Academic journal article Academy of Accounting and Financial Studies Journal

Earnings Management Using Pension Rate Estimates and the Timing of Adoption of SFAS 87

Academic journal article Academy of Accounting and Financial Studies Journal

Earnings Management Using Pension Rate Estimates and the Timing of Adoption of SFAS 87

Article excerpt


Concerns about earnings management and its effect on the usefulness of financial reporting continue to be pervasive and have prompted the Securities and Exchange Commission (SEC) to increase its enforcement activities. Flexibility in applying accounting provisions frequently provides opportunities for earnings management. Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions, (SFAS 87), provides extensive flexibility in choosing required pension estimates, and in timing the adoption of the standard. Several studies suggested that early adopters of SFAS 87 were motivated by its positive income effect.

This study investigated the relationship between the timing of adoption of SFAS 87 and earnings management using pension rate estimates subsequent to adoption. Study of 1,035 firms found that early adopters tended to use higher estimates of the rate-of-return on pension plan assets (ROR) subsequent to adoption, than on-time adopters. In the absence of higher actual returns, these findings suggest that early adopters were using the ROR estimates to facilitate earnings management subsequent to adoption. This may provide important information for the Financial Accounting Standards Board in assessing the effect of multi-year transition periods on earnings management.


Concerns about earnings management continue to be pervasive, and prompted the SEC to increase its regulatory enforcement activities to both prevent and detect earnings management. For example, in 1998, the SEC informed 150 firms that it may be reviewing their earnings reports and directed its Division of Corporate Finance to appoint a special task force to investigate potential earnings management problems (MacDonald, 1999, A2-6). In several of his speeches, Arthur Levitt, until recently chair of the SEC, and other SEC officials, such as former Chief Accountant, L.E. Turner have spoken out against earnings management that firms practice within the boundaries of Generally Accepted Accounting Principles (GAAP).

The potential for earnings management tends to arise when accounting standards provide for flexibility, require extensive estimates, and when long time horizons are involved. Accounting for defined benefit pensions combines all three of these criteria: it requires extensive estimates (e.g., of longevity, employee turn-over rates, and pension rates), permits flexibility in applying some of its provisions (e.g., in choosing pension rates), and typically involves an unusually long time horizon (i.e., employees for whom pensions benefits are currently accrued may not retire for several decades). In addition, SFAS 87, like a number of other recent accounting standards, provided for a long, multi-year transition period. In fact, the standard permitted firms to choose an adoption date from among three years.

Pension accounting evolved from the initial cash-as-you-go-basis to accrual accounting. SFAS 87 represents the newest in a series of accounting standards and was expected to improve the relevance and reliability of financial reporting related to defined benefit pension plans. However, Ali and Kumar (1993) found that the new standard provides more earnings management opportunities, than were available under the prior authoritative standard, APBO 8, Accounting for the Cost of Pension Plans. These enhanced earnings management opportunities arise in part from the provision that permits the discount rate to differ from the ROR, and due to income smoothing incentives (Ali & Kumar, 1993).

Prior research also found independent evidence of (1) an association between adoption timing of SFAS 87 and increased earnings at time of adoption (e.g., Langer & Lev, 1993; Tung & Weygandt, 1994), and (2) manipulation of pension rates subsequent to adoption (Blankley, 1992; Blankley & Swanson, 1995; Amir & Benartzi, 1998). Both of these findings are consistent with earnings management. …

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