessed 72 8

Total 882 100

2 Digit SICcode

Panel B: Industry distribution of FIN 46 firmsIndustry group name

Frequency Percent

67 Holding and other investment offices 31 19.049 Electric, gas, and sanitary services 15 9.260 Depository institutions 10 6.163 Insurance carriers 10 6.128 Chemicals and allied products 8 4.915 Building construction general contractors and operative

builders6 3.7

36 Electronic and other electrical equipment and components…

6 3.7

73 Business services 6 3.7Other (31 codes each 4 firms or less) 71 43.6

Total 163 100.0

Variable Panel C: firm characteristics of FIN46 firms in the year of initial

disclosureMean

Std.Dev.

Min 50thPct.

Max

Market value ofequity ($mill)

11,473 32,614 13 1757 242,767

Book value ofequity ($mill)

4518 11,729 (249) 828 85,318

Stock price 33.44 54.08 0.00 25.94 646.00Total assets

($mill)40,985 143,248 16 3234 1097,190

Total employees(th)

22.81 53.41 – 3.28 326.00

EPS (excludingEI)

1.76 3.03 (6.17) 1.47 24.05

Annual change inEPS

58% 1589% �4300% 8% 18,333%

Annual change insales

12% 28% �73% 9% 120%

ROA (based onIncome beforeEI)

3% 7% �44% 3% 18%

Leverage (debt as% of averageassets)

35% 25% 0% 35% 158%

(Continued)

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most frequent group, representing 38% of the sample (within which holding and otherinvestment offices represents half). Manufacturing, represents nearly another quarter ofthe sample, although spread over 13 different 2 digit codes. The type of entities whichare consolidated by our sample firms ranges widely and includes joint ventures, fran-chises, structured finance entities, leases and real estate partnerships among others.Panel C of Table 1 provides some basic firm characteristics for the sample of FIN 46firms for the fiscal year when FIN 46 disclosure was first made. Because FIN 46 firmsare significantly larger than the Compustat universe we match on size (as measured bytotal assets) as well as industry and year for our matched sample analysis. None of thefirm characteristics shown of FIN 46 firms are statistically significantly different fromthe characteristics of the 160 control firms. Because our empirical analyses utilize sev-eral various datasets and employ a multitude of variables we will describe the datarequirements for each analysis in the appropriate section below.

A ubiquitous variable that merits some discussion is the break point in time for thetransition from the pre-FIN 46 period to the post-FIN 46 period. The collapse of Enron inOctober through November 2001 brought to the public eye the dangers and intricacies ofoff-balance-sheet financing. Subsequently, finance professionals, including the financialpress, have continued to explore the implication of SPEs and the accounting rules appli-cable to them. Articles such as “Who else is hiding debt: Moving financial obligationsinto off-book vehicles is now a common ploy” in the January/2002 issue of BusinessWeek are evidentiary of the information discovery process preceding any change inaccounting rules. Also preceding accounting guidance were voluntary disclosures byselect firms, as motivated by the growing focus on the dangers of off-balance-sheetaccounting (see WSJ all Street Journal 4/10/2002 article). After Enron (and after the pas-sage of Financial Release No. 61 by the SEC which emphasized the need to report moreinformation in the MD&A section), the disclosure levels of firms using off-balance-sheetentities increased significantly but not uniformly. As early as February 2002, the account-ing standard setters revealed that rules for off-balance-sheet debt vehicles will bere-evaluated and amended in the near future (FASB discussion on 2/13/2002) with thefinal versions of FIN 46 and FIN 46R issued respectively in January and December2003. Thus, despite the fact that FIN 46/46R was effective starting only after 2003, it isevident that market participants were aware of related issues and of the impending

Variable Panel C: firm characteristics of FIN46 firms in the year of initial

disclosureMean

Std.Dev.

Min 50thPct.

Max

% of firm yearswith pre-taxLoss

17.9% 38% N/A N/A N/A

Notes: Market value of equity is the price at fiscal year close times common shares outstanding (MM).Book Value of Equity is total common equity at fiscal year close (MM$). Stock Price is as of fiscal yearclose (S&C). Total Assets are total assets at fiscal year close (MM$). Total Employees is total employ-ees at fiscal year close (M). EPS is basic EPS excluding extraordinary items. Annual Change in EPS ispercentage change in EPS (Note that the large standard deviation is due to firms with extremely smallvalues of lagged EPS. Excluding firms with very small absolute value of lagged EPS significantlyreduces the standard deviation of the percent change). Annual Change in Sales is percentage change innet sales. ROA is income before extraordinary items (MM$) divided by lagged total assets (MM$).Leverage is total long term debt (MM$) plus debt in current liabilities (MM$) divided by total averageassets at current and lagged fiscal years (MM$). % of Loss Firm Years is percentage of firm-years withpretax income less than zero.

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guidance change at least as early as 2002. It is plausible that market participantsresponded to this newly found awareness by increasing their information search regardingfirms’ VIE structures. For many firms the financial statements filed for the fiscal year2002, while not yet containing any information under the new accounting guidance, didcontain details about entities which subsequently qualified as VIEs. For example, CocaCola Co. in its 2003 10-K revealed FIN 46 related consolidation of certain bottling opera-tions because of profit guarantees and subordinated financial support. In its 2002 10-K itdisclosed details about these operations, such as ownership levels of almost 40%, whichlikely led an educated investor to the conjecture that these operations will be consolidatedunder the new guidance. Similarly, Municipal Mortgage & Equity LLC which in its 200310-K disclosed the consolidation of securitization trusts, a year earlier revealed that thecompany participates in securitization mechanisms. There is also evidence that securityanalysts increased their focus on various off-balance-sheet activities even before theimplementation of FIN 46. Citigroup Inc. analysts in March 2003 noted that the firm is inthe process of evaluating the impact of FIN 46 and discussed the impending changes tothe assets and liabilities of the firm as well as implications for its capital ratios.

Correspondingly, we examine two significant break points in our analyses. First, weconsider calendar years 2002 and subsequent (the variable “After 2001”), which capturesthe effects of accounting scandals, the expectation of a change in accounting guidance, theincreased press coverage, and voluntary firm disclosures. Second, we consider calendaryears after the relevant consolidations and disclosure (the variable “After Imp” differingfirm by firm), which captures the effects of the implementation of FIN 46 and FIN 46R.

4. Empirical analysis

We employ a difference-in-difference approach examining whether the dependent vari-ables of interest change for FIN 46 firms in a systematically different way than they dofor non-FIN 46 firms between the pre-FIN 46 period and the post-FIN 46 period. Spe-cifically, we examine the three time periods: pre-2002 (control period), post-2001(antici-pation period), and post-implementation (the period after the implementation year). Thisdifference-in-difference approach effectively controls for other regulatory events thatoccurred around the FIN 46 debate, notably the SOX and Regulation FD. This researchapproach is effective since there are no reasons why a firm that is subject to FIN 46 ismore (or less) likely to be affected compared to control firms by other contemporaneousrule changes. For our matched sample analysis we choose control firms that are closestin size to the sample firms in the Fama-French 48 industry in the same year but whichdid not make any FIN 46 disclosures. We assign the implementation year to the controlfirms of the FIN 46 firms to which they are matched.

4.1. Equity market participants

4.1.1. ERC analysis

We obtain all data for ERC analyses from the Center for Research in Security Prices(CRSP), Compustat and Institutional Brokers Estimate System (I/B/E/S) data files. Startingwith the universe of firms for 1990–2006 we require that the following relevant data benon-missing: from CRSP the firm’s annual returns, CRSP size decile annual returns, andhistorical data to calculate β from Compustat the market to book ratio and market capitali-zation. Additionally we impose the following data requirements utilized in prior literature:β between �10 and +10, β calculated based on at least 60 monthly observations, and posi-tive value of common equity. Our dependent variable is the size adjusted return of the

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stock obtained by calculating the compounded return of the stock and the CRSP size dec-ile returns (using year-end decile assignments) based on one year daily returns startingthree months after the start of the fiscal year. We estimate the following regression:

Return ¼ b0 þ b1UE þ b2UE �MBþ b3UE � Betaþ b4UE � Sizeþ b5FIN46

þ b6FIN46� UE þ b7After2001þ b8AfterImpþ b9After2001� FIN46

þ b10AfterImp� FIN46þ b11After2001� FIN46� UE þ b12AfterImp

� FIN46� UE þX59

M¼13

bMIndustry ð1Þ

Table 2. Earnings response coefficient analysis.

Matched sample Full sample

Unexpected earnings (UE) �0.018 0.000⁄⁄⁄

(0.991) (0.000)UE×M/B �1.179 0.012

(0.936) (0.012)UE×Beta 1.566 �0.001

(0.982) (0.021)UE× Size �0.079 0.001

(1.207) (0.021)FIN 46 0.000 0.013

(0.039) (0.031)FIN 46 ×UE �1.627 �0.077

(1.547) (0.326)After 2001 0.042 0.106⁄⁄⁄

(0.048) (0.017)After IMP �0.028 �0.175⁄⁄⁄

(0.060) (0.018)After 2001 × FIN 46 �0.040 �0.096⁄⁄

(0.064) (0.046)After IMP×FIN 46 0.020 0.165⁄⁄⁄

(0.076) (0.049)After 2001 × FIN 46 ×UE �2.651 �3.206⁄⁄⁄

(1.872) (1.309)After IMP×FIN 46 ×UE 5.980⁄⁄⁄ 5.068⁄⁄⁄

(1.870) (1.494)

Industry dummies and intercept Included Included

N 1412 28,834R2 0.03 0.01

Notes: The dependent variable (return) in this pooled OLS regression is the size adjusted return of thestock based on one year daily returns starting three months after the start of the fiscal year. The sampleperiod is 1990-2006 (November) and the units of observation are firm-years. FIN 46 is a variable thattakes a value of 1 if the observation is for a FIN 46 firm and of 0 for a matched control sample. After2001 is a variable that takes a value of 1 if the observation belongs to after 2001. After IMP is a vari-able that takes a value of 1 if the observation belongs to the period after implementation. UnexpectedEarnings is the analyst forecast error in the annual estimate scaled by price. MB is the ratio of marketvalue of equity to book value in the prior fiscal year end. Beta is the CAPM beta calculated over theprior sixty months. Size is the log of the market value of equity. Beta, Size and MB are all convertedinto indicator variables representing observations below and above the median in a given fiscal year.The Huber/White Robust standard errors are clustered by firm and reported in parentheses. ⁄⁄⁄, ⁄⁄ and ⁄shows statistical significance at 1, 5 and 10% level respectively.

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Our null Hypothesis 1a predicts that β11 and β12 will be equal to zero i.e. thatthe ERCs for FIN 46 firms have not changed subsequent to the adoption of FIN 46or in anticipation of such adoption. In the alternative, we expect, consistent withour prediction about idiosyncratic precision, that the ERC would decrease during theanticipation period because of the enhanced information uncertainty, but that itwould increase post-implementation, albeit only to a limited extent because of theambiguity of interpretation that was discussed earlier. Table 2 summarizes the resultsof the estimation on both the matched sample and the full sample for firm-yearunits of observation. The dependent variable is abnormal Return and the unexpectedearnings surprise is UE (actual earnings per share (EPS) minus the latest mean ana-lyst forecast of EPS prior to the earnings release date divided by stock price at thefiscal year end). The After2001 (AfterImp) variable takes a value of 1 when anobservation belongs to calendar years starting from 2002 (after the implementationyear for the matched sample and after 2003 for control firms within the full sam-ple).14 The FIN 46 variable is equal to 1 if the firm is in our FIN 46 sample (i.e.it is a category 1 or 2 discloser per our classification). Beta is calculated from theone factor model regressing stock return on just the market return, both adjusted forthe risk-free rate, using the monthly data from the five preceding years (using thethree or four factor model does not change the results). Size is the lagged log ofmarket value of equity and MB is the lagged ratio of market to book value ofequity. We follow the Teoh and Wong (1993) specification in converting the Beta,Size and MB variables into indicator variables representing observations below andabove the median in a given fiscal year. Huber/White Robust standard errors of esti-mates are provided below the estimated values, where the errors are clustered at thefirm level.

We observe that the coefficient on After2001×FIN 46×UE is negative (significantonly for the full regression) and the coefficient on AfterImp ×FIN 46 ×UE is positiveand significant. This result suggests that the accounting scandals and the intimations ofan impending stricter consolidation standard for FIN 46 firms increased informationuncertainty, resulting in a decrease in the weight attached to earnings surprises. Theresolution of uncertainty and/or the increase in accounting information quality uponimplementation reversed this effect.

4.1.2. Equity analysts

We obtain our analyst data from the I/B/E/S. We calculate the Barron et al. (1998)measures of precision of common and idiosyncratic information using the detail files(as done in prior literature) as follows:

Common Precision ¼ SE � DN

1� 1N

� �Dþ SE

� �2

Idiosyncratic Precision ¼ D

1� 1N

� �Dþ SE

� �2

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SÊ is the signed forecast error squared scaled by the absolute value of the actual EPS(where the forecast error is the actual EPS minus the mean of individual forecasts inthe 90 days prior to the earnings announcement). D is the variance of the individualforecasts scaled by the absolute value of the actual EPS, and N is the number of ana-lysts covering the firm. To calculate these measures we use all individual forecastsmade in the 90 days prior to the announcement of quarterly earnings (retaining the latestforecast for each analyst). We winsorize common and idiosyncratic precision variablesat 1% to eliminate the effect of extreme outliers and average the four quarterlycommon/idiosyncratic precision variables into an annual one.15

We estimate the following regression on the matched sample using ordinary leastsquares (OLS) with both analyst characteristics (Common Precision and IdiosyncraticPrecision) described above as dependent variables:

Precision ¼ b0 þ b1FIN46þ b2After2001þ b3AfterImpþ b4After2001� FIN46

þ b5AfterImp� FIN46þ b6Sizeþ b7ROAþ b8R&Dþ b9Leverage

þ b10Growthþ b11LossþX59

M¼12

bMIndustry ð2Þ

Our null Hypothesis 1b predicts that β4 = 0 and β5 = 0. Table 3 presents the estima-tion results of Equation (2). The sample period is 1990–2006 and the units of obser-vation are firm-years. After2001, AfterImp, and FIN46 variables are defined in thesame manner as in Section 4.1.1. Size is calculated as the log of total assets at priorperiod end, ROA as net income before extraordinary items scaled by prior total assets,R&D as the R&D expense scaled by total sales, Leverage as the total debt of thefirm scaled by total assets, Growth as the percent change in sales, and Loss as anindicator variable equal to 1 if the firm had negative pre-tax income. These variablesare all consistent with those used in prior literature (among others: Barth et al. 2001,Bowen et al. 2002, Mohanram and Sunder 2006). We also include 48 Fama Frenchindustry fixed effects in our specification which helps us rule out the possibility thatunobserved industry characteristics drive our results. Huber/White Robust standarderrors of estimates are provided below the estimated values, where the errors are clus-tered at the firm level.

We find results for idiosyncratic analyst precision. In the post Enron period ofexpected accounting guidance revisions, the precision of idiosyncratic information isreduced for FIN 46 firms more than for all other firms (After 2001×FIN 46). Thisresult suggests that anticipation of FIN 46 reduced the precision of private information.This is consistent with the argument that the anticipation of FIN 46 caused privateinformation about future income acquired before FIN 46 implementation to be noisier.We find no evidence that precision of private information is further reduced for thesefirms upon implementation of FIN 46 or that precision of public information is reducedfor FIN 46 firms upon either the anticipation or the implementation of the guidance (infact, upon implementation we see an increase in both precisions, albeit not statisticallysignificant).16 This is in accord with our prior expressed expectation that the revelationof more information upon implementation might increase precision (due to a reductionin information uncertainty and an increase in accounting information quality) only to alimited extent in light of the ambiguity of interpretation surrounding the consolidationinformation.

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4.2. Other Information Users

4.2.1. Bank Loan Analysis

The initial list of our sample consists of all publicly traded firms regardless of whetherthey have any bank loans during the sample period of 1990–2006 per LPC Dealscandatabase. Data in the LPC Dealscan database are compiled from the SEC filings by publicfirms and self-reporting by banks. Following prior literature (e.g. Kim et al. 2012), wecontrol for various loan specific characteristics and only include term loans, revolversand 364-day facilities in our sample. For our analysis we retain the FIN 46 firms whichhave bank loan data and the control firms which are closest in size in the same Fama-French 48 industry in the same year but which did not make any FIN 46 disclosures. We

Table 3. Equity analysts analysis.

Common precision Idiosyncratic precision

FIN 46 22.905 354.356(98.105) (257.726)

After 2001 �102.448 2.607(82.934) (283.925)

After IMP �230.307⁄⁄⁄ �855.664⁄⁄⁄

(70.595) (283.372)After 2001 × FIN 46 �87.261 �714.607⁄⁄

(121.724) (341.811)After IMP×FIN 46 76.213 330.130

(84.551) (344.256)Size 23.179 144.989

(26.727) (106.570)ROA 8689.800⁄⁄⁄ 11966.899⁄⁄

(2872.963) (4402.332)R&D 53.022⁄⁄⁄ 79.846⁄⁄⁄

(15.251) (24.691)Leverage 108.216 188.827

(164.774) (482.390)Growth 37.048 54.578

(30.192) (44.229)Loss �134.413 �986.565⁄⁄⁄

(122.522) (231.545)

Industry dummies and intercept Included Included

N 2076 2076R2 0.21 0.21

Notes: The dependent variables in this pooled OLS regression are Common (precision of commoninformation), and Idiosyncratic (precision of idiosyncratic information). The sample period is 1990-2006 and the units of observation are firm-years. FIN 46 is a variable that takes a value of 1 if theobservation is for a FIN 46 firm and of 0 for a matched control sample. After 2001 is a variable thattakes a value of 1 if the observation belongs to after 2001. After IMP is a variable that takes a value of1 if the observation belongs to the period after implementation. Size is log of total assets at prior fiscalquarter end. ROA is the Net Income before extraordinary items scaled by prior quarter’s total assets.R&D is the R&D expense scaled by prior total sales. Leverage is the total debt of the firm scaled bytotal assets. Growth is the percent change in sales from prior quarter. Loss is a variable equal to 1 ifthe firm had negative pre-tax income. The Huber/White Robust standard errors are clustered by firmand reported in parentheses. ⁄⁄⁄, ⁄⁄ and ⁄ shows statistical significance at 1, 5 and 10% levelrespectively.

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require the matched firms to have bank loan data also, which effectively removes theselection bias and enables us to estimate the result with OLS. The dependent variable isbank loan spread calculated as the difference between the borrowed rate and 6-monthLIBOR.17 The “spread” term used in this paper is the loan spread at origination andrepresented in basis points.18 We estimate the following equation:

Table 4. Bank loan analysis.

46R �0.377(9.438)

After 2001 10.717(10.877)

After IMP �7.920(11.700)

After 2001 × 46R 24.341(15.460)

After IMP× 46R �14.047(16.835)

Beta 24.370⁄⁄⁄

(9.741)Size �23.049⁄⁄⁄

(4.989)MB �2.246

(1.601)Leverage 222.773⁄⁄⁄

(38.697)Maturity �20.331⁄⁄

(11.202)Performance pricing �16.962⁄⁄

(8.061)Syndicate �21.185

(37.888)Number of lenders -0.696⁄⁄⁄

(0.269)Deal amount �0.007⁄

(0.004)

Loan purpose dummies IncludedLoan type dummies IncludedIndustry dummies and intercept Included

N 437R2 0.62

Notes: The dependent variable in the regression analysis (Spread) is the interest rate differentialbetween borrowed rate at origination and risk free rate. The sample period is 1990-2006 and the unitsof observation are firm-years. FIN 46 is a variable that takes a value of 1 if the observation is for aFIN 46 firm and of 0 for a matched control sample. After 2001 is a variable that takes a value of 1 ifthe observation belongs to after 2001. After IMP is a variable that takes a value of 1 if the observationbelongs to the period after implementation. Beta is the CAPM beta calculated over the prior sixtymonths. Size is the decile rank of the firm in the prior year. MB is the ratio of market value of equityto book value in the prior fiscal year end. Leverage is the ratio of long term debt to total assets in theprior fiscal year. Maturity is the natural log of the loan maturity period (in months). Performance Pric-ing is a variable which is equal to 1 if the loan contract includes performance pricing options. Syndi-cate is a variable that equals 1 for the syndicate loans. Number of Lenders is the number of lendingbanks for each loan. Deal Amount is measured by the amount of the loan given to a borrower. TheHuber/White Robust standard errors are clustered by firm and reported in parentheses. ⁄⁄⁄, ⁄⁄ and ⁄shows statistical significance at 1, 5 and 10% level respectively.

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Spread ¼ b0 þ b1FIN46þ b2After2001þ b3AfterImpþ b4After2001� FIN46

þ b5AfterImp� FIN46þ b6Betaþ b7Sizeþ b8MBþ b9Leverage

þ b10LoanMaturityþ b11PerformancePricing þ b12Syndicate

þ b13NumberLandersþ b14LoanSizeþX34

M¼15

bMPurposeþX38

M¼35

bMType

þX86

M¼39

bMIndustry ð3Þ

We hypothesize in 2a that β4 = 0 and β5 = 0, i.e. bank spreads will not change forFIN 46 firms after 2001 or after implementation. Table 4 presents the estimation resultsof Equations (3) and (4) where the units of observation are firm-years. If there are mul-tiple loans made in a year, we use the last loan as our observation.19 After2001, After-Imp, and FIN46 variables are defined in the same manner as in Section 4.1.1. Weinclude firm specific variables that likely affect the spread charged by the banks such asBeta, Size (decile of company market value), Market to Book ratio and prior years’Leverage (ratio of long term debt to total assets). Previous research on bank loan con-tracts shows that several loan-specific characteristics are related to the interest ratecharged by banks (e.g. Dennis et al. 2000, Kim et al. 2012, Bharath et al. 2008).Therefore, we include in Equation (3) a set of loan-level variables to isolate the poten-tial effect of loan characteristics on the loan spread from the effect of our test variables.The Loan Maturity variable is the log of the loan maturity period in months. The LoanSize variable is the amount of the loan given to a borrower. Syndicate is a variablewhich equals 1 if the loan is syndicated. We also include Loan Purpose, Loan Type,and Fama-French 48 Industry fixed effects in our specification. This helps us rule outthe possibility that unobserved loan purpose, loan type, and industry characteristicsdrive our results. Performance Pricing is a variable which is equal to 1 if the loan con-tract includes performance pricing options and Number of Lenders is the number oflending banks for each loan.

We find that estimated coefficients for After2001 ×FIN 46 and AfterImp ×FIN 46are not statistically significant after controlling for many loan and firm characteristicsthat are shown to be important spread determinants. This result suggests that borrowingcosts of FIN 46 firms did not change in the new environment differently from borrow-ing costs of other firms. This is consistent with the banks having been aware of theunderlying fundamentals of FIN 46 firms earlier than equity market participants. Therevelation of off-balance-sheet debt structures and consolidation information does notimpact bank spreads, since banks presumptively were aware of the overall debt struc-ture and profitability of the firms previously (due to relationship banking etc). Ourresults are in line with the prior literature’s evidence of banks’ superior knowledge.

4.2.2. Credit rating analysis

We use credit ratings issued by the four rating agencies that issue ratings as reported byMergent’s Fixed Income Securities Database (FISD): Standard and Poor’s, Moody’s,Fitch, and Duff and Phelps. S&P rates bonds from AAA down to D. For the AA to CCCclasses, S&P also supplies modifiers, such as A+, A, or A�. Similarly, Moody’s ratesbonds from AAA to C, with modifiers such as A1, A2, or A3. Fitch’s and DPR’s ratingsymbols are nearly identical to S&P’s. Following Jorion et al. (2005), we transform the

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credit ratings into a cardinal scale, starting with 23 as AAA, 22 as AA+, 21 as AA, andso on until 1. For our analysis we retain the FIN 46 firms which have credit ratings dataand the control firms which are closest in size in the same Fama-French 48 industry inthe same year but which did not make any FIN 46 disclosures. We require the matchedfirms to have credit ratings data also, which effectively removes the selection bias andenables us to estimate the result with OLS as per the following specification20:

Rating ¼ b0 þ b1FIN46þ b2After2001þ b3AfterImpþ b4After2001� FIN46

þ b5AfterImp � FIN46þ b6Beta þ b7Sizeþ b8MBþ b9Leverage

þX57

M¼10

bMIndustry ð4Þ

In this specification, the left hand side variable is an inverted credit rating rank (1 is thepoorest rating; 23 is the best rating). After2001, AfterImp, and FIN46 variables aredefined in the same manner as in Section 4.1.1. Our null Hypothesis 2b predicts thatβ4 = 0 and β5 = 0, i.e. that security credit ratings will not change for FIN 46 firms after2001 or after implementation. We include firm specific risk characteristics such as Beta,

Table 5. Credit ratings analysis.

FIN 46 0.401(0.334)

After 2001 �0.856⁄⁄

(0.372)After IMP �1.239⁄⁄

(0.517)After 2001 × FIN 46 �0.791⁄

(0.467)After IMP×FIN 46 0.995⁄

(0.583)Beta �2.197⁄⁄⁄

(0.333)Size 1.181⁄⁄⁄

(0.232)Market to book 0.035

(0.068)Leverage �6.836⁄⁄⁄

(1.224)

Industry dummies and intercept Included

N 652R2 0.47

Notes: The dependent variable in the regression analysis is the Credit rating using the FISD credit rat-ing data from all credit agencies, we converted all ratings into a scale between 1 (worst) – 23 (best)using the cardinal scales defined in Jorion et al. (2005). The sample period is 1990–2006 and the unitsof observation are firm-years. FIN 46 is a variable that takes a value of 1 if the observation is for aFIN 46 firm and of 0 for a matched control sample. After 2001 is a variable that takes a value of 1 ifthe observation belongs to after 2001. After IMP is a variable that takes a value of 1 if the observationbelongs to the period after implementation. Beta is the CAPM beta calculated over the prior sixtymonths. Size is the decile rank of the firm in the prior year. MB is the ratio of market value of equityto book value in the prior fiscal year end. Leverage is the ratio of long term debt to total assets in theprior fiscal year. The Huber/White Robust standard errors are clustered by firm and reported in paren-theses. ⁄⁄⁄, ⁄⁄ and ⁄ shows statistical significance at 1, 5 and 10% level respectively.

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Size (decile of company market value), Market to Book ratio and prior years’ Leverage(ratio of long term debt to total assets) to capture the contribution of these factors tothe rating. We included industry dummies (Fama-French 48 Industry classification) tocapture any industry-related credit rating spread variation. Huber/White Robust standarderrors of estimates are provided below the estimated values, where the errors are clus-tered at the firm level. We report the results in Table 5. We find that the estimated coef-ficient for After2001 ×FIN 46 is negative and weakly statistically significant whileAfterImp×FIN 46 is positive and weakly statistically significant (both at 10% signifi-cance level). This suggests that the rating agencies possibly had access to some infor-mation (but not to the same degree as banks) since the ratings declined marginally inanticipation of guidance and rebounded marginally once FIN 46 was implemented.21 Inother words, we observe a continuum of the degree to which different groups wereinformed. Preceding the FIN 46 debates, banks seem to have had the least informationuncertainty, credit rating agencies possessed somewhat more, and investors and equityanalysts were exposed to the highest levels of information uncertainty.

5. Concluding remarks

In this paper we investigate the impact of the promulgation of FIN 46 and FIN 46R ondecisions of different and distinct groups of market participants, as manifested in a vari-ety of measures. FASB had debated the appropriateness of “parking” assets and debt inVIEs off the balance sheets following the accounting scandals that surfaced during2001 and beyond. This debate culminated in the issuance of FIN 46 and its subsequentrevision to clarify the identification of entities that are subject to consolidation underARB No. 51 Consolidated Financial Statements. The interpretation and its revisionrequire a primary beneficiary of a VIE, who bears the majority of that entity’s risk and/or reaps the majority of the rewards, to consolidate the VIE and to include the resultsof its activities in the consolidated financial statements. The Interpretation also requiresexpanded disclosures of the firm’s involvement in the VIE. Thus, under the new FIN46 and FIN 46R guidance the explicit and implicit risks and rewards of off-balance-sheet structures are revealed as the company acknowledges that the economic structureof the VIE is such as to warrant consolidation.

Did FIN 46 and FIN 46R accomplish their objective of making the investment com-munity aware of what were the hidden risks, revenues or expenses up to the point intime at which FASB made known its intention to expand the types of entities subject toconsolidation? And, consequently, did the new guidance or the anticipation of its impacton the financial statements of affected firms change the pattern of decision-making bydifferent constituencies of market participants?

Our analyses and findings suggest that the new consolidation guidance had an impacton the decisions of those market participants who before 2002 were not likely to havehad significant information about the activities of VIEs sponsored by the firms affectedby FIN 46 and FIN 46R. Moreover, we find that this impact occurred prior to the actualimplementation of the interpretation (and as far back as 2002) following press coverage,voluntary disclosures and other revelations that presaged the change in GenerallyAccepted Accounting Principles (GAAP). In anticipation of the change, market actorswho were previously not aware of the involvement of the affected firms with VIEs,reacted in a way that betrays more acute sensitivity to the information uncertainty sur-rounding the solvency and prospects of these firms. Specifically, equity investors gener-ally reacted by attaching a smaller weight to earnings surprises, and analysts forecasts

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exhibited larger idiosyncratic errors. Some of these effects were reversed upon imple-mentation, possibly due to resolution of uncertainty as well as an increase in accountinginformation quality due to a reduction in earnings management opportunities.

On the other hand, constituencies that were more likely to be informed about theVIEs’ activities did not appear to change their conduct in similar fashion. Banks didnot increase the spreads they required from FIN 46 firms relative to other firms. Thisobservation is consistent with banks having access to superior information not generallyavailable to other investors. Credit rating agencies, also endowed with information, butapparently of poor quality or quantity, did downgrade the bond ratings of FIN 46 firmsbefore implementation more than the rating of other firms, albeit only marginally so(significant only at the 10% level). Correspondingly, upon implementation, the ratingsrebounded marginally more than those of matched peers.

The saga of consolidation is ongoing and it promises to provide a rich menu forfuture research in light of the sub-prime mortgage crises that recently engulfed the mar-kets, as well as FASB expanding the consolidation guidance. The latest rule (SFAS167) requires “reputational” risk to be reflected as liabilities in the financial statementsof the enterprise, albeit possibly under separate classification. Also, the balance sheetwill include assets restricted to be available for the benefit of the creditors of the con-solidated entity and that are not completely under the control of the consolidating firm,albeit again under a separate classification. The inclusion of these “non-assets” and“non-liabilities” even when separately disclosed may sow confusion. Thus, it is difficultto conjecture whether the net effect of the expanded consolidation and associated dis-closures will resolve information uncertainty to an extent that increases the weightattached to earnings surprises and/or analysts’ idiosyncratic precision, or whether it willhave the opposite results.

AcknowledgementsWe acknowledge helpful comments from Celal Aksu, Bill Cready, Ram Ramakrishnan andparticipants at the NYU-Yale joint conference, the 2009 AAA Annual Meeting, and the 2011APJAE Accounting Symposium.

Notes1. The information risk we are concerned with is the probability that accounting information

required by investors to price securities (or required by other users in their decision makingprocesses) is of insufficient quantity or quality; as such it encompasses not only the uncer-tainty in firm-specific information, but also users’ perception of that uncertainty. Notwith-standing the Knightian distinction between risk and uncertainty, we use information risk andinformation uncertainty interchangeably throughout the paper.

2. The terms VIE and SPE have on occasion been used interchangeably. We use the term VIEin accordance with the main choice of wording in FIN 46. For simplicity, we shall call com-panies subject to this rule change as “FIN 46 firms” throughout the paper.

3. SFAS 167 changes the criterion for consolidation into whether the firm has (1) power overthe significant economic activities of the VIE and (2) obligation to absorb losses or right toreceive benefits potentially significant to the VIE.

4. Examples in recent literature that address accounting effects on specific market publicsinclude Ke et al. (2008) who assess the impact of Reg FD on the abnormal selling of stocksby transient institutional investors, and Berger and Hann (2003) who examine, among otherthings, the effect of SFAS 131 on analysts’ forecast accuracy.

5. Paragraph D2 of FIN 46R.6. This is in contrast to the 3% sufficiency benchmark specified in EITF Issue No. 90-15, a

threshold widely relied upon previously in the structuring of financial vehicles. The 10 vs.3% is an element of FIN 46, which received attention in the press even before the first draft

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of the interpretation was distributed. See “Who else is hiding debt: moving financial obliga-tions into off-book vehicles is now a common ploy” in Business Week, 1/28/2002.

7. Small business issuers are allotted an extra year for application of FIN 46R, prior to whichFIN 46 is to be applied.

8. See Gorton and Souleles (2005) for a discussion of implicit recourse.9. See Barron et al. (1998), Botosan et al. (2004) for a discussion of the intuition behind these

measures.10. Although security analysts are heavily focused on the net earnings of the firm, they also

invest significant time and effort in the analysis of balance sheet items and their implication.For example, in March 2003 (prior to the implementation of the new rule), analysts followingCitigroup Inc. note that the firm is in the process of evaluating the impact of FIN 46 and dis-cuss the impending changes to the assets and liabilities of the firm as well as implications forits capital ratios.

11. This suggests that prior to the FIN 46R debate rating agencies were aware of the existence ofVIEs and the corresponding risk, even though in other contexts anecdotal evidence indicatesthat they were slow in updating their ratings. For example, Moody’s rated WorldCom debt asinvestment grade up until four days before its bankruptcy and Standard and Poor’s analystsexpressed faith in Enron’s ability to retain good credit rating even after the SEC informationrequest and the resignation of the CFO.

12. FIN 46 required deconsolidations of Trust Preferred Securities by nullifying EITF 84-40. Ininstances when the firm disclosed both material consolidation of some entities anddeconsolidation of others, the firm was classified as a category 1 discloser.

13. We do not discuss the disclosed consolidation impact magnitudes since the form of disclosurevaries greatly among firms and makes analysis unfeasible.

14. We define After2001 to take the value of 1 in all periods starting from 2002 (rather than inperiods from 2002 up to implementation only) for ease of coefficient interpretation of the var-iable AfterImp. The variable AfterImp, thus represents the incremental impact of guidanceimplementation on the perceived risk characteristics of the firm.

15. The results are very similar if we use the quarterly observations.16. Botosan et al. (2004) note that magnitudes of precision variables are not subject to meaning-

ful interpretation and may not be comparable between studies due to differences in computa-tion. The distributions of these variables in our sample are consistent with prior research.

17. Dealscan converts the coupon spread into a LIBOR spread by adding or subtracting aconstant differential reflecting the historical averages of the relevant spreads if loans is notbased on LIBOR (see Hubbard et al. 2002, for details).

18. For a given year we only analyze the loans made in that particular year, i.e. not all loansmade in prior years. Using that particular year’s loans eliminates the concern that prior years’loan spread may not adjust to new information in corporations’ financial statements.

19. Our results are not sensitive to this choice. We obtain similar results if we chose first loan ora loan borrowed closest to midyear, i.e. 1 July.

20. Our results and conclusions do not change if we employ ordered logit model instead of OLSto test our hypothesis.

21. Our results remain unaffected when only S&P ratings are used.

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Appendix A. Examples of FIN 46 and FIN 46R Disclosures (Categories 1 and 2are FIN 46 Firms)

Category 1: Impact from disclosed or implied consolidationCapital One Financial Corp., 12/31/2004

In July 2003, the Company adopted the provisions of FASB interpretation No. 46®,Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, Revised(“FIN 46®”). The Company has consolidated all material variable interest entities (“VIEs”)for which the Company is the primary beneficiary, as defined by FIN 46®. The consolida-tion of the VIEs resulted in a $15.0 million ($23.9 pre-tax) charge for the cumulative effectof a change in accounting principle …

Category 2: Expected impact from consolidation upon adoptionBear Stearns Companies Inc., 11/30/2003

Although the Company is still evaluating the impact of FIN No. 46 (R) relating to interestsin VIEs that existed prior to January 31, 2003, it is reasonably possible that FIN No. 46

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(R) will require consolidation of, or additional disclosures related to, the entities describedbelow …

Category 3: Minor impact (with few details provided)Gulfterra Energy Partners L P, 12/31/2003

We have no SPE’s as defined by FIN Nos. 46 and 46-R. We have evaluated our jointventures, unconsolidated subsidiaries and other contractual arrangements that could beconsidered variable interests or variable interest entities that were created before February1, 2003 and have determined that they will not have a significant effect on our reportedresults and financial position when we adopt the provisions of FIN No. 46-R in the firstquarter of 2004 …

Category 4: Impact from deconsolidationGreater Bay Bancorp, 12/31/2003

In accordance with the provisions of Financial Accounting Standard Board (“FASB”) Inter-pretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities” (“FIN 46”), we havedeconsolidated the six subsidiary trusts … We do not expect FIN 46 to have any othermaterial impact on our financial condition or operating results …

Category 5: No impact or immaterial impactAmbassadors International Inc., 12/31/2003

The adoption of FIN 46 did not and will not have a material effect on the Company’sfinancial position or results of operations …

Category 6: Impact is still being assessedCarlisle Companies Inc., 12/31/2003

The Company is evaluating the impact of applying FIN 46R but has not yet completed theanalysis. It is not expected that the adoption of this interpretation will have a materialimpact on the Company’s statement of earnings or financial position …

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