hspace=6As the New Year begins, investors and analysts eagerly await the release of 2009 year-end corporate financial statements. In a research paper titled Information Pursuit in Financial-Statement Analysis: Effects of Choice, Effort, and Disaggregation,  William B. Tayler, assistant professor of accounting at Emory University's Goizueta Business School, and Mark W. Nelson, a professor of management and accounting at Cornell University's The Johnson School, note that information pursuit bias-specifically seeking out and needing to calculate results in a financial statement-can lead to weighting that information more heavily in the decision-making process.

Investors must often calculate the results of a particular transaction and its importance in a financial statement. The authors label this process as transformational analysis. The lack of consistency on such things as accounting for leases, stock compensation, inventory cost flows, pensions and healthcare benefits, revenue recognition, and asset securitization and derecognition, for instance, require investors to sometimes dissect and interpret this information in the financial statement. It's often very hard to have a one-size-fits-all standard that allows for easy comparisons, says Tayler. 

The researchers find evidence for their bias conclusion by testing a common accounting entry: the capitalization of operating leases. Tayler and his co-author surmise that requiring financial-statement users to perform their own constructive capitalization will encourage them to generate risk assessments that weight that information more heavily than would be the case had they been provided with financial statements that were already transformed.

Interestingly, the authors note that the Securities and Exchange Commission (SEC) has asked the Financial Accounting Standards Board (FASB) to consider a ruling that would provide for a consistent approach to operating leases in financial statements. In this case, the SEC has called for FASB to require that auditors recognize or disclose assets and liabilities associated with operating leases.

In the study, the researchers polled a select group of MBA students who understood this accounting entry. The participants were asked to determine the riskiness of two franchise restaurants, with one company having no operating leases and the other company having significant amounts of operating leases. The first experiment conducted relied on three distinct variables to manipulate the effects: the decision to use transformed financial statements, effort spent on the transformation process, and disaggregation of the transposed financial statements.

The researchers set up a number of conditions, with the participants given the effects of constructive capitalization vs. choosing to get the information. Additionally, the study provided for an option to use a specific template for study participants to perform the calculations necessary to constructively capitalize operating leases vs. an option to use the results of calculations already provided to them. The paper notes, Results of experiment one indicate that participants' risk judgments were significantly affected by the effort and disaggregation manipulations, but not by the choice manipulation. Through debriefing sessions, the authors surmise that effort and disaggregation affected participants' perceptions of the extent to which they were well informed.

The second experiment delved into the impact of the effort effect. In this case, participants had equal access to information on the restaurants. The study subjects received the completed template (with the finished calculation provided) vs. the option of performing the calculation themselves within a given template. The results confirmed the researchers' earlier conclusions-those in the 'high effort' condition spent more time on the risk analysis task, again suggesting that the high risk ratings observed in that condition are due to participants expending greater effort.

The paper concludes that the research offers useful considerations for those involved in the direction of financial statement (auditors, company leaders, and regulators), as well as investors unfairly weighting the data they are actively pursuing in an audit. The authors note, These results have implications for standard setters who consider the relative benefits of recognition and disclosure, and for financial-statement users who transform financial statements as part of their analyses.

Unfortunately, Tayler concedes that accounting can never be an exact science. Differences in the way similar transactions are recorded do confound investors. For example, leases pose a particular dilemma for accounting purposes. He notes, When should leased property be treated as an asset of the firm (capital lease), and when should it be treated as a rental expense (operating lease)? There are several variables that could be used to determine the classification of the lease, such as the duration of the lease relative to the useful life of the asset or whether there will be a transfer of ownership at the end of the lease term.

But the research suggests that requiring users of financial statements to dig for information may lead to an increased weighting of it. Given the import of financial statements, especially post-Sarbanes Oxley, auditors and corporate management are now more concerned than ever about their role in the preparation of the audit.

The paper notes that participants in our experiments believed that disaggregation provided information about management credibility. In other words, the piecemeal presentation of certain financial transactions requiring effortful processing vs. a presentation interpreting the transaction, cast some doubt on the quality of management. Given the results, Tayler concludes that accounting standard setters (such as FASB), auditors and C-suite executives and board members should seriously consider how transactions are disclosed in an audit, especially when there is some flexibility in the presentation of this information.