Monitoring the Managers

Research from Singapore examines the impact of financial accounting standards on how managers and firms act and how reliable the information they disseminate is. The ultimate purpose is to help people solve economic problems.

SMU Office of Research – As a young university student in South Korea, Assistant Professor Cho Young Jun saw first-hand the direct hit that the Korean economy took in the 1997 Asian financial crisis.

“At that time, Korea was badly hit, and part of the reason for this crisis was the opaqueness of financial statements,” says the assistant professor of accounting at the Singapore Management University (SMU) School of Accountancy. “Foreign investors withdrew their capital; they didn’t believe the financial information provided by Korean companies.”

He had studied sociology with an interest in economics from a sociological standpoint but was fascinated by the processes of accounting and business, and the very real effect that actions taken or not taken in those realms could have on entire economies and social systems.

“Accounting and business are more pragmatic than sociology. I wanted to apply a practical perspective and produce tangible results. I wanted to look at what the accounting standards were, and how accounting transparency could be improved,” Professor Cho says.

After completing his undergraduate studies at Yonsei University in South Korea, he worked for the finance division of electronics giant LG before returning to Yonsei for an MBA, followed by a master’s degree in accountancy and a doctorate in management at Cornell University in the United States. “If I wasn’t an accounting professor, I’d probably be a sociologist,” he muses.

Stringent financial accounting regulations

Professor Cho studies the impact of financial accounting standards on how managers act, and how reliable the information they disseminate is.

Financial accounting is a reporting system where the information collected about a firm’s performance gets delivered to those outside the firm, such as regulators, creditors, lenders and investors. In comparison, in managerial accounting, the information collected about a firm is used by internal managers to model and plan their next course of action – say, about where the company should make its next investments, or what business units need to have their costs trimmed down.

For instance, Professor Cho examined a United States accounting standard called SFAS 131, which was adopted in 1998. It sets out standard ways in which a business should report its operating segments, including reporting about individual segments’ profits, losses, assets, expenditures, and so on.

“SFAS 131 required companies to define segments in a manner consistent with internal organisational structures, that is, how they actually operate their business. This change improved reporting transparency for external stakeholders,” he explains.

Prior to the adoption of this standard, segment reporting was not very transparent, allowing managers the discretion to hide segments with poor performance and also to allocate investments in a way that made them look good. All these caused agency problems: when managers work in their own interests, rather than in the interests of shareholders, there will be cost to the firm.

The new standard meant the actual structure of the business was exposed and managers came under more scrutiny, and also led to better investment and capital-allocation decisions. “I found that capital allocation decisions became more efficient,” says Professor Cho. “Before SFAS 131, there was a greater tendency to allocate capital to more poorly-performing business segments. But now, managers tend to reallocate more capital from bad segments to good segments.”

However, all these regulations did not necessarily result in higher values for a firm’s shares. The flip side of having to publicly reveal more operating information, Professor Cho explains, is that competitors can get hold of that information too. “So there’s a trade-off. It’s not clear how it affects share prices.”

The value of intangible assets

In a related project, Professor Cho examined the impact of another financial accounting standard called SFAS 142. Introduced in 2002, it lays out rules for how firms should value goodwill.

Goodwill is an intangible asset created when a company acquires another company. For example, Firm A has a market value of $1,000, but Firm B buys it for $2,000. That valuation implies that to B, A is worth an extra $1,000 because it provides some advantage – say manufacturing capability, synergy, or something else. The extra $1,000 premium, an intangible asset, is called goodwill. The SFAS 142 regulation states that companies must value goodwill every year, and report losses if the intangible goodwill turns out impaired.

To properly value goodwill each year, managers must collect additional information about their business. According to the information hypothesis, the availability of such information would help the firm make better investment decisions. And indeed, Professor Cho found that firms that had to comply with SFAS 142 had higher accuracy in their earnings forecast, as one might expect if more information led to more accurate predictions.

Now, he plans to carry on studying how the information hypothesis plays out, and how to extract more value from financial accounting information to firms and shareholders.

He hopes his work will help regulators before they make new regulations and implement new standards. For instance, some firms say that they find SFAS 142 a burden, while other researchers suggest that while it is beneficial in principle, there is no way to absolutely verify the value of goodwill, which could offer a loophole for managers to manipulate their earnings.

A satisfying outcome of his research, Professor Cho says, is to help to change the minds or broaden the views of those who read what he writes. The ultimate purpose of his work, he shares, is to “help people to solve economic problems”.

By Grace Chua