Divya Anantharaman

Executive Debt-Like Compensation

While executive compensation in the United States is believed to consist primarily of cash- and equity-based components, a nascent literature argues that compensation accrued by executives under pension and other deferred compensation (DC) plans has debt-like payoffs, and could function as “inside debt”. Inside debt holdings are predicted to counteract the risk-taking incentives created by inside equity holdings, and align top managers closer to outside debtholders vis-a-vis equityholders. Recent empirical studies suggest that pension and DC plan balances serve the role of inside debt to some extent, and are effective at mitigating equityholder-debtholder conflicts in leveraged firms. These findings not only change our understanding of the composition of top executive compensation, but also have implications for the recent debate on reforming executive compensation to mitigate excessive risk-taking by top executives.

Stakeholders’ Demand for Conservative Reporting: An Exploration of Accounting for Pension Liabilities

We examine whether conservatism in standard setting serves the information needs of primary user groups in a setting where liability measurement is complex and uncertain. Current US GAAP on pension liability measurement straddles two competing perspectives: a going-concern perspective that incorporates future salary increases into estimates of benefit cash flows (PBO), but switches to a settlement perspective for present valuing by using a high-quality corporate bond rate (AA rate). This yields a GAAP pension liability measure that is more conservative than either a fully going-concern-based measure, which uses PBO discounted at a rate that reflects future cash flows (the expected return on pension assets—EROA), or a fully settlement-based measure, which excludes future salary increases (ABO) and discounts using the AA rate. We find: (1) equity investor valuations imply the use of EROA discounting; (2) debt investor assessments imply a settlement perspective of AA rate discounting and ABO; and (3) current GAAP proves to be overly conservative for both primary user groups. Our study highlights a cost of conservatism in pension liability measurement: it detracts from the value- and credit-relevance of financial statements.

Standards or Incentives: What Determines Financial Reporting Transparency for Defined Benefit Pension Assets?

We examine whether regulation intended to improve disclosure can itself lead to higher disclosure quality in the absence of a change in preparer incentives. We exploit a setting involving a sequence of two similar regulatory changes, which have one key difference – while both regulatory changes mandate improvements to disclosure (specifically, on pension asset allocation), only one removes preparer incentives to disclose opaquely (by eliminating a key reporting assumption – the expected rate of return on pension assets or ERR, which can be more effectively manipulated if asset allocation remains opaque). We construct two difference-in-difference (DD) research designs to examine the disclosure consequences of each of these changes mandating more transparent disclosures on pension assets ((i) a 2008 rule change under US GAAP and (ii) a 2011 rule change under IFRS), and examine the difference in disclosure outcomes between these two changes. We find that the IFRS disclosure standard, which also removes preparer incentives to obfuscate asset allocation, is effective at improving pension asset transparency as intended by the standard, whereas the US standard, which solely mandates better disclosure while leaving unchanged preparer incentives to disclose or obfuscate, is not as effective at improving pension asset transparency. Using a setting in which firms have a well-documented incentive for lower financial reporting quality (i.e., incentives to manipulate the ERR so as to lower pension expense and boost reported income), our findings reinforce the view in the “standards versus incentives” literature that accounting quality cannot be improved effectively with higher-quality standards alone; preparers’ incentives must work in concert with higher-quality standards to pull firms towards more transparent reporting.

Understanding Pension Liabilities: A Closer Examination of Discount Rates

The discount rate represents a critical choice in accounting for corporate defined-benefit pension plans due to the long-term nature of pension liabilities. U.S. GAAP and IFRS mandate the AA corporate bond rate. Their requirement is subject to much debate, with the risk-free rate and the expected return on pension assets (EROA) often proposed as alternatives. We examine which of these rates best fits pension values as perceived by equity- and debt-market participants. For equity values, the EROA rate dominates, while for credit ratings, the AA rate dominates. For financially healthy firms, however, discounting at the EROA produces the best fit for both equity values and credit ratings. In contrast, for firms nearing financial distress, discounting at the AA rate provides the best fit. We also find that the accumulated benefit obligation measure consistently dominates the projected benefit obligation in explanatory power for credit ratings. Overall, we find that market participants adjust GAAP-recognized pension obligations in both amount and discount rate, in a manner that appears consistent with firm-specific economic realities.