JOURNAL OF BUSINESS AND ACCOUNTING Corporate Crisis: An Examination of Merck's Communication...

JOURNAL OF BUSINESS

AND ACCOUNTING Volume 5, Number 1 ISSN 2153-6252 Fall 2012

Corporate Crisis: An Examination of Merck’s Communication Strategies in the Vioxx Case .................................................................................. Mary Stone, Sheri L. Erickson, Marsha Weber

Conflict Minerals Disclosures: A Mandate of the Dodd-Frank Act ............................................................................................ Deborah L. Lindbert and Khalid Razaki

Hedging With Currency ETFS: The Implications of Return Dynamics ................................................................................................................................ Robert B. Burney

Financial Statement Presentation: A Sneak Peak at the Proposed Format ........................................................................... Suzanne P. Ward, Dan R. Ward, and Alan B. Deck

The Comparative Reporting Impact of the FASB and IASB Treatments of Research and

Development Expenditures .................................................................................... Patricia G. Mynatt and Richard G. Schroeder

IFRS Adoption in Japan: Road Map and Challenges ............................................................. Noriaki Yamaji, Joshua Hudson, and Douglas K. Schneider

Issues With Mandatory Audit Firm Rotation ......................................... Homer L. Bates, Bobby E. Waldrup, David G. Jaeger, and Vincent Shea

The Impact of Tax Incentives on the Location of Manufacturing Facilities ............................................................ Juan Luis Jay Ramirez, Anwar Y. Salimi, and Hassan Hefzi

Tax Practitioners and Ordering Effects of Information in an Ethical Decision ........................................................... Scott Andrew Yetmar, Peter Poznanski, and Elizabeth Koran

Anomalies of Tax Legislation: The First Time Homebuyer Credit ................................................................................................... Sheldon Smith and Amourae Riggs

Accounting for Sustainability ............................................................................................................................... Mehenna Yakhou

A Factor Analysis of the Skills Necessary In Accounting Graduates ......................................................................................... Suzanne N. Cory and Kimberly A. Pruske

The Effect of Timing on Student Satisfaction Surveys ................................................................. Pierre L. Titard, James E. DeFranceschi, and Eric Knight

Student Plagiarism and Economic Versus Moral Based Pedagogy

.................................................................................................Tackett, Shaffer, Wolf and Claypool

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JOURNAL OF BUSINESS AND ACCOUNTING

ISSN ISSN 2153-6252

Volume 5, Number 1 Fall 2012

TABLE OF CONTENTS

CORPORATE CRISIS: AN EXAMINATION OF MERCK’S COMMUNICATION

STRATEGIES IN THE VIOXX CASE

Mary Stone, Sheri L. Erickson, and Marsha Weber .................................................................. 3 CONFLICT MINERALS DISCLOSURES: A MANDATE OF THE DODD-FRANK ACT

Deborah L. Lindbert and Khalid Razaki ................................................................................. 15

HEDGING WITH CURRENCY ETFS: THE IMPLICATIONS OF RETURN DYNAMICS

Robert B. Burney ........................................................................................................................... 25 FINANCIAL STATEMENT PRESENTATION: A SNEAK PEAK AT THE PROPOSED

FORMAT

Suzanne P. Ward, Dan R. Ward, and Alan B. Deck ................................................................ 36 THE COMPARATIVE REPORTING IMPACT OF THE FASB AND IASB

TREATMENTS OF RESEARCH AND DEVELOPMENT EXPENDITURES

Patricia G. Mynatt and Richard G. Schroeder ......................................................................... 50 IFRS ADOPTION IN JAPAN: ROAD MAP AND CHALLENGES

Noriaki Yamaji, Joshua Hudson, and Douglas K. Schneider .................................................. 59 ISSUES WITH MANDATORY AUDIT FIRM ROTATION

Homer L. Bates, Bobby E. Waldrup, David G. Jaeger, and Vincent Shea .............................. 70 THE IMPACT OF TAX INCENTIVES ON THE LOCATION OF MANUFACTURING

FACILITIES

Juan Luis Jay Ramirez, Anwar Y. Salimi, and Hassan Hefzi ................................................. 76 TAX PRACTITIONERS AND ORDERING EFFECTS OF INFORMATION IN AN

ETHICAL DECISION

Scott Andrew Yetmar, Peter Poznanski, and Elizabeth Koran ................................................ 90 ANOMALIES OF TAX LEGISLATION: THE FIRST-TIME HOMEBUYER CREDIT

Sheldon Smith and Amourae Riggs ...................................................................................... 103 ACCOUNTING FOR SUSTAINABILITY

Mehenna Yakhou .................................................................................................................. 112 A FACTOR ANALYSIS OF THE SKILLS NECESSARY IN ACCOUNTING

GRADUATES

Suzanne N. Cory and Kimberly A. Pruske ............................................................................ 121 THE EFFECT OF TIMING ON STUDENT SATISFACTION SURVEYS

Pierre L. Titard, James E. DeFranceschi, and Eric Knight .................................................... 129

STUDENT PLAGIARISM AND ECONOMIC VERSUS MORAL BASED PEDAGOGY

James Tackett, Raymond Shaffer, Fran Wolf and Greg Claypool..........................................136

Journal of Business and Accounting

Vol. 5, No. 1; Fall 2012

3

CORPORATE CRISIS: AN EXAMINATION OF MERCK’S

COMMUNICATION STRATEGIES IN THE VIOXX CASE

Mary Stone

Sheri L. Erickson

Marsha Weber

Minnesota State University Moorhead

ABSTRACT

Image management is essential in crisis situations. This study uses critical analysis to

examine Merck’s communication strategies in the press when the drug Vioxx was removed

from the market. Benoit (1995) and Marcus and Goodman (1991) communication typologies

are used as a framework to determine whether Merck communicated in a way that enhanced

shareholder value. Marcus and Goodman find that when crises are classified as a scandal,

accommodating strategies provided more shareholder value, whereas in product recall type

crises, the results were unclear. Our research indicates that initial negative stock price

reaction could be the result of using defensive rather than accommodating strategies. In

addition, subsequent communication strategies result in mixed market reaction to

shareholders, which is in line with findings of Marcus and Goodman for product recall crises.

INTRODUCTION

Image management is essential to corporations and other organizations, particularly

in crisis situations. Numerous pharmaceutical drugs have been pulled from the market in

recent years, after information concerning product safety has come into question. A crisis of

this nature can deeply hurt an organization and affects many stakeholders. Seeger, Sellnow

and Ulmer (1998) define crisis as, “a specific, unexpected and non-routine organizationally-

based event or series of events which creates high levels of uncertainty and threat or

perceived threat to an organization’s high priority goals” (p. 233). One such crisis involved

Merck’s arthritis drug Vioxx, which was pulled from the market in September 2004 due to

evidence that the drug increased the risk of heart attack and stroke.

The purpose of this paper is to examine the image repair communication strategies

that Merck utilized in press releases during the Vioxx recall. We use Benoit’s (1995) Image

Restoration Typology to analyze Merck’s responses to the media following allegations that

Vioxx posed a health threat. We then compare the analysis using Benoit’s framework to the

framework used by Marcus and Goodman (1991) who found that different types of

communication strategies had varying levels of success in providing value to shareholders,

depending on the type of organizational crisis. As Rotthoff (2010) found, Merck lost $26.8

billion in stock value when Vioxx was pulled from the market.

Our motivation for this study stems from several prior studies. First, while Lyon and

Mirivel (2011) examined the communication strategies of Merck pharmaceutical

representatives with physicians, we examine communication strategies of Merck

representatives in the media. Lyon and Mirivel looked at the purpose and consequences of

communications. With the purpose of boosting sales of Vioxx, Merck’s sales representatives’

communications approach had the logical consequence of obscuring physicians’ ability to

Stone, Erickson, and Weber

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make a significant choice and resulting in more patients’ lives being put at risk (Lyon &

Mirivel 2011). Our current study examines Merck’s communication strategies with the

overall market of consumers, physicians, and investors after the company pulled Vioxx off

the market. While the intended purpose of these communications is to repair Merck’s image

and maintain stock price for shareholders, our study will show that not all communication

strategies are beneficial.

Second, Chen, Ganesan, and Liu (2009) found that a firm’s strategy for dealing with a

product recall case has an effect on stock market reaction. They found that a proactive

communication strategy, as opposed to a reactive strategy, had a negative effect on firm

value. Marcus and Goodman (1991) discovered that the stock market reacts differently to

corporate communications that are accommodating compared to those that are defensive

during times of accident, scandal, and product safety crisis. Their study was conducted before

Benoit’s (1995) framework was developed, therefore a fresh look into this area, using

Benoit’s framework to categorize communication strategies, is warranted. Marcus and

Goodman (1991) conclude that their ambiguous results in the product safety crisis may be the

result of the latent nature of the effects of corporate communications, therefore suggesting a

replication with a different group of observations.

Our current research study will examine Merck’s corporate communications around

the time of their Vioxx product recall using Benoit’s (1995) framework. We will also

compare our findings to Marcus and Goodman (1991) to determine if their findings are

supported by our study.

MERCK AND COMPANY

Merck and Company, the world’s second largest pharmaceutical company, introduced

Vioxx in May 1999. Along with its competitor Celebrex, Vioxx was a pain relief medicine

used to treat arthritic inflammatory pain. These two medicines, categorized as Cox-2

inhibitors, were scientific breakthrough drugs because while their pain relieving attributes

were similar to aspirin and ibuprofen, they showed a lower risk of causing gastrointestinal

troubles, including ulcers. These drugs were hugely successful, earning more money in their

first year on the market than any other medicine before them (Petersen, 2000).

Research studies, which continued after Vioxx was on the market, revealed an

alarming result; Vioxx increased the risk of heart attacks and strokes by up to two to three

times (Weitz & Luxenberg, 2010). As a result, Merck & Co. voluntarily recalled Vioxx on

September 30, 2004. At the time of the recall, Vioxx was used by approximately 2 million

people and was the source of 11 percent of Merck’s revenue. Merck’s stock price plunged

and they quickly lost $26.8 billion in market capitalization (Rotthoff, 2010). Thousands of

lawsuits, brought by patients, their survivors, and shareholders have been filed against

Merck. In 2010, Merck agreed to a settlement which requires $4.85 billion in payments to

patients who were harmed or killed, $12.15 million payment for plaintiff’s attorney fees, and

many organizational restructuring activities which monitor product safety (The Associated

Press, 2010).


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CORPORATE CRISIS AND REPUTATION MANAGEMENT

Corporate communication during a crisis reflects the firm’s strategic management of

the situation and is critical in determining how much, if any, damage is done to the firm’s

image. Because stakeholders attribute some responsibility to the organization or industry in

which the crisis exists, communications must explain the facts of the crisis and provide the

feeling that steps are being taken to ensure that the crisis won’t happen again (Fortunato,

2008). By strategically managing the crisis situation through reliable, credible, and

transparent communication, a corporation addresses stakeholders’ anxieties, manages its

corporate image, and restores its reputation (Geppert & Lawrence, 2008).

Communication is a goal-directed activity that involves a purpose. One of the central

goals of communication for the corporation is to maintain a positive public image (Benoit,

1995). A reputation may be damaged intentionally or unintentionally through word or deed.

When this happens the communicator is faced with the problem of negative public image.

According to Valentine (2007, p. 38), a damaged reputation can “translate into decreased

brand value; lowered share price; lost customers, partners, and strategic relationships; and

difficulty in recruiting and keeping top employees.”

Benoit creates his theory based on the assumption that, due to this potential negative

image resulting from a damaged reputation, the communicator is motivated to restore its

image as one of the central goals of its communication to the public.

IMAGE RESTORATION THEORY

Researchers have developed several image restoration strategies based on social

legitimacy theory, which argues that an organization’s continued existence is contingent on

its ability to receive support or approval from stakeholder audiences. In addition to Benoit’s

theory, other image restoration typologies include Allen and Caillouet (1994); Hearit (1995),

Ware and Linkugel (1973), Scott and Lyman (1968), and Suchman (1995) ; however,

Benoit’s (1995, 1997) typology is used most often by communication researchers to analyze

strategic responses to legitimacy issues.

Benoit’s typology identifies five image restoration strategies: 1) denial, or refuting

that the company had any part in the crisis, 2) evasion of responsibility, where the firm

attributes the crisis to actions of another party, 3) reducing the offensiveness of the act, in

which the firm tries to make the crisis seem less threatening, 4) corrective action occurs when

the firm implements steps to solve the problem and prevent a repeat of the crisis, and

5) mortification, where the firm takes responsibility for the crisis and apologizes. The

communication classification categories are somewhat hierarchical in that denial is the best

strategy, if a company is truly blameless. Evasion of responsibility, blaming the crisis on the

provocation of another, claiming defeasibility or the accidental nature or good intentions of

the company becomes a good choice if the company is not able to convince the public that it

had no responsibility for the crisis. If it becomes clear that this strategy will not suffice, most

companies resort to attempting to reduce the offensiveness of the crisis. Very few companies

take immediate corrective action and even fewer use mortification by apologizing. Table 1

below provides a detailed summary of Benoit’s five categories which include 14 unique

communication strategies.


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Table 1. Benoit’s (1995) image restoration strategies.

Marcus and Goodman (1991) classified corporate crises into three types. Accidents

are those in which there are identifiable victims and involve an unfortunate event that occurs

without warning. They note that companies “can plausibly deny responsibility for an

accident because it can claim that the events occurred almost entirely by chance” (p. 284). A

second type of crisis includes scandals, which are “disgraceful or discreditable occurrences

that compromise the perpetrators’ reputations” (p. 284). A third type of crisis is a product

safety and health incident, which is described as not being a single crisis, but rather a series

of events. At first glance, the Vioxx withdrawal falls into this category.

Marcus and Goodman (1991) placed all corporate communication responses into two

categories, accommodating and defensive. Their description of accommodating signals

include those where management accepted responsibility, admitted to the existence of the

problem, apologized, and took action to remedy the situation. Their description of defensive

policies include those in which management denied the existence of a problem, alleviated

doubts about the firm’s future viability, denied intent, and took actions to resume normal

operations quickly (Marcus and Goodman (1991).

Marcus and Goodman (1991) found that for accidents, defensive communications had

a positive effect on shareholder value, as measured by the closing stock price on the day the

crisis was disclosed in the press, using a model that tests for excess returns. Alternatively,

accommodative communications had a positive effect for scandals. They showed an

inconclusive effect for product safety and health crises. Two research questions are:

Categories

Strategy Description/example

Denial 1. Simple denial

2. Shifting the blame

Refuting outright that the organization had any

part in the event

Asserting that someone else is responsible

Evasion of

responsibility

3. Scapegoating

4. Defeasibility

5. Accident

6. Good intentions

Blaming the event on the provocation of another

Not knowing what to do; lacking knowledge to

act properly

Claiming the event was “accidental”

Claiming the company had good intentions

Reducing the

offensive act

7. Image bolstering

8. Minimization

9. Differentiation

10. Transcendence

11. Reducing the credibility

12. Compensation

Using puffery to build image

Stating the crisis is not bad

Indicating that this crisis is different from more

offensive crises

Asserting good acts far outweigh the damage of

this one crisis

Maintaining the accuser lacks credibility

Paying the victim; making restitution to set things

to where they were before the event

Taking corrective

action

13. Corrective action Taking measures to prevent event from

reoccurring

Mortification 14. Mortification Admitting guilt and apologizing


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RQ1: What are the communication strategies, classified according to Benoit (1995), used by

Merck when Vioxx was pulled from the market?

RQ2: Do the strategies Merck used support the findings of Marcus and Goodman (1991)?

DATA AND METHODOLOGY

In the following section we analyze Merck’s responses to media questions on

September 30, 2004, when Vioxx was pulled from the market. We use a critical analysis

method to study communication strategies employed by Merck spokespeople to attempt to

repair its tarnished image. Critical analysis of strategic communication has been used by

many scholars, including Benoit (2006); Benoit and Czerwinski (1997); Benoit and Henson

(2009); Blaney, Benoit, and Brazeal (2002); Coombs (1995); Hearit (1995); Huang and Su

(2009); Erickson, Weber, Segovia, and Dudney (2010); Erickson, Weber, and Stone (2011);

and, Seeger, Sellnow, and Ulmer, (2003). A variety of texts have been evaluated using

critical analysis, including speeches, advertising, newspaper articles, and public relations

announcements.

Wall Street Journal, New York Times, and CNN Money excerpts from 2004, which

exemplify Merck’s responses to the crisis, were analyzed using Benoit (1995). Proquest was

used to find all articles regarding Vioxx and quotes from company employees and

spokespeople were used for analysis. Two researchers independently categorized the

excerpts and all categorizations were mutually agreed upon. Merck used a wide variety of

communication strategies to address questions that arose concerning this crisis. The

following section provides a summary of Merck’s responses and a brief analysis of

responses.

ANALYSIS OF COMMUNICATIONS

On September 30, 2004, Merck announced a worldwide withdrawal of Vioxx based

on results of trials indicating that individuals taking Vioxx were more likely to experience

cardiovascular problems than those not taking the medication. We analyzed 21 excerpts that

included 27 responses from October 1, 2004-December 21, 2004 and analyzed these

responses using Benoit’s (1995) Image Restoration Typology.

Merck used strategies intended to reduce the offensiveness of the crisis in 21 of its

responses. The most commonly used strategy was that of image bolstering (12 instances),

where Merck used phrases such as “serving the best interest of patients” (Merck yanks

arthritis drug Vioxx, 2004) and “putting patient safety first” (Mathews & Martinez, 2004) to

try to rebuild its reputation. Other examples of image bolstering included, “We were

financially strong before this and we will be financially strong after” (Martinez, et al, 2004)

and that Merck remains “very strong financially, with very strong cash flow” (Merck yanks

arthritis drug Vioxx, 2004). Another excerpt states, “…we concluded that a voluntary

withdrawal is the responsible course to take” (A Vioxx elegy, 2004, p. A.14). Perhaps the

most amusing example of bolstering was made by legal counsel for Merck: “Merck wasn’t

dragging its feet” and “It’s pretty hard for me to imagine that you could have done this more

quickly than we did” (Berenson, et al., 2004. p. 1.1).

Some of the above examples that mentioned that Merck was financially strong could

also be categorized as examples of minimization because Merck was attempting to show that


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lost sales of Vioxx would not significantly harm the company financially. Another example

of the use of minimization included “we believe it would have been possible to continue to

market Vioxx with labeling that would incorporate these new data…” (A Vioxx elegy, 2004,

p. A.14). This example is an attempt by Merck to indicate that the only problem was

improper labeling, not the product itself.

Another way to reduce the offensiveness of the crisis is to reduce the credibility of the

accuser. Merck used this tactic three times after Vioxx was pulled off the market. One

comment, in response to an editorial, states that the editorial “is flawed in many important

respects” (Martinez & Hensley, 2004, p. B.8.) and “that the information was ‘taken out of

context’” (Mathews & Martinez, 2004). In response to a Congressional investigation, Merck

stated that documents “will be deliberately presented out of context to advance the interest”

of plaintiffs (Martinez, 2004).

Merck used evasion of responsibility strategies in 5 responses. Defeasibility was used

3 times, primarily when Vioxx was first pulled from the market and the company indicated

that, “What we saw was stunning. We certainly don’t understand the cause of this effect, but

it is statistically significant and it indicated there was an issue” (Berenson et al., 2004). Not

only does this imply that the company lacked the knowledge or ability to understand, but the

use of the word “issue” is an attempt to minimize the crisis. Another example of

defeasibility is, “I’m sorry that I didn’t know four years ago what I know now, but the data

didn’t lead us there four years ago” (Berensen, et al, 2004).

The company also used good intentions, another evasion strategy, twice when it

talked about the study of the effects of Vioxx and stated “we did our best to think of the most

comprehensive study we could have done” (Berenson et al., 2004). Finally, Merck stated that

it “acted responsibly and appropriately as it developed and marketed Vioxx” (E-mails

suggest Merck knew Vioxx’s dangers at early stages, 2004), an example of simple denial.

This strategy is only appropriate if the firm is truly blameless. If the firm uses a denial

strategy and later is found to have blame in the crisis, its reputation can be irreparably

damaged.


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Table 2 provides a summary of our analysis of the responses made by Merck after

pulling Vioxx off the market.

Table 2. Categories of communication responses after pulling Vioxx.

Typology Number of

Times Used

Total for

Category

Denial:

Denial 1

Shifting the Blame

Total for Denial 1

Evasion of Responsibility

Scapegoating

Defeasibility 3

Accident

Good Intentions 2

Total for Evasion of Responsibility 5

Reducing the Offensiveness

Bolstering Image 12

Minimization 6

Differentiation

Transcendence

Reducing the Credibility 3

Compensation

Total for Reducing the Offensiveness 21

Taking Corrective Action

0

Mortification

0

TOTAL

27

In their research, Marcus and Goodman (1991) compared the stock market reaction of

accommodating communications to the reaction of defensive communications. Their

description of accommodating signals include those where management accepted

responsibility, admitted to the existence of the problem, apologized, and took action to

remedy the situation. Their description of defensive policies include those in which

management denied the existence of a problem, alleviated doubts about the firm’s future

viability, denied intent, and took actions to resume normal operations quickly. Mapping

Marcus and Goodman’s descriptions onto Benoit’s framework produces the following

comparison, as shown in Table 3. Accommodative communications are those which Benoit

titles Corrective Action, and Mortification; while Defensive policies are those categorized as

Denial, Evasion of Responsibility, and Reducing the Offensiveness.


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Table 3. Comparison of Marcus and Goodman to Benoit.

Marcus and Goodman (1991) Corporate Policy signals Benoit’s Crisis Communication Framework

Accommodating Corrective Action

Mortification

Defensive Denial

Evasion of Responsibility

Reducing the Offensiveness

In effect, Merck used only defensive communication strategies for the crisis.

According to Marcus and Goodman’s (1991) study, this type of strategy only serves

shareholder interests effectively by providing significantly better returns to shareholders

when the cause of the crisis is an accident.

The crisis in this study involves a safety and product recall crisis, which, according to

Marcus and Goodman (1991), indicated no significant differences between accommodative

and defensive communication strategies. Although this crisis was that of the product recall

variety, it could be argued that because management had knowledge of the medical risks for

months, yet continued to market Vioxx, it could be considered a scandal. Prior knowledge of

the dangers of Vioxx was indicated on May 18, 2004 when the Wall Street Journal reported

that Merck had requested that their employee, Dr. Cannuscio, be removed from a study

which found harmful side effects for patients who used Vioxx. Merck, claimed, “Merck

disagreed with the conclusions and didn’t think it was appropriate to have a Merck author”

(Burton, 2004, p. B.1). Merck also stated, “You’re not able to control completely for the

differences between groups. There were serious limitations to the analysis” (Burton, 2004, p.

B.1). Also, on November 1, 2001, the Wall Street Journal reported that Merck executives

had been worried in the 1990s that Vioxx would show greater heart risk than cheaper pain

killers (Rotthoff 2010). Both of these communications with the public gave hints that the

product recall crisis was more of a scandal than an accident.

Regardless of whether this crisis is a scandal or a product recall, according to Marcus

and Goodman (1991), shareholders would have been better served by accommodating

strategies. Because Merck utilized defensive strategies, we would expect to see negative

stock market reactions, which is clearly the case on September 30, 2004. Merck withdrew

Vioxx after the market closed on 9/29/2004 and the stock price fell from $45.07 that day to

$33.00 at the close of the market on 9/30/2004, a loss of $26.8 billion in market value

(Rotthoff, 2010). Rotthoff shows the market acted quickly and efficiently to the news.

Marcus and Goodman suggest that Merck needed to handle the crisis, if classified as a

scandal, by using more accommodative strategies, such as corrective action and

mortification.

Corrective action could have included the offer to pay for medical exams for patients

taking Vioxx in order to access possible heart damage. Mortification requires an apology,

which legal counsel generally discourages. Merck researcher Dr. Reicin was the only

individual to say that she was “…sorry that I didn’t know four years ago what I know

now…” (Berenson, et al., 2004), but it isn’t clear what she was actually sorry about: Death

of patients who used Vioxx? Perhaps she was sorry about not withdrawing the drug sooner,

which Rotthoff (2010) contends would have resulted in a smaller total financial loss for


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Merck. Table 4 shows the closing stock prices on the days (after the initial announcement)

that communication strategies analyzed in this study were made public.

Table 4. Stock market prices on days Merck communicated to the press.

Date

Stock price day

before

communication

Stock price day

of

communication

Change

(direction)

Percent change

October 1, 2004 33.00 33.31 0.31 (+) +1%

October 5, 2004 34.23 33.43 0.8 (-) -2.34%

October 6, 2004 33.43 31.67 1.76 (-) -5.26%

October 7, 2004 31.67 30.98 0.69 (-) -2.18%

November 1, 2004 31.31 28.28 3.03 (-) -9.68%

November 2, 2004 28.28 26.80 1.48 (-) -5.23%

November 14, 2004 26.45 26.45 0 (mkt. closed) 0

November 15, 2004 26.45 27.09 0.64 (+) +2.42%

December 15, 2004 29.62 30.48 0.86 (+) +2.90%

December 21, 2004 31.51 31.98 0.47 (+) +1.49%

Source: http://www.merck.com/investors/financials/stock-information/historical-price-lookup.html

The direction of the stock price reaction was positive on four of the ten dates, and was

negative on the other five dates. These data provide mixed results. Marcus and Goodman

found that accommodating strategies were more beneficial (positive excess returns) to

shareholders in scandal situations than they were in accident situations. They also found that

defensive communication strategies were more beneficial to stockholders in accident

situations than they were in scandal situations. Marcus and Goodman found no significant

difference in stockholder returns following defensive and accommodating strategies in the

product harm case and the above data support their findings if this crisis can be classified as a

product recall; however, if this crisis is classified as a scandal for the reasons mentioned

above, then the results in table 4 should have shown a decrease in stock price for each of the

days that Merck used a defensive strategy.

Perhaps stockholders initially receive product recall news as an accident, and would

accept defensive communications from the company as appropriate. As time passes and

information becomes available which indicates the company knew of product safety concerns

for quite a while before the recall, the stockholders might view the product recall as a

scandal, making accommodative corporate communications more appropriate. If this were

the case, Merck’s use of defensive strategies would be viewed favorably immediately after

the recall, but become negative as time progressed. This is not what is seen in this case.

Instead, we see one positive change, followed by five negative price reactions, followed by

three more positive reactions. This is especially curious when November 1, 2004 was the

day that the Wall Street Journal reported that Merck executives were worried in the late

1990s that Vioxx posed a heart risk (Rotthoff 2010). This date would provide evidence to

the general public that the product recall crisis has changed from an accident to a scandal.

We would expect that all further defensive communications would be accompanied by

negative price changes, but three of the six communications after November 1 are met with

positive stock price reactions. Therefore, the results of this study support Marcus and


12

Goodman if the crisis is classified as a product recall, but do not support their study if the

crisis is classified as a scandal.

CONCLUSION

The current study examined stock price reaction to corporate communications

following crisis. Using Benoit (1995) and Marcus and Goodman (1991) as a framework,

authors mapped Merck Pharmaceutical’s image restoration communications around the time

of the Vioxx recall onto the former scholar’s outcomes. The communications were

categorized as “denial”, “evasion of responsibility”, and “reducing the offensiveness of the

act”, as per Benoit’s framework. These would all map to defensive strategies under Marcus

and Goodman’s typology.

Our results mirror Marcus and Goodman’s (1991) results if the Vioxx crisis can be

labeled as a product recall. However, if viewed as a scandal, our results do not support the

Marcus and Goodman study. We examined the direction of stock price change at the time of

corporate communication. All of the communications we analyzed were defensive, yet the

direction of stock price change was negative in over half of the observations, and was

positive in the remainder of the communications.

If corporate management believes that stockholders will view the product safety

crises more like an accident, management should use defensive strategies. If management

believes stockholders will view the crisis more like a scandal, accommodating strategies

should be used. In the early phases of a product recall crisis, management may want to make

stakeholders believe that this is an accident, not a scandal; therefore utilizing defensive

communication strategies. As the reality of the slow evolution of product recall cases

becomes known by the external stakeholders, the crisis begins to look more like a scandal

than an accident, making defensive communication strategies less appropriate. The mixed

pattern of results in the current study does not support this temporal view of product recall

crisis. Instead of the ambiguous results being a result of stakeholder attitudes differing over

time, perhaps attitudes differ between individual stakeholders. Some might view a product

recall crisis as an accident, while others view it as a scandal; leading to inconclusive results.

Crisis communication is important and management should be cautious when

selecting the proper communication strategy. More studies need to be conducted on product

recall crises in order to better understand which type of communication strategies provide

increased shareholder value. In addition, organizations need to determine if product recall

crises may actually fall into the accident category, like the Tylenol crisis, or into the scandal

category, which appears to be the case for the Vioxx crisis. When faced with a scandal,

companies should use accommodating communication strategies to provide increased

shareholder value.

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http://www.weitzlux.com/vioxx/recallhistory_94.html


Vol. 5, No. 1; Fall 2012

15

CONFLICT MINERALS DISCLOSURES:

A MANDATE OF THE DODD-FRANK ACT

Deborah L. Lindberg

Illinois State University

Khalid Razaki

Dominican University

ABSTRACT

For certain humanitarian reasons, such as deprivation of financial resources to

militant groups that seek arms for nefarious purposes, the civilized world is seeking to

eliminate or significantly diminish the trade in “conflict minerals”. The United States is

trying help in this effort by various means, including (a) forcing the publicly traded user

companies of these minerals to establish their supply sources, and (b) after a proper audit,

reporting the results in annual financial statements and official websites.

Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of

2010 (Dodd-Frank Act) requires a new reporting requirement for publicly traded companies

that manufacture products for which “conflict minerals” are necessary for their functionality

or production. The conflict minerals included in this provision of are cassiterite, columbite-

tantalite, gold, wolframite, or their derivatives. The supply source of concern is the

Democratic Republic of the Congo or countries adjoining the Congo. The requirements apply

to both domestic and foreign issuers of publicly traded equities (issuers), including smaller

companies that must report to the Securities and Exchange Commission.

Industries that may be subject to these new reporting requirements include aerospace,

automotive, electronics, communication, jewelry, and manufacturers of healthcare machines.

However, while it could be argued that the U.S. Congress' attempts to curb violence in the

Congo and adjoining countries is commendable, there are several issues regarding the

disclosure requirements for conflict minerals.

INTRODUCTION

For certain humanitarian reasons, such as deprivation of financial resources to

illegitimate groups that seek arms for nefarious purposes, the civilized world is seeking to

eliminate or significantly diminish the trade in “conflict minerals”. The United States is

trying help in this effort by various means, including (a) forcing the publicly traded user

companies of these minerals to establish their supply sources, and (b) after a proper audit,

reporting the results in annual financial statements and official websites.

Though there are no specified penalties for the use of conflict minerals (McDermott

Will & Emery, 2010), the U.S. Congress hoped that mandating public disclosure might

shame [the “name and shame” incentive, according to Ayogu and Lewis, 2011] user

companies to curb or eliminate such trade, resulting in the denial of funds to abusers of

human rights (Zweig, 2011).

Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of

2010 (Dodd-Frank Act) requires a new reporting requirement for publicly traded companies

that manufacture products for which “conflict minerals” are necessary for their functionality

Lindberg and Razaki

16

or production (McDermott Will & Emery, 2010). The conflict minerals included in this

provision of the Dodd-Frank Act are cassiterite, columbite-tantalite, gold, wolframite, or

their derivatives (SEC, 2010). By passing this section of the Dodd-Frank Act, Congress in

effect ordered the U.S. Securities and Exchange Commission (SEC) to require publicly

traded companies to disclose whether raw materials essential to their products originated

from the Democratic Republic of the Congo or countries adjoining the Congo (DRC

countries) (SEC, 2010; Zweig, 2011). Countries contiguous to the Democratic Republic of

the Congo included in this legislation are South Sudan, Uganda, Rwanda, Burundi, Tanzania,

Malawi, Zambia, Angola, Congo, and the Central African Republic (Ayogu and Lewis,

2011).

The disclosure requirements apply to both domestic and foreign issuers of publicly

traded equities (issuers), including smaller companies that must report to the Securities and

Exchange Commission (SEC, 2010). Industries that may be subject to these new reporting

requirements include aerospace, automotive, electronics, communication, jewelry, and

manufacturers of healthcare machines (Ayogu and Lewis, 2011).

BACKGROUND

Warring factions in the Democratic (sic) Republic of Congo have financed the acts of

murder, mutilation, kidnapping, rape, child labor, pillaging by mining and selling “conflict”

minerals (described below). The Congolese supply amounts to about 20% of the total global

supply (Zweig, 2011).

Congress adopted Section 1502 of the Dodd-Frank Act in the hopes that reporting

requirements about conflict minerals will help curb the violence in the Congo (SEC, 2010).

Disclosures related to the so-called “conflict” minerals are aimed at stemming the brutal

militia groups that often take over the mining and sale of these minerals to finance their

military actions (Wyatt, 2012). While the conflict mineral disclosures mandated by the Dodd-

Frank Act do not impose any penalties on companies that are using such minerals in their

products, the intention of the disclosures is to allow the investing public the opportunity to

judge such companies (McDermott Will & Emery, 2010).

Zweig (2011) expected that about 1200 companies would eventually fall under this

reporting provision. The number of companies meeting this reporting requirement is

increasing (from 2 companies in 2010 to over 40 in 2011 (Ibid). There are significant

monetary and non-monetary costs of adopting this requirement. Zweig (2011) cites the case

of a small company with a market value of $11 million and net income of $228,000 that

estimated its cost of compliance to be around $1 million. Such costs are obviously

prohibitive and untenable for smaller companies.

CONFLICT MINERALS

The conflict minerals specified in the Dodd-Frank Act, for which disclosure by

publicly traded companies will be required, are cassiterite, columbite-tantalite, gold, and

wolframite, or their derivatives (SEC, 2010). Each mineral will be discussed in the following

sections.

Cassiterite: Cassiterite is an important source of the type of tin used in coffee cans

and circuit boards (Wyatt, 2012). It is also used in cell phones, DVD players, and computers.


17

Columbite-tantalite: “Coltan” is short for columbite-tantalite (Epstein & Yuthas,

2011). In industrial uses this mineral is known as “tantalite” or “tantalum.” After columbite-

tantalite is refined it is used in products ranging from small cell phones to giant turbines

(Wyatt, 2012). It is also used in such consumer electronic products as DVD players, video

games, and computers. In Intel’s 2011 annual report, the corporation notes that its goal for

2012 is to verify that the tantalum used in it microprocessors is conflict free (Intel

Corporation, 2012).

Gold: Gold is of course extensively used in jewelry. In addition, gold is often used in

electronic products as a conductor (Wyatt, 2012). This precious metal also has a myriad of

other uses, ranging from dentistry to coins to electric wiring.

Wolframite: Wolframite is used to produce the tungsten that is used in such products

as light bulbs and machine tools (Wyatt, 2012). It is also used in armor-piercing ammunition.

These conflict minerals are sometimes referred to as “3TG” minerals (tin, tantalum,

tungsten, and gold (Ayogu and Lewis, 2011). Refer to Table 1 for a summary of conflict

minerals and their uses in products.

Table 1: Conflict Minerals and Their Use in Products

Conflict Mineral Other Names for

These Minerals Consumer Products

Cassiterite Tin

Coffee cans;

Computers;

Cell phones;

DVD players

Columbite-tantalite

Coltan;

Tantalite;

Tantalum

Cell phones;

DVD players;

Video games:

Computers;

Turbines

Gold Gold Jewelry;

Electronic products

Wolframite Tungsten

Light Bulbs;

Machine Tools;

Armor-piercing ammunition

CONFLICT MINERALS DISCLOSURES

The rules issued by the SEC require a reporting issuer (publicly traded company) to

disclose whether its conflict minerals originated in one of the DRC countries after conducting

a reasonable country of origin inquiry process. Thus, the burden of proof shifts from

corporations relying on their suppliers’ assurances that they don’t have conflict minerals to

the publicly traded company determining the source of the minerals. If the company

concludes its conflict minerals did not originate in any of the DRC countries, it would

describe this determination and the reasonable country of origin process it used to make it. If

Lindberg and Razaki

18

the reporting company concludes that its conflict minerals did originate in one or more of the

DRC countries, it would disclose this conclusion and be required to provide a “Conflict

Minerals Report” and a certified private sector audit of the Conflict Minerals Report (SEC,

2010). Each of these requirements will be discussed in the following sections.

REQUIRED DISCLOSURES - NO CONFLICT MINERALS FROM DRC

COUNTRIES

If after a reasonable country of origin inquiry process a reporting company concludes

its conflict minerals did not originate in any of the DRC countries, it would describe this

determination and the inquiry process it used to make it. Similarly, if after a reasonable

inquiry of the country of origin a company is unable to determine the origin of its minerals, it

must disclose that fact (Ayogu and Lewis, 2011). More specifically, the issuer will be

required to:

Make the disclosure available on its Internet website

Provide the Internet address of this website

Maintain records demonstrating that its conflict minerals did not originate in any

of the DRC countries (SEC, 2010).

CONFLICT MINERALS REPORT - REQUIRED FOR CONFLICT MINERALS

FROM DRC COUNTRIES

If the reporting company concludes that its conflict minerals did originate in one or

more of the DRC countries, the company must disclose this conclusion and issue a Conflict

Minerals Report as an exhibit to the annual report. Specific disclosures would require the

issuer to:

Describe its products manufactured or contracted to be manufactured containing

conflict minerals originating in any of the DRC countries

Disclose the facilities used to process such conflict minerals

Disclose conflict minerals’ country of origin

Describe the efforts used to determine the mine or location of origin with the

“greatest possible specificity”

Note that the Conflict Minerals Report is included as an exhibit to the annual

report

Furnish the Conflict Minerals Report

Make the Conflict Minerals Report available on its Internet website

Disclose that the Conflict Minerals Report is posted on its Internet website

Provide the Internet address of this website (SEC, 2010).

Reporting companies would describe the measures taken by the company to exercise

due diligence regarding the source and chain of custody of conflict minerals that are

necessary to the functionality or production of its products (SEC, 2010).

CERTIFIED INDEPENDENT PRIVATE SECTOR AUDIT

There must be a certified private sector audit of the Conflict Minerals Report (SEC,

2010). However, many constituencies expressed significant reservations regarding several


19

aspects of the audit requirement. For example, in a letter to the SEC sent by Grant Thornton

LLP during the comment period, the CPA firm expressed the following concerns:

It appears that either an attestation engagement or a performance audit would

meet the audit requirement. However the two engagements differ significantly in

nature, scope, and reporting requirements, potentially causing confusion and

misunderstanding among users of the audit report.

The objective of the audit, including the opinion or conclusion to be expressed on

the issuer's Conflict Minerals Report is not described.

The criteria to be used to evaluate the subject matter in the Conflict Minerals

Report are not described (Grant Thornton LLP, 2011).

The American Institute of Certified Public Accountants (AICPA) expressed similar

reservations and concerns in a letter that the organization sent to the SEC (Coffee, 2011).

Moreover, both Grant Thornton and the AICPA expressed concerns regarding

independence issues surrounding the private sector audit of the Conflict Minerals Report.

Grant Thornton noted that the SEC proposal, while consistent with terminology used in the

Dodd-Frank Act, indicates that the independent audit is a “critical component of due

diligence” on the part of the reporting company (Grant Thornton LLP, 2011). However, this

statement is contrary to the concept of an independent audit opinion (Grant Thornton LLP,

2011), since the auditor should not be part of the process regarding the assertion by

management that the audit firm is attesting to. The AICPA noted that since the rules

regarding private sector audit is silent as to independence issues, the SEC needed to clarify

which independence standards apply to the audits of Conflict Mineral Reports. Independence

requirements under Attestation Engagements issued by the AICPA, Performance Audits

within Government Auditing Standards (GAGAS), and audits following SEC independence

standards have differing requirements regarding the independence of the audit firm from its

client (Coffee, 2011).

Several of these concerns were addressed in the final rules issued by the SEC on

August 22, 2012 (Ernst & Young, 2012). For example, regarding auditor independence, the

final rules indicate that the independent private sector audit of the Conflict Minerals Report

must comply with independence standards issued by the Governmental Accounting Office

(GAO). Further, the SEC stated that an audit firm could perform both the audit of the

Conflict Minerals Report and the audit of the financial statements of the issuer and still be

considered independent (SEC, 2012). In the final rules the SEC also indicated what the

objective of an audit of a Conflict Minerals Report it, noting that “the audit’s objective is to

express an opinion or conclusion as to whether the design of the issuer’s due diligence

framework as set forth in the Conflict Minerals Report, with respect to the period covered by the

report, is in conformity with, in all material respects, the criteria set forth in the nationally or

internationally recognized due diligence framework used by the issuer, and whether the issuer’s

description of the due diligence measures it performed as set forth in the Conflict Minerals

Report, with respect to the period covered by the report, is consistent with the due diligence

process that the issuer undertook” (SEC, 2012, p. 217). However, there is still ambiguity in terms of the auditing standards to employ for an

audit of a Conflict Minerals Report. In its final report, the SEC notes that either the standards

Lindberg and Razaki

20

for Attestation Engagements or the standards for Performance Audits will be applicable

(SEC, 2012).

EFFECT OF THE DISCLOSURES ON CORPORATE BEHAVIOR

Even though the disclosure requirements for conflict minerals are not yet in place,

companies such as Intel, Motorola and Hewlett-Packard have already taken significant steps

to inspect and adjust their supply lines to avoid obtaining conflict minerals from DRC

countries (e.g., Wyatt, 2012). For example, in its 2011 annual report disclosures, Intel noted

that it has developed programs to allow for tracking of its source materials, in particular those

sourced from the Democratic Republic of the Congo. Further, Intel states that it will continue

to work to establish a conflict-free supply chain for the company and its industry (Intel

Corporation, 2012).

Several other corporations have already expressed concern about the “reputational

effect” their association with conflict minerals may have. To illustrate, in its 2011 annual

report disclosures, Sprint notes that because their supply chain is complex, the company may

face reputational challenges with its customers and other stakeholders if they are unable to

verify the origins of all the metals used in its products (Sprint Nextel Corporation, 2012).

Dell, Inc. makes a similar statement in its annual report for the fiscal year ended February 3,

2012, noting that the corporation may face reputational harm if its customers or other

stakeholders conclude that Dell is unable to verify sufficiently the origin of the minerals used

in its products (Dell, Inc., 2012). These and other examples of corporate disclosures

associated with the SEC’s disclosure requirements for conflict minerals are provided in Table

2.

Table 2: Conflict Minerals Disclosure Examples

Company FY Ended p. # Excerpts of Disclosures Related to “Conflict Minerals”

Advanced

Micro Devices,

Inc.

12/31/11

26,27

These new requirements could affect the sourcing and availability of

minerals used in the manufacture of semiconductor devices. Also, there

will be additional costs of compliance such as costs related to determining

the source of any conflicting minerals used in our products.

Cabot

Corporation

9/30/11

5

“An independent audit conducted by a third party auditor assigned by the

Electronics Industry Citizenship Coalition and Global e-Sustainability

Initiative (as part of the Conflict-Free Smelter Validation Program)

confirmed that our tantalum supply chain is free of conflict minerals.”

Dell, Inc.

2/3/12

35

“We will incur costs to comply with the new disclosure requirements of

this law and may realize other costs relating to the sourcing an availability

of minerals used in our products. Further, since our supply chain is

complex, we may face reputational harm if our customers or other

stakeholders conclude that we are unable to verify sufficiently the origins

of the minerals used in the products we sell.”

Helen of Troy

Limited

2/29/12

25 If rules are not modified before becoming effective, they will increase the

cost of our sourcing compliance operations.


21

Intel

Corporation

12/31/11

19 “In 2012, Intel will continue to work to establish a conflict-free supply

chain … Intel’s goal for 2012 is to verify that the tantalum we use in our

microprocessors is conflict free, and our goal for 2013 is to manufacture

the world’s first verified, conflict-free microprocessor.”

Motorola

Solutions, Inc.

12/31/11

27

The implementation may limit the pool of suppliers who can provide us

verifiable DRC Conflict Free components and parts, and we are not certain

that we will be able to obtain products in sufficient quantities that meet the

requirements.

RF

Monolithics

Inc.

8/31/11

15 It is unclear whether we will be affected materially.

Sprint Nextel

Corporation

12/31/11

23

The proposed regulation may leave only a limited pool of suppliers who

provide conflict free metals, and we not be able to obtain products in

sufficient quantities or at competitive prices. Also, because our supply

chain is complex, we may face reputational if we are unable to sufficiently

verify the origins for all metals used in the products we sell.

Tiffany & Co.

1/31/12

13

Once polished, it is not considered possible to distinguish conflict

diamonds from diamonds produced in other regions. Tiffany seek(s) to

exclude such diamonds, which represent a small fraction of the world’s

supply, from legitimate trade using an international system of certification

and legislation known as the Kimberley Process Certification Scheme.

*A Supermetals Business listed under Discontinued Operations in Cabot’s 10-K for the fiscal year

ended September 30, 2011 (Cabot Corporation, 2012).

Source: Recent 10-K reports of the corporations listed in this table were the source of the conflict

minerals disclosures included above (Advanced Micro Devices, Inc., 2012; Cabot Corporation, 2012; Dell Inc.,

2012; Helen of Troy Limited, 2012; Intel Corporation, 2012; Motorola Solutions, Inc., 2012; RF Monolithics,

Inc., 2012; Sprint Nextel Corporation, 2012; Tiffany & Co., 2012). The page numbers indicated are from the

SEC’s “Edgar” database of Form 10-K’s for each respective company.

ANTICIPATED COSTS

There are significant costs associated with the compliance by SEC reporting

companies regarding the conflict minerals disclosure mandate in the Dodd-Frank Act of

2009. The National Association of Manufactures has estimated national compliance costs

between $9 billion and $16 billion, whereas the SEC estimate is $71 million (Ayogu and

Lewis, 2011). The extreme variation between the two estimates results from the speculative

nature of the estimation process, the verification process, and the underlying assumptions.

Plausible cost estimates will be available only after the SEC has finalized all the requisite

rules for verification and reporting. An enumeration of possible costs to companies using

conflict minerals is presented below:

Verification Cost: This cost component may be the most significant monetary

cost. Under the new requirements, the cost of establishing source of supply is

shifted from supplier to user (reporting issuer). It should be noted that there is

an “escape clause” for companies experiencing problems with verification. If

a company cannot determine the origins of its conflict minerals, it can just

disclose that fact without any further consequences (Ayogu and Lewis, 2011).

Increased audit costs due to greater testing by auditors. The SEC can help

significantly reduce the overall cost of compliance by providing specific

definitions and audit standards (Ayogu and Lewis, 2011).

Lindberg and Razaki

22

Cost of recording and reporting: A company must file three different forms of

paperwork and publish a “Conflict Minerals Report” in both its audited annual

financial statements and website (Ayogu and Lewis 2011).

If current supply of conflict minerals is tainted, its replacement from

legitimate sources might constrict the remaining global supply, resulting in

higher raw materials cost (Zweig, 2011).

Reputational Cost (Zweig 2011, Ayogu and Lewis 2011): cost of potential

harmful public aversion and bad publicity if a legitimate source of supply

cannot be found. This cost may be difficult to measure or estimate.

Opportunity costs of lost business if customers avoid or boycott products

containing conflict minerals (Zweig, 2011).

Opportunity cost related to increased cost of capital if major investors

(pension plans, religious and other human rights activist investors, social

values investment funds, etc.) disinvest or refuse to invest in involved

companies. On the other hand, there seems to be no effect on the stock prices

of companies that did report using conflict minerals (Zweig, 2010).

FILING REQUIREMENTS

Issuers are required to file a newly created specialized disclosure report (Form SD)

annually by May 31 for the prior calendar year (Ernst & Young, 2012.) The first required

filings of form SD will be on May 31, 2014 for calendar year 2013 (SEC, 2012). The SEC

finalized rules allow issuers to describe their products as “DRC conflict undeterminable” for

the first two years if the issuers cannot determine the source and/or chain of custody of the

minerals they use; during this “transition” period, any such issuers must file the Form SDs,

but they don’t have to have them audited (Ernst & Young, 2012.)

CONCLUSION

While it could be argued that the U.S. Congress' attempts to curb violence in the

Congo and adjoining countries is commendable, there are still several unresolved issues

regarding the disclosure requirements for conflict minerals. For instance, since disclosures

are based on a “reasonable” country of origin inquiry process, the term reasonable is subject

to interpretation by companies, and likely will not be interpreted in a consistent manner

among companies. The “due diligence” required regarding the source and chain of custody of

conflict minerals is also subject to wide interpretation. In addition, the specific requirements

of the certified independent private sector audit that is to be furnished as part of the Conflict

Minerals Report has many unanswered questions (Ayogu and Lewis, 2011; Coffee, 2011;

Grant Thornton LLP, 2011).

The costs of compliance with this mandate are expected to be very significant. In the

case of smaller companies, they may be prohibitive. At present, these costs cannot be fairly

estimated due to the non-specificity by the SEC regarding definitions and standards. Without

making any value judgments, this is another case of increased regulation for the

accomplishment of the government’s socio-political goals that places a financial burden on

businesses. Perhaps most importantly, however, the only consequences of a publicly traded

company continuing to use conflict minerals are the reputational effects of using these


23

minerals. However, if nothing else, disclosures regarding conflict minerals will heighten

awareness of the humanitarian issues in the DRC and their relationship to U.S. trade (Ayogu

and Lewis, 2011).

REFERENCES

Advanced Micro Devices, Inc. (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934). For the fiscal year ended December 31, 2011,

www.sec.gov/Archives/edgar/data/2488/000119312512075837/d257108d10k.htm.

Ayogu, M. and Lewis, Z. (2011). “Conflict Minerals: An Assessment of the Dodd-Frank Act.” The

Brookings Institute, October 3, http://www.brookings.edu/research/opinions/ 2011/10/03-

conflict-minerals-ayogu.

Cabot Corporation (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934). For the fiscal year ended September 30, 2011,


Coffee, S.S. (2011). Letter to U.S. Securities and Exchange Commission. (American Institute of

Certified Public Accountants, New York, NY), March 1, http://www.sec.gov/comments/s7-

40-10/s74010-123.pdf.

Dell, Inc. (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the Securities

Exchange Act of 1934). For the fiscal year ended February 3, 2012,

www.sec.gov/Archives/edgar/data/826083/000082608312000006/dell10k020312.htm.

Epstein, M.J. and Yuthas, K. (2011). “Conflict Minerals: Managing an Emerging Supply-Chain

Problem.” Environmental Quality Management, Volume 21, Issue 2, 13-25.

Ernst & Young (2012). “Final Conflict Minerals Rule Addresses Many Stakeholder Concerns.”

August 24. http://www.ey.com/UL/en/AccountingLink/Current-topics-SEC-Other-

regulators.

Grant Thornton LLP. (2011). Letter to U.S. Securities and Exchange Commission. (Grant Thornton

LLP, Chicago, IL). March 2, http://www.sec.gov/comments/s7-40-10/s74010-127.pdf.

Helen of Troy Limited (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934). For the fiscal year ended February 29, 2012.

www.sec.gov/Archives/edgar/data/916789/000110465912030645/a12-2513110k.htm.

Intel Corporation (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934). For the fiscal year ended December 31, 2011,

www.sec.gov/Archives/edgar/data/50863/ 000119312512075534/d302695d10k.htm.

McDermott Will & Emery (2010). “The ‘Conflict Minerals’ Provision in the Dodd-Frank Act

Imposes New Disclosure Requirements on Manufacturers.” July 22,

http://www.mwe.com/publications/uniEntity.aspx?xpST=PublicationDetail&pub= 5870.

Motorola Solutions, Inc. (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934). For the fiscal year ended December 31, 2011.


RF Monolithics (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the Securities

Exchange Act of 1934). For the fiscal year ended August 31, 2011.


Securities and Exchange Commission (SEC) (2010). “SEC Proposes Specialized Disclosure of Use

of Conflict Minerals under Dodd-Frank Act.” December 15.

http://www.sec.gov/news/press/2010/2010-245.htm.

Securities and Exchange Commission (SEC) (2012). “Conflict Minerals.” August 22.

http://www.sec.gov/rules/final/2012/34-67716.htm.

http://www.sec.gov/Archives/edgar/data/50863/%20000119312512075534/d302695d

Lindberg and Razaki

24

Sprint Nextel Corporation (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934). For the fiscal year ended December 31, 2011.

www.sec.gov/Archives/edgar/data/101830/000010183012000015/sprint201110-k.htm.

Tiffany & Co. (2012). Form 10-K (Annual Report Pursuant to Section 13 or 15(d) of the Securities

Exchange Act of 1934). For the fiscal year ended January 31, 2012.


Wyatt, E. (2012). “Use of ‘Conflict Minerals’ Gets More Scrutiny from U.S.” New York Times,

March 19, http://www.nytimes.com/2012/03/20/business/use-of-conflict-minerals-gets-

more-scrutiny.html?pagewanted=1&_r=1.

Zweig, J. (2011). “The Intelligent Investor: Can Annual Reports Save Lives?” The Wall Street

Journal , December 17, B1.


Vol. 5, No. 1; Fall 2012

25

HEDGING WITH CURRENCY ETFS:

THE IMPLICATIONS OF RETURN DYNAMICS

Robert B. Burney

Coastal Carolina University

ABSTRACT

The emergence of currency exchange traded funds (ETFs) has provided an alternative

vehicle for both speculation and hedging in the currency markets. Because currency ETFs

typically have small minimum transaction sizes and trade like equities, they represent an

easily accessible alternative for the small investor or small business operator. The ease of

access relative to other markets providing foreign exchange exposure makes currency ETFs

of particular interest to those market participants who only occasionally have currency

components to their strategies.

This paper begins with a description of foreign currency transaction options available

for smaller transaction sizes, contrasting the ease of access of the alternatives. Then an

overview of currency ETFs is provided with an emphasis on investment objectives and the

resultant fund return dynamics. Next various hedging scenarios are examined showing

possible outcomes and the potential divergence from initial intended results. These scenarios

are constructed demonstrating both extreme market conditions and typical market conditions.

Finally, recommendations are made concerning how market participants might assess the

utility of currency ETFs in their specific foreign currency risk hedging applications.

OVERVIEW

The trade press has presented various practitioner oriented articles concerning the

usefulness of currency ETFs in hedging foreign currency risk. However, such discussions

typically do not approach the topic systematically. Generally, such treatments fail to

recognize the similarities and differences between ETF based hedges and other hedging

techniques using futures contracts, options contracts, or money market transactions. Most

notably, many of the practitioner oriented articles discount the use of currency ETFs in

hedging applications because of the necessity of tying up capital during the hedge. This

criticism lacks merit since other well established techniques for dealing with foreign

exchange risk also tie up capital during the hedging period. In the following sections this

paper reviews the issues which arise in using currency ETFs in managing foreign exchange

risk. Transaction details specific to currency ETFs are then discussed. Examples are given

contrasting various hedging techniques, with special emphasis on how currency ETF

investment objectives can impact the effectiveness of a hedge.

MANAGEMENT ISSUE

The basic issue at hand is the management of foreign currency risk for those market

participants who face only very small or occasional foreign currency exposures. For such

market participants, existing liquid market derivative securities simply do not match the

transaction scale. Table One summarizes this situation for the dominant U.S. market

derivatives for the euro. In this case, the smallest notional principal amount involves 10,000

Burney

26

euros. A smaller size transaction would force the market participant to, in effect, take on a

residual exposure of opposite nature to the initial exposure.

While services for small scale market participants do exist among the retail foreign

exchange dealers, these arrangements have a reputation of being of a disadvantageous cost

structure with account details which may create more difficulties for the potential hedger

(full margin calls, etc.). Also, the smaller FX dealer based derivative contracts or minor

electronic exchanges suffer from illiquidity which may negatively impact pricing.

Table One: Example Derivative Contract Sizes

PHLX:

Euro Options 10,000 euros

CME:

Euro Futures* 125,000 euros

E-mini Futures 62,5000 euros

E-micro Futures 12,5000 euros

*CME Options are limited to larger contracts.

CURRENCY ETFS

In recent years numerous currency ETFs (CETFs) have been introduced. These

include ETFs which cover most of the major currencies and an increasing number of second

tier currencies. Variations include both long and short position ETFs, and more recently,

double and triple long and short varieties. Table Two presents a sample listing of available

CETFs as presented on the Artremis.com website.

CETF managers strive to match the change of the target currency in the specified

proportion on a day-to-day basis. Essentially, the CETF substitutes for a long or short

position in the target currency. Because the CETFs are traded on a share basis, an investor

can take any conceivable position depending on the number of shares purchased. Based on

varying notional amounts, most attempt to capture the daily percentage change of the target

currency. While most applications of both speculation and hedging in foreign currencies can

be accomplished with outright currency trades and traditional derivatives, the ease of trading

CETFs is attractive to the new or occasionally foreign currency impacted investor. Also,

there is no set denomination per share of such CETFs. Some CETFs are quoted in multiples

of the underlying currency, while others are based on an arbitrary notional principal. Recent

per share values range from $15.87 to $132.72 for the CETFs presented in Table One.

The minimum number of shares which an individual investor could trade depends on

the individual brokerage housing the account. This conceivably could be a few as one share,

and should not be confused with the inter-institutional “creation units” of much larger

magnitude (Abner, 2010). Commissions on CETF trades are also subject to wide variation,

with typical commissions at discount brokerages below $10 per trade. Some brokerages also

offer commission-free trading on select ETFs. The basic CETFs involve foreign currency

denominated bank accounts. The inverse or leveraged CETFs also use derivatives to attempt

to meet their objectives. (Lachini, 2011)


27

Table Two: Examples of Currency ETFs*

Symbol Name Fund Family Currency

FXE CurrencyShares Euro Trust Rydex Euro

EU WisdomTree Dreyfus Euro WisdomTree Euro

ERO iPath EUR/USD Exchange Rate ETN iPath Euro/U.S. dollar exchange rate

ULE Ultra Euro ProShares ProShares 2x EUR/USD daily price change

EUO UltraShort Euro ProShares ProShares 2x inverse EUR/USD daily price

change

URR Market Vectors Double Long Euro Market Vectors 2x long euro

DRR Market Vectors Double Short Euro Market Vectors 2x short euro

UUP PowerShares DB US Dollar Index Bullish PowerShares US Dollar

UDN PowerShares DB US Dollar Index Bearish PowerShares short US Dollar

FXY CurrencyShares Japanese Yen Trust Rydex Japanese Yen

JYF WisdomTree Dreyfus Japanese Yen WisdomTree Japanese Yen

JYN iPath JPY/USD Exchange Rate ETN iPath Japanese Yen/U.S. dollar exchange

rate

YCL Ultra Yen ProShares ProShares 2x JPY/USD daily price change

YCS UltraShort Yen ProShares 2x short , JPY/USD daily price

change

FXC CurrencyShares Canadian Dollar Trust Rydex Canadian Dollar

* Source: Artimis.com

CETF INVESTMENT OBJECTIVES AND RESULTING RETURN DYNAMICS

CETFs are available in both long and short varieties, and in leveraged long and short

varieties. Naturally, the capability to easily take either short or long positions using these

financial instruments would be of interest to those engaged in hedging applications. The

potential utility of using CETFs in hedging foreign exchange risk would appear at first glance

be highest for those who only occasionally face foreign exchange risk or those who face

foreign exchange risk in magnitudes smaller than the sizes of the existing exchange traded

currency derivatives. While foreign currency dealers have in recent years introduced smaller

trading lots, the trading startup learning curve for trading forward currency contracts

probably serves as a deterrent for the market participants in question.

However, existing CETFs operate under investment objectives which are defined

relative to the daily returns on the underlying currency. The nature of the fund’s investment

objective is crucially important to the potential use of CETFs in constructing hedging

portfolios. The essence of any hedging approach is to create an offsetting position which is

negatively correlated to the position originally at risk. However, this inverse relationship

must be defined relative to the entire holding period. It is here that the CETF investment

objective is crucial. While the typical CETF does a good job of tracking the daily changes in

the reference currency, the effect is to create a compound return which can differ

significantly from a continuous holding period return (Cheng and Madhavan, 2009). Thus,

constructing hedge portfolios using CETFs can be problematic.

Burney

28

Given the existing CETFs one day return defined investment objective, the value of

the CETF is driven by its own value change during the previous trading day. This differs

significantly from other hedging instruments such as futures and forward contracts in which

the value of the contract is always defined relative to the current value of the underlying.

The overall effect is that CETF based hedges will drift away from the “perfect hedge” over

time while derivatives based hedges will not deviate from the perfect hedge state during the

contract period.

The drift effect is more pronounced for larger daily changes in the price of the

underlying currency, and for longer periods of time. For lower volatility markets and for

shorter periods of time, the drift effect is negligible. However, for longer periods of time or

high volatility markets, the effect can be substantial. Thus, to ensure a CETF based hedge

remains effective, ongoing rebalancing of the CETF position is required. This rebalancing,

though relatively easy to accomplish due to the CETF trading format, significantly offsets the

apparent appeal of CETFs as a hedging instrument for the occasional or small scale foreign

currency market participant. Table 3 gives a numerical example of the potential divergence

between the returns on a hypothetical underlying currency and a related inverse CETF. The

example is built around a starting point of parity (i.e. 1.00 to 1.00) stated in home currency direct

terms. This data is presented graphically in Figure 1.

Table 3: Hedge Results under Negative and Positive Trends

ETF

Net ETF (Net)

Hedge Hedge Futures

Day Return S Long -1xETF X-S Portfolio Position Hedge

-20 -0.05 0.36 0.36 2.65 0.64 3.01 2.01 1.00 -19 -0.05 0.38 0.38 2.53 0.62 2.90 1.90 1.00 -18 -0.05 0.40 0.40 2.41 0.60 2.80 1.80 1.00 -17 -0.05 0.42 0.42 2.29 0.58 2.71 1.71 1.00 -16 -0.05 0.44 0.44 2.18 0.56 2.62 1.62 1.00 -15 -0.05 0.46 0.46 2.08 0.54 2.54 1.54 1.00 -14 -0.05 0.49 0.49 1.98 0.51 2.47 1.47 1.00 -13 -0.05 0.51 0.51 1.89 0.49 2.40 1.40 1.00 -12 -0.05 0.54 0.54 1.80 0.46 2.34 1.34 1.00 -11 -0.05 0.57 0.57 1.71 0.43 2.28 1.28 1.00 -10 -0.05 0.60 0.60 1.63 0.40 2.23 1.23 1.00 -9 -0.05 0.63 0.63 1.55 0.37 2.18 1.18 1.00 -8 -0.05 0.66 0.66 1.48 0.34 2.14 1.14 1.00 -7 -0.05 0.70 0.70 1.41 0.30 2.11 1.11 1.00 -6 -0.05 0.74 0.74 1.34 0.26 2.08 1.08 1.00 -5 -0.05 0.77 0.77 1.28 0.23 2.05 1.05 1.00 -4 -0.05 0.81 0.81 1.22 0.19 2.03 1.03 1.00 -3 -0.05 0.86 0.86 1.16 0.14 2.02 1.02 1.00 -2 -0.05 0.90 0.90 1.10 0.10 2.01 1.01 1.00 -1 -0.05 0.95 0.95 1.05 0.05 2.00 1.00 1.00 0 1.00 1.00 1.00 0.00 2.00 1.00 1.00


29

1 0.05 1.05 1.05 0.95 -0.05 2.00 1.00 1.00 2 0.05 1.10 1.10 0.90 -0.10 2.01 1.01 1.00 3 0.05 1.16 1.16 0.86 -0.16 2.02 1.02 1.00 4 0.05 1.22 1.22 0.81 -0.22 2.03 1.03 1.00 5 0.05 1.28 1.28 0.77 -0.28 2.05 1.05 1.00 6 0.05 1.34 1.34 0.74 -0.34 2.08 1.08 1.00 7 0.05 1.41 1.41 0.70 -0.41 2.11 1.11 1.00 8 0.05 1.48 1.48 0.66 -0.48 2.14 1.14 1.00 9 0.05 1.55 1.55 0.63 -0.55 2.18 1.18 1.00

10 0.05 1.63 1.63 0.60 -0.63 2.23 1.23 1.00 11 0.05 1.71 1.71 0.57 -0.71 2.28 1.28 1.00 12 0.05 1.80 1.80 0.54 -0.80 2.34 1.34 1.00 13 0.05 1.89 1.89 0.51 -0.89 2.40 1.40 1.00 14 0.05 1.98 1.98 0.49 -0.98 2.47 1.47 1.00 15 0.05 2.08 2.08 0.46 -1.08 2.54 1.54 1.00 16 0.05 2.18 2.18 0.44 -1.18 2.62 1.62 1.00 17 0.05 2.29 2.29 0.42 -1.29 2.71 1.71 1.00 18 0.05 2.41 2.41 0.40 -1.41 2.80 1.80 1.00 19 0.05 2.53 2.53 0.38 -1.53 2.90 1.90 1.00 20 0.05 2.65 2.65 0.36 -1.65 3.01 2.01 1.00

In this example, the hedger would be attempting to hedge the home currency value of

an anticipated foreign currency cash inflow. Thus the positions in the hedge instruments

(futures or inverse CETF) would be short positions. The data is presented on a per unit basis.

In this example the daily change in the underlying exchange rate is set at 5% to

accentuate the potential divergence issue. From the middle of the table, the daily change of

5% runs for 20 days in both the positive (up from center) and negative (down from center)

directions. The results are significant. As the exchange rate increases or decrease relative to

the starting rate (1.00), the change in the CETF value begins to significantly diverge from the

inverse change in value of the underlying currency exchange rate. This occurs regardless of

the direction of the exchange rate change.

Here S denotes the spot exchange rate in home currency direct terms, while X denotes

the contract exchange rate on a hypothetical futures contract with contract price X = 1.00.

Thus, X-S represents the value of short position in a futures contract. The table also shows

the net value of the inverse CETF position. Net value here defined as the current value of the

CETF minus the amount originally invested in the CETF.

Burney

30

In this case, the hedge would be ineffective in the sense that the hedged value was not

maintained regardless of whether the exchange rates were to rise or fall. However, in this

circumstance, the deviation from the “pure hedge” would be to the hedger’s benefit since

there would be a net “gain” on the hedge. This pattern results regardless of the size of the

daily returns, although the divergence increases with both time and the magnitude of the

daily returns.

In the second case, the assumption is made of complete volatility in the daily returns.

Here we use perfect negative correlation between subsequent daily returns. Again we use a

daily return of absolute magnitude of 5% to accentuate the result. In Table Four, the returns

for a perfectly reversing pattern of daily returns beginning with a positive return are shown.

These data are presented graphically in Figure Two.

Table Four shows a pattern which begins with a positive return on the first day,

followed by sequentially reversing returns thereafter. The volatility leads to a constant

deterioration in the CETF hedge. In this stylized case, the hedged position underperforms the

futures hedge noticeably with the long position in the foreign currency remaining above the

ETF hedged value. The CETF hedge would dampen volatility, but would be seen to be

inferior to hedging with forward contracts or not hedging at all.

That is, the volatility leads to a constant deterioration in the ETF hedge. In this

stylized case, the hedged position underperforms the futures hedge noticeably with the long

position in the foreign currency remaining above the ETF hedged value.

Figure One: ETF vs. Futures Hedges Under No Volatility

0.00

0.50

1.00

1.50

2.00

2.50

3.00

0.36 0.42 0.49 0.57 0.66 0.77 0.90 1.05 1.22 1.41 1.63 1.89 2.18 2.53

Spot Exchange Rate

Hed

ged

Posi

tion

Net ETF Hedge

Futures Hedge

Long


31

Table Four: Hedge Results Under Volatile Trends

Net

ETF

Hedge Futures Day Return S Long -1xETF X-S Position Hedge

0 1.00 1.00 1.0000 0.00 1.00 1.00 1 0.05 1.05 1.05 0.9500 -0.05 1.00 1.00 2 -0.05 1.00 1.00 0.9975 0.00 1.00 1.00 3 0.05 1.05 1.05 0.9476 -0.05 1.00 1.00 4 -0.05 1.00 1.00 0.9950 0.00 0.99 1.00 5 0.05 1.04 1.04 0.9453 -0.04 0.99 1.00 6 -0.05 0.99 0.99 0.9925 0.01 0.99 1.00 7 0.05 1.04 1.04 0.9429 -0.04 0.99 1.00 8 -0.05 0.99 0.99 0.9900 0.01 0.98 1.00 9 0.05 1.04 1.04 0.9405 -0.04 0.98 1.00

10 -0.05 0.99 0.99 0.9876 0.01 0.98 1.00 11 0.05 1.04 1.04 0.9382 -0.04 0.98 1.00 12 -0.05 0.99 0.99 0.9851 0.01 0.97 1.00 13 0.05 1.03 1.03 0.9358 -0.03 0.97 1.00 14 -0.05 0.98 0.98 0.9826 0.02 0.97 1.00 15 0.05 1.03 1.03 0.9335 -0.03 0.97 1.00 16 -0.05 0.98 0.98 0.9802 0.02 0.96 1.00 17 0.05 1.03 1.03 0.9312 -0.03 0.96 1.00 18 -0.05 0.98 0.98 0.9777 0.02 0.96 1.00 19 0.05 1.03 1.03 0.9288 -0.03 0.96 1.00 20 -0.05 0.98 0.98 0.9753 0.02 0.95 1.00

Figure Two: ETF vs. Futures Hedges Under High Volatility With Positive Start

0.90

0.92

0.94

0.96

0.98

1.00

1.02

1.04

1.06

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Days

Valu

e p

er

Un

it

Futures Hedge

Net ETF Hedge

Long

Burney

32

In our final case, volatility is again systematic, but with the first of the daily returns

being negative. Each subsequent daily return is of the same absolute magnitude, but of

opposite sign. The resulting values are presented in Table Five. These data are presented

graphically in Figure Three.

Table Five: Hedge Results Under Volatile Trends

Net

ETF

Hedge Futures Day Return S Long -1xETF X-S Position Hedge

0 1.00 1.00 1.00 0.00 1.00 1.00 1 -0.05 0.95 0.95 1.05 0.05 1.00 1.00 2 0.05 1.00 1.00 1.00 0.00 1.00 1.00 3 -0.05 0.95 0.95 1.05 0.05 1.00 1.00 4 0.05 1.00 1.00 1.00 0.00 0.99 1.00 5 -0.05 0.95 0.95 1.04 0.05 0.99 1.00 6 0.05 0.99 0.99 0.99 0.01 0.99 1.00 7 -0.05 0.94 0.94 1.04 0.06 0.99 1.00 8 0.05 0.99 0.99 0.99 0.01 0.98 1.00 9 -0.05 0.94 0.94 1.04 0.06 0.98 1.00

10 0.05 0.99 0.99 0.99 0.01 0.98 1.00 11 -0.05 0.94 0.94 1.04 0.06 0.98 1.00 12 0.05 0.99 0.99 0.99 0.01 0.97 1.00 13 -0.05 0.94 0.94 1.03 0.06 0.97 1.00 14 0.05 0.98 0.98 0.98 0.02 0.97 1.00 15 -0.05 0.93 0.93 1.03 0.07 0.97 1.00 16 0.05 0.98 0.98 0.98 0.02 0.96 1.00 17 -0.05 0.93 0.93 1.03 0.07 0.96 1.00 18 0.05 0.98 0.98 0.98 0.02 0.96 1.00 19 -0.05 0.93 0.93 1.03 0.07 0.96 1.00 20 0.05 0.98 0.98 0.98 0.02 0.95 1.00

From Figure Three it can be seen that the pattern of sequentially reversing returns

which starts with a negative of the first day of the hedge results again in a deteriorating ETF

hedge relative to the benchmark futures hedge. However, in this case the ETF hedged

position value is bracketed by the value of the underlying long position in the foreign

currency. Thus the hedge is reducing volatility, but is not eliminating volatility as would

occur under the futures hedge.

REAL WORLD RELEVANCE OF CETF HEDGE DIVERGENCE

From the examples presented, it is clear that the divergence of a CETF based foreign

currency hedge arises from the shape of the functions. Because the CETF has a return

dependent on is own past return, its relationship to the underlying currency can be curvilinear

(Schubert, 2011). Meanwhile, the futures contract value remains in a linear relationship to


33

the underlying currency since its value is always X-S, which is the contract price minus the

spot price on the value date.

The issue of CETF hedge divergence is thus dependent on the size of the daily returns

in the underlying currency and the length of time over which the hedge position is held. In

our examples, the absolute magnitude of the daily return (i.e. change in price) of the

underlying currency was set at 5%. Clearly this is an unusually high level of change being

only matched occasionally for any currency in the historical record. As a benchmark, from

its high of around $1.45/€1.00 in June 2011, to its current level at the time of this writing

(June 2012) of $1.25/€1.00, the euro has experienced only an aggregate percentage return

(price change) of negative 13.79%. This one year change implies daily average price

changes of .04% over the period. If this period is seen as a relatively volatile period against

the backdrop of the ongoing Eurozone financial crisis, the example volatilities from our

hypothetical cases are clearly extraordinarily large.

For smaller daily returns in the currency whose value is to be hedged, the divergence

of the CETF based currency hedge can be negligible. Table Six presents hedging errors for a

CETF based hedge like those of our first example for various levels of daily currency returns

over representative time periods. As can be seen from the data, for smaller daily returns of a

more typical real world magnitude, the potential divergence of a CETF based hedge can be

quite small.

SUMMARY

The examples above have demonstrated the potential problem of divergence of CETF

based hedges of foreign currency cash flows. The examples show that the divergence can be

extreme under certain daily return scenarios involving exceptional levels of volatility or

exceptional levels of daily returns. However, under assumptions more in keeping with the

historical record, it is seen that the divergence of the CETF based hedge from the benchmark

futures based hedge is rather small.

Figure Two: ETF vs. Futures Hedges Under High Volatility With Positive Start

0.90

0.92

0.94

0.96

0.98

1.00

1.02

1.04

1.06

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Days

Valu

e p

er

Un

it

Futures Hedge

Net ETF Hedge

Long

Burney

34

Table Six: Percentage Hedging Errors

Daily Return

Day 0.001 0.01 0.05 0.10

-20.00 0.95% 3.81% 101.18% 484.91%

-15.00 0.53% 2.10% 54.22% 238.31%

-10.00 0.23% 0.90% 22.76% 94.24%

-5.00 0.05% 0.20% 5.01% 20.10%

0.00 0.00% 0.00% 0.00% 0.00%

5.00 0.05% 0.20% 5.01% 20.10%

10.00 0.23% 0.90% 22.76% 94.24%

15.00 0.53% 2.10% 54.22% 238.31%

20.00 0.95% 3.81% 101.18% 484.91%

It has been noted in the literature that the divergence of an ETF hedge can be

eliminated by periodic rebalancing of the hedge (Hill and Teller, 2010). In essence, this

requires selling or purchasing the “excess” or “deficit” amount in the ETF resulting from the

divergent returns on the ETF relative to the underlying asset. However, since our initial

objective in this study was to access the suitability of hedging currency risk by less

sophisticated market participants, we have not included an assessment of the impact of a

rebalancing strategy on the effectiveness of a CETF hedge. That is, to address the

divergence issue through rebalancing can be seen to complicate the situation as much or

more than the introduction of alternative hedging instruments (i.e. futures and forwards).

While CETFs appear to be useful to market participants of this category, more precise

development of implementation criteria is needed.

Bearing in mind the nature of the market participant in question, the result from

consistent directional returns from our first example should be further considered.

Specifically, in that case the returns assumptions modeled a situation in which the currency

being hedged began a persistent, non-reversing, and significant price change. In both the

positive and negative direction, the CETF based hedge diverged from the benchmark futures

hedge in a way that would benefit the hedger. Thus, in situations in which the risk is defined

as plummeting foreign currency value, the simple CETF based hedge should result in an

outcome similar in general effect to an option based straddle position.

ISSUES FOR FURTHER RESEARCH

While the basic construct seems robust, justification for use of CETFs for small scale

foreign exchange risk hedging depends on some operational details. First, while the CETF

management objectives are clearly stated (ex. track double the inverse of the change in the

underlying currency), the effectiveness of the CETF managers should be tested. For example,

a double long CETF should correlate highly to 200% of the underlying currency’s value

change. If not, the utility of using double or triple long or short CETFs to reduce the amount

of capital that is tied up is diminished.

Second, while many widely used currency risk hedging techniques (money market

hedges, back-to-back loans) do tie up capital during the duration of the hedge, the proper


35

opportunity cost treatment for CETF based hedging must be more completely developed.

Surely, those who dismiss CETF based hedging due to this factor overstate the severity of the

issue. Nonetheless, a systematic incorporation of capital availability and costs must be

established.

Finally, it is clear that a CETF hedge would require monitoring and potentially

rebalancing to ensure the hedge objectives were met. However, the required rebalancing must

be assessed relative to the potential adjustments necessary for other types of hedges (ex.

rolling between futures contracts) for longer hedging periods. That is, through ongoing

rebalancing, a CETF hedge could be held open indefinitely. While studies of the

effectiveness of such rebalancing approaches have been conducted for index and commodity

ETFs, the author is unaware of similar studies specifically addressing CETFs (Fill and

Foster, 2009).

REFERENCES

Abner, David (2010). The ETF Handbook, John Wiley & Sons, Hoboken, New Jersey.

Cain, Alexandra (2011). ASmall Exporters Getting Savvy About Currency Risk.@ Sydney Morning

News, July 27.

Cheng, Minder and Ananth Madhaven (2009). “Dynamics of Leveraged and Inverse ETFs.”

Barclays Global Investors, October.

(2011). ACurrency Exchange Traded Funds (ETFs)@. Artremis.com, September 14.

Hill, Joanne and George Foster (2009). “Understanding Returns of Leveraged and Inverse Funds.”

Jounal of Indexes, September/October.

Hill, Joanne and Solomon Teller (2010). “Hedging with Inverse ETFs: A Primer.” Journal of

Indexes, November/December, 18-24.

Goodboy, David (2008). AFOREX spot trades vs. Currency Futures.” TradingMarkets.com, May

21.

(2009). A Hedge Against Exchange Rate Risk With Currency ETFs.” Investopedia, August 12.

Hudacheck, Dennis (2011). ACurrency-Hedged ETFs Lower Volatility.” Index Universe, November

16.

Lachini, Michael (2011). “Leveraged and Inverse ETFs: Not Right for Everyone.” Schwab.com,

October 20.

Lachini, Michael and Tatjana Michel (2011). “Currency ETFs: The Facts and Current Dollar

Outlook.” Schwab.com, October 31.

Schubert, Leo (2011). “Hedge Ratios for Short and Leveraged ETFs.” Revista Atlántica de

Economia, Volumen 1, 1-33.

Yates, Tristan (2007). “The Case Against Leveraged ETFs.” Seeking Alpha.com, May 17.

Zweig, Jason (2009). “How Managing Risk with EFTs Can Backfire.” Wall Street Journal, February

26.


Vol. 5, No. 1; Fall 2012

36

FINANCIAL STATEMENT PRESENTATION:

A SNEAK PEAK AT THE PROPOSED FORMAT

Suzanne P. Ward

Dan R. Ward

The University of Louisiana at Lafayette

Alan B. Deck

Bellarmine University

ABSTRACT

Under current US GAAP and iGAAP (i.e., IFRSs), alternative formats for statement

presentation are allowed with transactions/events not necessarily being reported or classified

consistently from one statement to another. The FASB and the IASB have both recognized

the potential problems in this area with each independently adding a financial reporting

project to their agendas in 2001. In 2004, the two rule-making bodies joined forces to

conduct a joint project on financial reporting to establish a common international standard to

improve how information is organized and presented in financial statements as part of the

overall international convergence movement. This paper overviews the results to date of this

joint FASB-IASB project on financial statement presentation.

INTRODUCTION

A company’s financial statements are central to financial reporting. Investors,

creditors, and other external users look to these statements for information regarding the

financial position, cash flows, and operations of an entity and frequently consider them key

resources for decision making. However, under current US GAAP and iGAAP (i.e., IFRSs),

alternative formats for statement presentation are allowed with transactions/events not

necessarily being reported or classified consistently from one statement to another. Thus, the

linkage among the financial statements as well as the relationships among the items being

reported is frequently difficult for users to understand.

The ever-increasing internationalization of business has only exacerbated this

situation. As businesses expand globally, so does the need for consistent financial reporting

of events and transactions in the financial statements. While the FASB and the IASB have

committed to a program of harmonization of US GAAP and iGAAP and have taken many

steps toward such a convergence, the presentation of information in the financial statements

is governed by two separate and divergent sets of rules. International accounting standards,

or IFRS, provide minimum presentation requirements and US GAAP provides only

fragmented guidance presented in a piecemeal fashion throughout a variety of reporting

standards. This situation simply enhances opportunities for companies to apply their own

unique interpretation of the requirements while still complying with those requirements.

Thus, comparability between different entities’ financial statements and the usefulness of

such statements for users is lessened. This is particularly true for those companies who must

comply with both US GAAP and IFRSs – whose rules must be followed?


37

The FASB and the IASB have both recognized the potential problems in this area

with each independently adding a financial reporting project to their agendas in 2001. In

2004, the two rule-making bodies joined forces to conduct a joint project on financial

reporting to establish a common international standard to improve how information is

organized and presented in financial statements as part of the overall international

convergence movement. This paper overviews the results to date of this joint FASB-IASB

project on financial statement presentation. The first section provides a time line of project

activities with the second section summarizing the proposed guidelines for the financial

statements as a whole. The third section compares financial statements prepared under the

current format with those prepared under the proposed format. The fourth section discusses

the results from selected FASB-IASB outreach activities and the final section presents the

current status of the project and looks toward the future of financial statement presentation.

TIME LINE OF THE JOINT PROJECT

The revision of the basic financial statements was originally initiated to address

several long-standing user concerns: the lack of a common approach for presenting

information in financial statements particularly on a global basis, the lack of linkage and

consistency in reporting information in the financial statements, and the lack of

disaggregation of information in the financial reports themselves. Phase A of the joint

FASB-IASB project, begun in 2004 and completed in 2005, resulted in several amendments

to iGAAP, primarily to bring IFRSs more closely into alignment with how US GAAP reports

comprehensive income. FASB, however, elected not to amend US GAAP until completion

of subsequent phases of the project. After over two years of deliberations with parties

interested in the fundamental issues of financial statements, a joint discussion paper

“Preliminary Views on Financial Statement Presentation” was issued in 2008. Based on

five years of comments from interested parties, results of outreach activities, and academic

research, the IASB and the FASB staffs each individually issued a Staff Draft in July 2010.

These documents, which are essentially the same with slight differences in detail designed to

address specific issues relevant to each Board, reflect the tentative joint decisions by the two

Boards up to that time as well as amendments to the proposals put forth in the discussion

paper. In the United States, the Staff Draft excludes proposals to change the presentation of

Other Comprehensive Income as well as Discontinued Operations; both of which are the

subject of separate FASB projects. This paper focuses on the FASB Staff Draft which differs

from the Discussion Paper in several areas: the format of the statement of cash flows,

application of cohesiveness principle, disaggregation of by-nature information by segments,

and analysis of changes in asset and liability line items.

Both the FASB and the IASB determined, in July 2010, that this ongoing project

required additional outreach activities focusing on what users and preparers perceive as the

benefits and costs of the project as well as what implications the project may have for

financial reporting by financial services entities. Outreach activities related to users focus

primarily on how statements prepared under the proposed guidelines would enhance

statement analysis and resource allocation decisions. Preparer-oriented outreach activities

relate to costs and efforts involved in the adoption of the proposed guidelines. The Boards

Ward, Ward, and Deck

38

decided to consider the results of this stepped up program of outreach activities before

issuing an Exposure Draft which, at that time, was expected to occur early in 2011.

In October 2010, the two Boards determined that neither had the requisite capacity to

properly evaluate the results of the outreach activities nor to modify, if needed, the guidelines

contained in the Staff Drafts. Accordingly, completion of the project has been postponed

until capacity is available. This lack of capacity has been re-affirmed at every FASB Board

meeting since that time. However, outreach activities are continuing and the two Boards plan

to consider information from those activities in the re-evaluation of the Staff Draft. At this

time, however, such re-evaluation is not expected to occur until requisite capacity is available

as the two Boards are concentrating on completing the convergence projects currently

underway by 2013.

PROPOSED STAFF DRAFT GUIDELINES

The objective of the joint project is to “establish a standard that will guide the

organization and presentation of information in the financial statements” with the goal of

improving usefulness of the statement information for decision making. Then FASB

chairman, Robert Herz has noted that “(w)e are trying to set the stage for what financial

statements will look like across the globe for decades to come.” [Stuart, 2008]. The

guidelines apply to all business entities, including non-public ones, which prepare financial

statements in accordance with either IFRSs or US GAAP (specified pension plans are

excluded) as well as to all financial statements. As noted previously, both US GAAP and

IFRS allow alternative presentations of information in the financial statements resulting in a

lack of comparability across companies. The upswing in global business activities has

increased the pressure for a common set of guidelines regarding the preparation of financial

statements.

According to the FASB Staff Draft, financial statement presentation should be based

on two core principles: cohesiveness and disaggregation. These principles, based on the

objectives of financial reporting and developed using input from users and advisory groups,

work together to enhance statement understandability and consistency of presentation

between and among financial statements. The Cohesiveness Principle requires that the

statements show a cohesive financial picture of the company’s activities with relationships

between items clearly identifiable and statements complementing each other as much as

possible. This principle should be applied at the category level rather than the line-item

level. The Disaggregation Principle states that resources should be separated by the activity

for which each is used as well as by economic characteristics. Disaggregation should be by

function, nature, and measurement base in the statements as a whole with liquidity and

financial flexibility considered as part of disaggregation.

The FASB Staff Draft includes several changes to US GAAP designed to correspond

to requirements already in place in IAS 1. Specifically, the FASB Staff Draft defines a

complete set of financial statements as including the Statement of Financial Position, the

Statement of Comprehensive Income, the Statement of Cash Flows, and the Statement of

Changes in Equity. Furthermore, a minimum of one period of comparative information is

required with each statement being given equal weight and prominence; however, disclosures

of additional periods are allowed. This proposed authoritative definition of a complete set of


39

financial statements converges U.S. GAAP with the iGAAP definition contained in IAS 1.

Table 1 presents the current names for specified U.S. financial statements with the names

proposed in the Staff Draft for a complete set of statements.

Table 1

Proposed Names for Complete Set of Financial Statements

Current

Proposed Balance Sheet

Statement of Financial Position

Income Statement

Statement of Comprehensive Income Comprehensive Income Statement

Statement of Cash Flows

Statement of Cash Flows

Retained Earnings Statement

Statement of Changes in Equity

As can be seen in the following table from the Introduction and Summary of July 1,

2010, Staff Draft, a standardized structure for the three basic statements (Statement of

Comprehensive Income, Statement of Financial Position, and Statement of Cash Flows) with

the same required sections, categories, and subcategories on all three has been identified.

However, the order of presentation of categories and subcategories within the sections, while

the same on all statements, is to be determined by the entity. Totals/subtotals and headings

are required for sections, categories, and subcategories and related information must be

classified in the same section on each statement. A single measurement base should be used

for each line item.

The Business Section reports items that are used by the entity to create value in its

day to day business activities (i.e., to produce goods or provide services which generate

revenue) as well as other income producing activities. Items in the Business Section should

be divided into the Operating Category and the Investing Category. The Operating Category

contains items related to transactions with customers, suppliers, and employees with select

liabilities directly related to operating activities classified in a separate subcategory.

Examples of items, which according to the Staff Draft should be included in this section, are

Cash, Accounts Receivable, Plant Assets, Accounts Payable, Cost of Goods Sold, and

Postemployment Benefit Service Cost. Generally, the sub-category, Operating Finance,

includes all liabilities and related assets that do not meet the definition of financing, are

initially long term, and have a time value of money. Examples of items the Staff Draft

classifies here include Net Pension Liability, Lease Liability, Expected Return on Plan

Assets, and Postemployment Benefit Interest Costs. Cash flows associated with this category

and sub-category are considered Operating. The Investing Category reports those items that

produce non-revenue income and are unrelated to the entity’s day to day activities. Items


40

classified in this category include Short Term Investments, Investments in Securities, Equity

Method Investments, Interest Income, Equity Income, and Gains/Losses.

Table 2 – Standardized Structure

Source: Introduction to and Summary of July 1, 2010. Staff Draft

The Financing Section reports how the entity finances its business activities; e.g.,

what the entity does to obtain capital and repay capital. This Section is divided into two

categories on the Statement of Financial Position: Debt Category and Equity Category.

Neither the Statement of Comprehensive Income nor the Statement of Cash Flows subdivides

this section. The Debt Category includes obligations involving a borrowing arrangement

designed to raise/repay capital and the related revenues/expenses/cash flows. Examples from

the Staff Draft are Short Term Debt, Long Term Debt, Interest Payable, and Interest Expense.

The Equity Category contains assets/liabilities resulting from transactions with the owners of

the entity with Common Stock being the primary example from the Staff Draft. The

Financing Section does not include a “Treasury Category”; these assets/liabilities being used

as a substitute for cash should be classified in the Business Section.

COMPARISON OF STATEMENTS USING CURRENT AND PROPOSED

FORMATS

This section compares and contrasts financial statements prepared under the current

U.S. GAAP guidelines with those prepared under the proposed format. Proposed guidelines

for each statement are briefly discussed and example statements are presented.


41

STATEMENT OF FINANCIAL POSITION

The Statement of Financial Position is presently known as the Balance Sheet. Under

current U.S. GAAP, this statement is a formal presentation of the accounting equation with

assets, liabilities, and equity divided into subcategories. Assets are generally presented in

order of liquidity, liabilities by due date, and equities in order of permanence. Under the

current format, the balancing of total assets with total liabilities and equity is both readily

apparent and familiar to users. The proposed guidelines change this approach and no longer

allow the presentation of assets, liabilities, and equity in those specific groups, but rather

report items together which are related by major activity (i.e., assets and liabilities netted by

activity). How an item is classified should be determined by the function of that item (i.e.,

how management uses the item) and, thus, is a way of disaggregating the information in the

statements. Explanations of these classifications by management should be included in the

notes. The specific sub-categories are determined by the entity itself and should be the ones

that, in its opinion, provide the most relevant information to users. Sub-category choices

include short term vs. long term (determined using a fixed period of one year) or in order of

liquidity. Assets and liabilities for each category and for each sub-category (if presented)

must be totaled on the face of the statement. Classifications on the other financial statements

are determined by classifications in the Statement of Financial Position. Cash equivalents

would no longer be part of cash but would be classified as a short term investment.

Exhibit 1 presents a statement of financial position prepared under the proposed

guidelines. At first, glance, the proposed statement does not appear to balance; however, all

of the assets, liabilities, and equities currently reported on the Balance Sheet are still being

reported on this proposed statement. The difference is the classifications and arrangements of

the items. As previously noted, the Business section is presented first broken into the

Operating Category and the Investing Category. In the Operating Category, those assets that

contribute to the production of revenue are listed with no distinction between those now

classed as current and those now classed as non-current although the assets are generally

shown in order of liquidity. Operating liabilities, in a separate subcategory within the

operating category (aka Operating Finance Subcategory), generally reflects short term

obligations that are associated with the production of revenue. The second category in the

Business Section, the Investing Category presents the assets that produce non-revenue

income and which are not related to the day to day activities of the entity. These are

primarily the assets that are presently classified in the long term investment section of the

balance sheet. As can be seen, all categories and subcategories must be totaled.

In this example, the income tax section is presented next, but the order is determined

by the individual entity. Since income taxes are primarily a result of revenue or income

producing activities, placement of the income tax section here presents these liabilities in

close proximity to the related assets and liabilities.

The final section on the Statement of Financial Position, the Financing Section, is

subdivided into the Debt Category and the Equity Category and explains how an entity

obtained its capital. All debts not classified in the Operating Finance Subcategory are

presented in the Debt Category and, in this example, are shown in order of due date. The

Equity Category is essentially unchanged from the presentation in current statements. Under


42

the proposed guidelines, this statement is no longer a “Balance” Sheet as the presentation no

longer parallels the accounting equation. However, all of the assets, liabilities, and equity

currently being presented are still being disclosed, albeit in another arrangement.

20x1 20x2BusinessOperatingAssets

Cash $25,000 $29,900

Accounts Receivable 41,000 71,000

Interest Receivable 1,800 1,600

Merchandise Inventory 56,000 71,000

Prepaid Expenses 9,000 5,000

Investment in Trading Securities 21,200 70,000

Notes Receivable 30,000 30,000

Building (net) 150,000 134,000

Equipment (net) 90,000 99,000

Land 50,000 50,000

Patent 20,000 20,000

Total Operating Assets $494,000 $581,500Liabilities

Accounts Payable (45,000) (60,000)

Wages Paya ble (7,000) (4,500)

Notes Payable (Short-term) (60,000) (40,000)

Total Operating Liabilities (112,000) (104,500)

Net Operating Assets $382,000 $477,000Investing

Investment in AFS Securities - Fair Value 100,000 110,000

Investments -Equity Method 72,000 118,000

Total Investing Assets $172,000 $228,000

Net Business Assets $554,000 $705,000

Income Tax

Income Taxes Payable 3,000 4,600

Net Income Tax Liability 3,000 4,600FinancingDebt

Interest Payable 13,000 10,200

Notes Payaboe 60,000 60,000

Bonds Payable 200,000 175,000

Total Debt $273,000 $245,200Equity

Common Stock 25,000 35,000

Preferred Stock 35,000 35,000

APIC-Common Stock 120,000 191,000

Retained Earnings 98,000 184,200

Accumlated OCI 0 10,000

Total Equity $278,000 $455,200Total Financing $551,000 $700,400

Total Assets $666,000 $809,500

Total Liabilities $388,000 $354,300

Exhibit 1

Proposed Statement of Financial Position


43

STATEMENT OF COMPREHENSIVE INCOME

The Statement of Comprehensive Income is the subject of a separate joint project of

FASB and IASB. Accordingly, the Staff Draft only provides general guidance regarding this

statement which presents information regarding changes in the entity’s net assets during a

period from transactions other than those with owners. This proposed format of this

statement in the Staff Draft combines the current Income Statement with the current

Statement of Comprehensive Income, thus utilizing the single statement approach to the

reporting of comprehensive income. The current format of the Income Statement divides

revenues and expenses into Operating and Non-Operating categories with Extraordinary

Items and Discontinued Operations presented separately. Revenues and expenses are

currently separately reported on the Income Statement with relevant subtotals (e.g., gross

profit) also presented. The current format of the Statement of Comprehensive Income

separates the non-owner changes to equity into Net Income and Other Comprehensive

Income Items.

The proposed Statement of Comprehensive Income, as shown in Exhibit 2, is divided

into two sections, Net Income and Other Comprehensive Income. A subtotal for Net Income

must be presented on the face of the statement. Classification of revenues and expenses

should follow the same categories in the same order as those on the Statement of Financial

Position with related items on both statements classified in the same manner on both. Within

each category, revenue and expense items should be disaggregated by function first (e.g.,

selling goods, providing services) and then those functional amounts should be disaggregated

by nature (e.g., salaries, rent, depreciation) either in the statement itself or in the notes. Each

item reported on the Statement of Comprehensive Income, whether part of net income or as

an other comprehensive income item, must be clearly identified as to whether it relates to an

operating, an investing, or a financing activity. This approach still reports revenues and

expenses in a manner similar to the current format as the operating sections retains the

majority of revenues and expenses currently classed as operating while the non-operating

items will be divided between the investing and financing sections. However, interest

expense will now be classed as a financing expense rather than as an operating one.

Allocation of income taxes continues as in the past and no extraordinary items are

allowed (a change for US GAAP and a convergence with IFRSs). Other Comprehensive

Income Items will be reported in the last section on this statement in a manner similar to

current presentation guidelines. Key subtotals must be presented for each section with the

final figure on the statement being Comprehensive Income. There will no longer be an option

to present a Statement of Comprehensive Income separate from the Income Statement.

Those two current statements will be combined under the proposed guidelines. The IASB

refers to this statement as the “Statement of Profit or Loss and Other Comprehensive

Income”; however, this is a suggested title not a required one. The FASB Staff Draft uses the

name “Statement of Comprehensive Income.”


44

Business

Operating

Sales $1,540,000

Cost of Goods Sold 425,000

Gross Profit on Sales 1,115,000

Selling Expenses $540,000

Administrative Expenses 378,000

Unusual Flood Loss 20,000

Research and Devleopment 45,000 983,000

Total Operating Income 132,000

Investing

Interest Revenue 3,800

Income From Securities - Equity Method 68,000

Gain on Sales of Trading Securities 300

Total Investment Income 72,100

Total Business Income 204,100

Financing

Interest Expense 19,000

Total Financing Expense 19,000

Income From Continuing Operations before Taxes 185,100

Income Tax Expense 56,900

Net Income 128,200

Other Comprehensive Income

Unrealized Gain - Available for Sale Securities (Net) 10,000

Total Other Comprehensive Income 10,000

Total Comprehensive Income $138,200

Exhibit 2

Proposed Statement of Comprehensive Income

STATEMENT OF CASH FLOWS

The guidelines for Statement of Cash Flows as presented in the Staff Draft differ from the

original ones put forth in the Discussion Paper. This statement, as before, explains the

change in cash during a period by reconciling beginning and ending cash as reported on the

Statement of Financial Position (cash equivalents are no longer allowed) and provides a

meaningful depiction of how the entity generated its cash and how it spent its cash during a

particular period. The majority of entities at the present time utilize the currently acceptable

Indirect Approach which adjusts net income as reported on the income statement for all non-

cash revenues and expenses. The categories parallel the ones proposed under the Staff Draft

for all financial statements (Operating, Investing, and Financing). However, the Staff Draft

classifies several items in a different category than the present approach. Both the current

and the proposed approaches require the reconciliation of beginning and ending cash

balances.


45

Business

Operating

Cash Collected from Customers $1,510,000

Cash paid for Merchandise Inventory (425,000)

Cash Paid for Wages (80,500)

Cash Paid for Operating Expenses (785,000)

Cash Paid for Research and Development (45,000)

Purchase of Building (39,000)

Purchase of Equipment (25,000)

Cash Paid on ST- Note (20,000)

Net Cash Flows from Operating Activities 90,500

Investing

Cash Received for Interest 4,000

Sale of Trading Securities 21,500

Purchase of Trading Securities (70,000)

Cash Received for Dividends 22,000

Net Cash Flows from Investing Activities (22,500)

Financing

Cash paid for dividends (42,000)

Cash Paid for Interest (21,800)

Cash Paid for Bonds (25,000)

Cash received from Sale of Common Stock 81,000

Net Cash Flows from Financing Activities (7,800)

Income Tax

Cash paid for Income Taxes (55,300)

Increase in Cash 4,900

Beginning Cash 25,000

Ending Cash $29,900

Proposed Statement of Cash Flows

Exhibit 3

The Staff Draft requires the use of the direct method for preparing the Statement of

Cash Flows (see Exhibit 3) as well as the presentation of the reconciliation of operating

income to operating cash flows. Classifications of cash flows on this statement must be

consistent with how the related items/transactions are classified on the other financial

statements, particularly the Statement of Financial Position. Furthermore, information

regarding significant non-cash activities is required to be presented in the body of the

Statement of Cash Flows rather than the notes. As can be seen in Exhibit 3, cash flows

associated with plant assets which are currently classified as Investing Activities would,

under the proposed guidelines, be presented in the Operating Category in the Business

Section. In addition, several cash flows currently reported in the operating activity category

such as cash inflows for interest and dividends and inflows/outflows related to trading

securities, would be reported in the investing category with cash outflows for interest in the

financing section and income taxes in its own separate section.

STATEMENT OF CHANGES IN EQUITY AND NOTES TO FINANCIAL

STATEMENTS

The footnotes, as always, are required for full disclosure purposes and, under the Staff

Draft, new as well as expanded disclosures must be provided in addition to those currently


46

required. For example, companies will be required to analyze changes in all asset and

liabilities which are important in understanding changes in the company’s financial position.

However, descriptions of the basis for classifying assets and liabilities into categories will no

longer necessary. Companies must explain each individual change relating to cash

transactions, non-cash transactions, accounting allocations, write downs/impairment losses,

acquisitions/ dispositions, and other remeasurements. Disclosures must include a note

identifying remeasurement amounts recognized on the Statement of Comprehensive Income

as well as a narrative putting each of those amounts into context.

Current U.S. GAAP requires that an entity explain all changes in equity items during

a period; however, these disclosures are generally provided in the footnotes or as a

supporting schedule in those footnotes. Under the proposed guidelines, these disclosures

would be presented in a separate Statement of Changes in Equity which would have equal

prominence with the other three financial statements Exhibit 4 illustrates this new financial

statement.

Common

Stock

Preferred

Stock

APIC

Common

Stock

Accum.

Other Comp

Income

Items

Retained

Earnings Total Equity

Balance as of 1/1/20x2 $25,000 $35,000 $120,000 $0 $98,000 $278,000

Comprehensive Income

Net Income 128,200 128,200

Other Comprehensive Income 10,000 10,000

Total Comprehensive Income 10,000 226,200 416,200

Transactions with Owners

Issuance of Common Stock 10,000 0 71,000 81,000

Dividends Paid (42,000) (42,000)

Balance as of 12/31/20x2 $35,000 $35,000 $191,000 $10,000 $184,200 $455,200

Proposed Statement of Changes in Equity

Exhibit 4

OUTREACH ACTIVITIES

The FASB and the IASB have been conducting a variety of outreach activities to

obtain feedback regarding the proposed revamping of the financial statements. A summary

of selected activities is presented in the next paragraphs.

An example of an outreach activity conducted involved a field test utilizing preparers

of financial statements. This field test was designed to evaluate if the proposed presentation

in the Discussion Paper improved the usefulness of the statements to users, to gain an

understanding of implementation costs, and to identify any unintended consequences of the

proposal. In this field test, thirty companies recast the financial statements for any two

consecutive years using the guidelines from the Discussion Paper. These companies also

completed a 32 question survey about their experience, documenting all time and cost

constraints each encountered. Participating companies represented seven different countries,

with the majority from the U.S. and Europe, as well as seventeen different industries

including banking, insurance, entertainment, and steel works.

The findings from this field test indicated that the majority of participants believe that

the recast statements communicate their company’s results much the same as those prepared


47

using the current guidelines or, in some cases, worse than those utilizing the current

guidelines. Disaggregation of information in the reports, one of the objectives of this project,

increased as an approximately 50 percent increase in line items was indicated. However, the

participants did not feel that this increased disaggregation necessarily translated into an

increase in usefulness. Furthermore, the participants did not perceive that categorizing

information by nature on the face of the statements provided any benefits and they

questioned the effectiveness of the proposed definitions as well as the disaggregation

guidance.

Another outreach activity involved interviews with users of the financial statements

in order to obtain input and feedback regarding the proposed guidelines. Fifty six individuals

from seven different countries with broad, extensive experience in using the financial

statements were interviewed. These users, including analysts, fund managers, and lenders,

expressed no widespread dissatisfaction with financial statements prepared using the current

guidelines nor did they demand any drastic modifications to the current financial statement

presentation. While net income was the normal starting point for analysis, that figure was

not necessarily one of the three most important measures to the participants as users of

financial reports. Furthermore, these users were indifferent concerning the reporting of

comprehensive income in a separate statement as long as the other comprehensive income

items were readily apparent and separately reported. The majority, however, did prefer

utilization of the direct method over the indirect method for preparing the Statement of Cash

Flows.

An additional outreach activity was an academic study conducted under the auspices

of the Financial Accounting Standards Research Initiative. This study focused on the

classification of items in the financial statements into categories as well as on the

disaggregation of expenses by function and nature. Sixty credit analysts were randomly

assigned a complete set of financial statements with different versions varying in category

classification and disaggregation of expenses. Findings indicated that forecasts and

judgments improved when related information associated with classification and

disaggregation were placed together. Furthermore, the disaggregation of information on the

face of the statements while reporting classifications in the notes was somewhat effective.

Interestingly, the reverse situation (classification on the face of the statements with

disaggregation in the notes) was actually counterproductive.

As can be seen from this discussion of selected outreach activities, the results of the

proposed guidelines appear to be mixed with neither users nor preparers endorsing all of the

changes. As previously noted, the findings from outreach activities conducted prior to

Summer 2010 were considered in preparing the Staff Drafts issued by the FASB and by the

IASB in July 2010 resulting in several modifications of the proposals contained in the

discussion paper. Given these results, both Boards wisely elected to continue conducting

outreach activities to gather additional data concerning the amended proposed guidelines

contained in the Staff Drafts.

Plans for future outreach activities include meeting with constituents, both users and

prepares, to discuss details of the FASB Staff Draft as well as the costs/benefits of the

proposed guidelines. Investors and other users will be asked for input regarding the

limitations of current financial reports as well as any benefits they foresee from the proposed


48

format. Preparers will be asked to evaluate costs involved in adopting the proposal with

additional companies, including financial services and non-public entities, asked to recast

two years of statements using the proposed guidelines. These activities continue to provide

valuable feedback to both Boards.

CURRENT STATUS/UNKNOWN FUTURE

The format for financial statements proposed in the Staff Draft significantly changes

the presentation of financial position, results of operations, and cash flows by all entities –

both in the U.S. and globally – in an attempt to develop a common presentation approach.

Furthermore, the proposal provides for an increased amount of disaggregation in the financial

statements as well as for standardization in presentation to augment the articulation and flow

among the financial statements.

Both the FASB and the IASB have engaged in a series of focused and targeted

outreach activities designed to elicit feedback regarding this project with additional such

activities continuing to be conducted. Findings from these activities have been mixed; some

have reported improvements in financial reporting while others report little or even declines

in usefulness. Users and preparers welcome some of the proposed changes, but do not

appear to appreciate others. Results from these activities have been and continue to be

provided to the Boards; however, both the FASB and the IASB acknowledge that a lack of

capacity exists to properly evaluate these results at this time. Accordingly, the project’s time

line has been modified and the project postponed until the requisite capacity is available.

This decision, originally made in October 2010, has been reaffirmed at each subsequent

Board meeting and no further action on the project by either Board is expected until requisite

capacity is achieved.

A project of this magnitude must be taken slowly and implemented with extreme

caution. As both the FASB and the IASB have discovered, such a massive change, even one

undertaken in answer to user requests, is not always welcomed with open arms by those

requesting the change. Costs and benefits of such a change for both users and preparers must

be collected and assessed; a process which both Boards are painstakingly undertaking. This

collection and analysis takes time and requires that everyone involved, both users and

preparers, be receptive to the changes being proposed. The FASB and the IASB appear to

recognize this and have shown admirable restraint regarding a rush to revamping of the

financial statements. However, little by little, both appear to be taking baby steps toward the

goal of international harmonization of financial statement presentation.

REFERENCES

Ernst & Young (2010, July 7). FASB Staff Draft of New Presentation Model for Financial

Statements. Hot Topic No. 2010-34.

Ernst & Young, (2011, May). Joint Project Watch: FASB/IASB joint projects from a US GAAP

Perspective.

FASB/IASB Joint Project Financial Statement Presentation. Retrieved from www.fasb.org/project/financial_statement_presentation.shtml

FASB (2010, July 1). Staff Draft of an Exposure Draft on Financial Statement Presentation.


49

FEI Financial Reporting Blog: Financial Statement Presentation Project ‘Pauses;’ Removed From

FASB, IASB June, 2011 Priorities, Retrieved from http://financialexecutives.blogspot.com/2010/10/financial-statement-presentation-pauses.html

IFRS Foundation: Introduction to and Summary of July 2010 Staff Draft. Retrieved from www.fasb.org/project/financial_statement_presentation.shtml

KPMG International Financial Reporting Standards (2010, August). New on the Horizon: Financial

Statement Presentation. (Principal authors: S. McGregor, M. Oki, J. Sage, and D. Ward)

McClain, G., and A. McLelland (2008, November). “Shaking Up Financial Statement Presentation”,

Journal of Accountancy. Retrieved from

(http://www.journalofaccountancy.com/Issues/2008/Nov/ShakingUpFinancialStatementPres

entation.com)

Stuart, A. (2008, February), “A New Vision for Accounting”. CFO Magazine. Retrieved from

(http://www.cfo.com/printable/article.cfm/10597001)


Vol. 5, No. 1; Fall 2012

50

THE COMPARATIVE REPORTING IMPACT OF THE FASB AND

IASB TREATMENTS OF RESEARCH AND DEVELOPMENT

EXPENDITURES

Patricia G. Mynatt

Richard G. Schroeder

University of North Carolina at Charlotte

ABSTRACT

In 2002 The Financial Accounting Standards Board and the International Accounting

Standards Board announced their intention to develop high-quality, compatible accounting

standards that could be used for both domestic and cross-border financial reporting (the

Norwalk Agreement). The two bodies are currently working to harmonize differences

between their respective standards. One such difference is in the treatment of research and

development costs (R&D). This paper analyzes the reporting consequences of this difference

to determine if the failure to harmonize this disparity might be a major impediment to the

goals of the Norwalk Agreement. Our study found that the majority of firms reporting in the

U. S. under IASB standards were large firms. Consequently, a company’s decision to

capitalize or expense R&D costs may be influenced by the political visibility theory of

accounting choice because the impact of capitalization is an increase in earnings. This

conclusion is further evidenced by the large difference in average reported earnings between

companies reporting under U. S. generally accepted accounting principles and the companies

reporting under IASB standards. Further support for this conclusion is found in a study of

French firms reported by Cazavan-Jeny, et al, 2007, which indicated that firms capitalizing

R& D expenditures are smaller and are poorer performers than firms expensing R&D

expenditures.

INTRODUCTION

The purpose of accounting is to provide the information for sound economic decision

making. This purpose is attempted to be accomplished by preparing financial reports that

provide information to external parties, such as investors, creditors and tax authorities, about

a firm’s financial performance. In efficient capital markets, investors incorporate public

information into security prices swiftly and accurately. In contrast, in capital markets in

which there is incomplete public information, prices reflect that information slowly,

incompletely or not at all (Stout, 2003).

In order for firms to report financial information fairly and consistently, a set of

accounting standards needs to be developed. There are currently two major standard setting

bodies, The Financial Accounting Standards Board (FASB) and the International Accounting

Standards Board (IASB). The FASB is currently the organization designated by the

Securities and Exchange Commission (SEC) as the authoritative standard setting body in the

United States; whereas, the IASB is recognized as the organization responsible for

promulgating accounting standards by approximately 120 foreign countries.

At a joint meeting in Norwalk, Connecticut, on September 18, 2002, the FASB and

the IASB both acknowledged their commitment to the development of high-quality,


51

compatible accounting standards that could be used for both domestic and cross-border

financial reporting (the Norwalk Agreement). The two boards pledged to use their best

efforts to (1) make their existing financial reporting standards fully compatible as soon as is

practicable; and (2) coordinate their future work programs to ensure that once achieved,

compatibility is maintained. The boards’ goal is to improve the usefulness of the information

provided in an entity’s financial statements to help users make decisions in their capacity as

capital providers (FASB, 2002).

One major area of difference between the two bodies’ standards is in the treatment of

research and development (R&D) costs. The FASB’s Statement of Financial Accounting

Standards (SFAS) No. 2 provides the following definitions of research and development:

Research is planned search or critical investigation aimed at discovery

of new knowledge with the hope that such knowledge will be useful in

developing a new product or service or new process or technique or in

bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge

into a plan or design for a new product or process or for a significant

improvement to an existing product or process whether intended for sale or

use. It includes the conceptual formulation, design and testing of product

alternatives, construction of prototypes, and operation of pilot plants. It does

not include routine or periodic alterations to existing products, production

lines, manufacturing processes, and other ongoing operations even though

these alterations may represent improvements and it does not include market

research or market testing activities (FASB, 1974).

The FASB standard requires all R&D costs to be charged to expense as incurred

(FASB, 1974). However, the IASB standard allows development costs to be capitalized

(recorded as assets) if they are found to have future economic benefit. The IASB discussed

this issue in International Accounting Standard (IAS) No. 38 as follows:

Development costs are capitalised only after technical and commercial

feasibility of the asset for sale or use have been established. This means that

the entity must intend and be able to complete the intangible asset and either

use it or sell it and be able to demonstrate how the asset will generate future

economic benefits (IAS No. 38, 2004)

Discussions on the accounting treatment for R&D expenditures are important because

R&D investments in the U.S. and other developed economies have witnessed unprecedented

growth in the last two decades. The U.S. currently leads the global market in corporate R&D

expenditures with 2005 R&D expenditures of $226 billion in current-year dollars, increasing

by $10.3 billion from the 2004 level (National Science Foundation, 2007). R&D investment

is used as one of the critical strategies to maintain and/or enlarge market share. Prior studies

demonstrate that companies with a higher level of R&D investment show far better earnings

and stock performance than companies with a lower level of spending in R&D (Daum,

2001).

All corporate investments, including R&D expenditure, create information

asymmetries between management and investors (Aboody & Lev, 2000), because

management can continually observe changes in investment productivity on an individual

Mynatt and Schroeder

52

asset basis. As a result, managers have superior information about the future cash flows and

earnings of the firm. However, R&D has been identified as a specific source of information

asymmetry (Aboody & Lev, 2000; Givoly & Shi, 2007).

Proponents of capitalization maintain that this treatment allows managers to signal

private information about future performance of the firm through the decision to capitalize or

expense R&D expenditures. That is, signalling theory1

explains how information asymmetry

can be reduced when the more informed party communicates their private knowledge to the

less informed party (Morris, 1987). Opponents of R&D capitalization argue that it creates

opportunities for managers to manipulate earnings by accelerating or delaying impairments

of R&D expenditures of projects with a low probability of success (Cazavan-Jeny et al,

2007). The two standard setting bodies’ differing treatments have reporting consequences in

that net income and assets could be materially different for companies having large amounts

of R&D expenses depending on which treatment standard is adopted.

Prior to 2007 foreign companies wishing to list their securities in United States

capital markets were required to recast their financial statements into U. S. generally

accepted accounting principles (GAAP) by using the Securities and Exchange Commission’s

(SEC) Form 20-F reconciliation. However, for years ending after November 15, 2007, the

SEC has allowed foreign private issuers to present IFRS based financial statements in their

SEC filings, without reconciliation to U.S. GAAP. The SEC’s rationale for this action was to

foster the adoption of a set of globally accepted accounting standards (SEC, 2007). Earlier, in

2005, the chief accountant of the SEC described a roadmap for arriving at a common set of

high-quality global standards and the removal of the need for the reconciliation requirement

for non-U.S. companies that use IFRSs and are registered in the United States (Nicolaisen,

2005).

The SEC also took another step in the direction of convergence in 2007 when it

decided to explore the possibility of allowing U.S. companies to adopt International Financial

Reporting Standards (IFRS) (SEC, 2007). In explaining its rationale for this decision, the

SEC noted that the movement to IFRS has begun to affect U.S. companies, in particular those

with a significant global foot- print. That is, under the new rule amending Form 20-F adopted

by the SEC, foreign registrants can use either U.S. GAAP or IFRS without reconciling their

earnings and shareholders’ equity to U.S. GAAP; consequently, it would seem more

equitable for U.S. companies, which compete for capital in the same securities market, to

also be able to use either U.S. GAAP or IFRS (SEC, 2007). In 2008, the SEC voted to

publish for public comment a proposed roadmap that could lead to the use of IFRS by U.S.

issuers beginning in 2014 (SEC, 2008).

A recent SEC staff paper summarized an analysis of the financial reports of 183

companies, both SEC registrants and other companies, which were prepared under IFRS.

With respect to the reporting of intangible assets, they wrote “For many companies, it was

unclear what costs were being capitalized; thus, comparability was difficult to assess.” (SEC,

2011). The objective of this study is to determine whether there are observable differences

for U.S. listed firms that report under the FASB’s and the IASB’s prescribed accounting

treatments for R&D costs.

The underlying research hypothesis is that there is a material difference on reported

R&D costs, income and assets that is attributable to the alternative treatments for companies


53

with large R&D expenditures. Companies reporting under IFRS may capitalize development

costs as an intangible asset after technical and commercial feasibility has been established.

Companies reporting under FASB standards must expense such costs. We expect, therefore,

that intangible assets, specifically the number reported by firms for intangible assets other

than goodwill, will be larger on average for firms reporting under IFRS as opposed to under

U.S. GAAP. We also expect that R&D expenditures will be smaller on average for firms

reporting under IFRS as opposed to under U.S. GAAP. To control for the overall difference

in firm size, we investigate reported other intangible assets, scaled by firm total assets and

reported R&D costs, scaled by firm total assets. Because IFRS reporting firms may

capitalize some development costs, we also look for an income difference between

companies reporting under IFRS and U.S. GAAP. We expect that net income may be higher

for IFRS reporting firms. We again control for firm size using total assets. Our sample

includes all firms listed in the Compustat North America Annual Database for fiscal year end

2010, in the following five, two-digit sic codes:

28 - Chemical and Allied Products

35 - Industrial Machinery and Equipment

36 - Electrical Equipment

37 - Transportation Equipment

38 - Measuring Instruments

These industries were selected because of historically high research and development

expenditures. (Chan et al, 2001). Wharton Research Data Services (WRDS) was used in

compiling the data for this project.2 We require data on total assets, other intangible assets

and net income. Removal of observations with missing data results in our sample of 1,939

firm observations (73 reporting under IFRS, 1866 reporting under U.S. GAAP).

BACKGROUND AND SIGNIFICANCE

The proper treatment of R&D expenditures has been an important issue for over four

decades and the events that originally led to the adoption of SFAS No. 2, are chronicled by

Selling (2010). At the time that SFAS No. 2 was promulgated, four varieties of R&D-

intensive companies were in evidence: (1 and 2) IBM and AT&T, by dominating the

computer hardware and telecommunications industries respectively, were in classes by

themselves; (3) a group of large pharmaceutical companies whose patented drugs made them

extremely profitable; and (4) numerous smaller technology-driven companies attempting to

gain capital and market acceptance.

In regards to accounting standards, prior to SFAS No. 2, accounting for R&D was

"principles-based." This meant that R&D costs were supposed to be deferred (and matched

with future revenue from a project) if the expenditure created a probable future benefit. The

costs of unsuccessful projects would have been immediately charged to expense. However,

then current market conditions also played a role in the decision to capitalize or expense

R&D expenditures as the conventional wisdom held that only those smaller companies

capable of reporting positive net income in an initial public offering (IPO) prospectus would

have any chance for a successful stock offering.

The result was that actual practice turned out to be the polar opposite of theory; in

that virtually every company did it incorrectly. Smaller companies seeking a successful IPO


54

would capitalize all R&D expenditures, because that was the only way to report positive net

income. For those other R&D intensive companies—like IBM, AT&T and the large

pharmaceutical companies being too profitable was generally not in their best interests, in

part because increased profitability would attract the attention of regulators (the political

visibility theory of accounting choice).3

As a consequence, the large companies expensed

their entire R&D expenditures, even though, because of their market power and

concentration of intellectual capital, they had many successful projects. Consequently, the

situation that the FASB had to confront was one where the R&D projects with the highest

likelihood of success were being expensed, while the smaller companies would defer their

R&D expenditures as long as possible. The FASB attempted to develop a set of subjective

criteria that would permit deferral of some R&D costs, but it ultimately concluded that no set

of qualitative or quantitative criteria would result in comparability across companies.

Consequently, the FASB ruled that all R&D expenditures must be expensed in the period

they were incurred.

There have been a number of empirical studies examining the value relevance of the

treatment of R&D expenditures. Relevance is a quality that makes accounting information

useful for decision making. It generally refers to the impact of accounting information on

decision makers. Relevant accounting information makes a difference to decisions by

improving decision makers’ capacities to predict or by providing feedback on earlier

expectations (FASB, 1980).These empirical studies have generally reported that capitalized

R&D expenditures are value relevant and that their association with the firm’s value exceeds

that of expensed R&D expenditures (See for example, Lev and Sougiannis, 1996; Abrahams

and Sidhu, 1998). Additionally, allowing managers to credibly signal their superior

information by either capitalizing successful R&D investment or expensing unsuccessful

R&D investment is seen as reducing information asymmetry between managers and the

firm’s external users of accounting information, and is likely to enhance firms’ financial

statements relevance, capital markets’ efficiency and resource allocation (Oswalt & Zarowin,

2007). These conclusions tend to favor the IASB’s standard.

On the other hand, it has been argued that mandatory expensing of R&D costs is the

preferred treatment because of earnings concerns. That is, management may manipulate or

misrepresent capitalized R&D accounting data to satisfy earnings forecasts (Davies and

Wallington, 1999; Healy and Wahlen, 1999). By mandating expensing of R&D expenditures,

standard setters imply that they believe the cost of possible earnings misstatement exceeds

the benefits of signaling.

To date, the IASB has sided with the value relevance argument; whereas, the FASB

supports the earning management argument. The two bodies’ positions are apparently firmly

entrenched because there is currently no ongoing project to reconcile this disagreement. Our

study does not address either the value relevance or earnings management arguments, rather

we examine the reporting consequences of adopting one or the other of the two possible

treatments in an attempt to determine if the adoption of one or the other of the methods might

have a material effect on reported financial performance. This information is important for

both academics and policymakers, because it addresses the fundamental issues of whether

and how accounting matters. Additionally, it is important to know the potential balance sheet

and income statement effects if U. S. companies are allowed to report using IFRSs in the


55

future. Finally, no current research studies have focused on the alternative treatments of

R&D expenditures for U.S. listed firms.

RESULTS

The number of reports gathered from each of the selected industries is summarized in

Table 1. Summary data for all observations is presented in Table 2. After controlling for

overall firm size by scaling by total assets, differences between groups were analyzed by

using a T-test for the difference between proportions. Two of the measures expected to differ

between the reporting groups, other intangible assets and net income, are not found to differ

significantly. Other intangible assets relative to total assets for IFRS firms are 8.79%;

whereas, other intangible assets relative to total assets for firms reporting under FASB

standards are 6.86%. Other intangible assets were expected to be higher for IFRS reporting

firms because of the opportunity to capitalize development costs; however, the difference

between the groups was not found to be statistically significant. Average net income relative

to total assets is 8.24% for firms reporting under IFRS standards, and 11.01% for firms

reporting under U.S. GAAP. Net income was expected to be higher, not lower, for firms

reporting under international standards, but again, the difference between the two groups was

not found to be statistically significant. There is a mildly significant difference in reported

R&D costs (p < .05). Average R&D costs relative to total assets are lower, as expected, for

IFRS reporting firms. Average R&D costs were 10.98% for IFRS firms as compared to

20.45% for firms reporting under U.S. GAAP.

Table 1

Industry Representation

Industry

Industry Code

Companies

reporting

under IASB

Standards

Companies

reporting

under FASB

Standards

All

Chemical and Allied

Products

SIC 28

34

617

651

Industrial Machinery

and Equipment

SIC 35

9

279

288

Electrical Equipment

SIC 36

13

515

528

Transportation

Equipment

SIC 37

11

123

134

Measuring

Instruments

SIC 38

6

332

338

All Industries 73 1866 1939

The data in Table 2 indicates, based on both assets and revenues, that foreign issuers

reporting under IASB standards are much larger than the average firm reporting under FASB

standards. That is, the average assets for foreign firms were $23,237,876, while the average

assets for firms reporting under FASB standards were $2,861,026. Similarly, the average

revenue for foreign firms was $16,640,792; whereas, the average revenue for firms reporting

under FASB standards was $2,179,109. This finding is, at least, partially attributable to the

fact that larger firms are more likely to be attempting to find additional sources of capital

than are smaller firms. Additionally, finding mild results for lower R&D costs relative to


56

assets for IFRS firms, but not finding results for higher intangible assets relative to total

assets for the same group, may be explained by this size difference between the groups since

IFRS firms are larger on average and it may be that larger firms are less R&D intensive.

Table 2

Summary Data by Reporting Standard

(000 omitted for dollar amounts)

Variable/Reporting Group

Companies

reporting under

IASB Standards

(n=73)

Companies

reporting under

FASB Standards

(n=1866)

All Companies

(n=1939)

Average Total Assets (TA) $23,237,876 $2,861,026 $3,628,179

Average Other Intangibles (OI) $2,097,832 $235,196 $305,321

Average OI/TA 8.79% 6.86% 6.93%

Average Revenues $16,640,792 $2,179,109 $2,723,566

Average R&D Expense $1,259,829 $128,526 $171,117

Average Net Income (NI) $1,236,532 $150,125 $191,027

Average NI/TA 8.24% 11.01% 10.87%

Average R&D Expense/TA* 10.98% 20.45% 20.07%

*p<.05

CONCLUSIONS

Although IASB standards allow development costs to be capitalized if certain criteria

are met, this study shows only mild support for lower R&D costs for IFRS reporting firms

and does not support higher levels of other intangible assets or higher net income for firms

reporting under international rules. Companies routinely reported, as the following quote

from AIXTRON SE illustrates, that given the regulatory, technical and market uncertainties

inherent in their respective industries, development costs are generally expensed as incurred.

Expenditure on development comprises costs incurred with the purpose of using

scientific knowledge technically and commercially. As not all criteria of IAS 38 are met or

are only met at a very late point within the development process, for reasons of materiality

AIXTRON did not capitalize such costs. [Quote from AIXTRON SE 2010 Form 20F, filed

with SEC on March 1, 2011 (accessed through Morningstar Document Research)]

AIXTRON manufactures semiconductors in the industrial machinery and equipment

industry. Similar comments are noted in the filings of other companies, including those in the

chemical and allied products and in the measuring instruments industries. The current

reporting standards for R&D expenditures do not appear to create significant differences

across firms due to the minimal application of capitalization, even when permitted.

The information perspective holds that managers would signal their private

information to the market, including for example, progress on various R&D projects at

different stages of completion and with varying degrees of uncertainty. Those R&D projects

whose benefits are highly probable would be capitalized, and those whose benefits are less

probable would be expensed. In this way, the quality of financial reports would be


57

maintained and information asymmetry between investors and managers would be reduced.4

However, our finding may be explained by factors similar to those that led to the

development of SFAS No. 2, as detailed earlier. Our study found that the majority of the

firms reporting in the U. S. under IASB standards were large firms. Consequently, a

company’s decision to capitalize or expense R&D costs may be influenced by the political

visibility theory of accounting choice because the impact of capitalization is an increase in

earnings. This conclusion is further evidenced by the large difference in average reported

earning between companies reporting under U. S. GAAP and the companies reporting under

IASB standards. Finally, further support for this conclusion is found in a study of French

firms reported by (Cazavan-Jeny et al, 2007) which indicated that firms capitalizing R&D

expenditures are smaller and are poorer performers than firms expensing R&D expenditures.

Additional research is needed to determine the factors that influence firms’ decisions to

expense or capitalize R&D costs.

ENDNOTES

1Signalling refers to any activity by a party whose purpose is to influence the perception and thereby

the actions of other parties. 2This service and the data available thereon constitute valuable intellectual property and trade secrets

of WRDS and/or its third-party suppliers. 3The political visibility theory of accounting choice suggests that larger firms are less likely to make

income increasing choices (Hand and Skantz, 1998; Holthausen and Leftwich 1983). 4Under the information perspective on accounting, investors seek information (from whatever source)

that will allow them to make investment decisions. Accounting’s role is not to measure firm value

(the measurement perspective on accounting), but to provide information useful to investors in

developing their own assessment of firm value.

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performance measurement. Australian Journal of Management. 23:169-183.

Cazavan-Jeny, A., Joos, P. & Jeanjean, P. (2007). Signaling Future Performance through

Accounting Choice: The Case of R&D Accounting in France. Unpublished Working Paper,

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Chan, L. K., Lakonishok, J. & Sougiannis, T. (2001). The Stock Market Valuation of Research and

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Davies, J., Wallington, A. (1999). The R&D paradox. Accountancy (April), 86.

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http://www.sec.gov/spotlight/ifrsroadmap.htm


Vol. 5, No. 1; Fall 2012

59

IFRS ADOPTION IN JAPAN: ROAD MAP AND CHALLENGES

Noriaki Yamaji

Kwansei Gakuin University

Joshua Hudson

Altia Central

Douglas K. Schneider

East Carolina University

ABSTRACT

The Japanese government announced the delay of a road map for IFRS adoption for

publicly traded companies due to potential costs to Japanese companies already hard hit from

the 2011 earthquake and tsunami (The Accountant 2011). Previously, the Japanese Financial

Services Agency (FSA) had stated that it would make it mandatory for Japanese companies

to report under IFRS in 2015 or 2016, a time frame that has now been abandoned. In

addition, Japan is waiting to see how IFRS adoption plays out in the U.S. and determine if it

should take a similar path. However, when adoption of IFRS is reconsidered, Japan’s

Business Accounting Council (BAC) and Accounting Standards Board of Japan (ASBJ)

should consider an adoption of IFRS that is right for Japan. The majority of Japanese

companies do not issue consolidated financial statements to the investing public.

Accordingly, the optimal application of IFRS in Japan would be to limit IFRS to those

companies that publicly issue consolidated financial statements. Those companies that do

not issue consolidated financial statements to the public should be excluded from the

requirement to report under IFRS.

IFRS ROADMAP IN JAPAN DELAYED

In June, 2009 the International Accounting Standards Board (IASB) announced that

Japan’s Business Accounting Council (BAC) approved a roadmap for Japan’s adoption of

International Financial Reporting Standards (IFRS). The BAC in Japan serves as an advisory

body to the Commissioner of the Financial Services Agency (FSA), which is ultimately

responsible for approving the adoption of IFRS (IASB 2009). Previously, the Japanese

Financial Services Agency (FSA) had stated that it would make it mandatory for Japanese

companies to report under IFRS in 2015 or 2016.

Soon after, the IASB and the Accounting Standards Board of Japan (ASBJ)

reaffirmed their commitment to converging Japanese accounting standards with IFRS: “The

boards [IASB and ASBJ], meeting in Tokyo on 6 and 7 June 2011, also announced their

intention to deepen their co-operation in preparation for a decision around 2012 on the

mandatory application of IFRSs in Japan. Some Japanese domestic companies are already

permitted to prepare financial statements in accordance with IFRSs” (ASBJ 2009; IASB

2011).

However, later in 2011 the Japanese government announced, through the FSA, that it

was delaying the road map for IFRS adoption for publicly traded companies due to concern

over the potential costs to Japanese companies already struggling from the lasting effects of

the earthquake and tsunami that occurred in March, 2011 (The Accountant 2011). If and

Yamaji, Hudson, and Schneider

60

when the adoption of IFRS in Japan will occur is uncertain. The Minister of Financial

Services in Japan (i.e., the FSA), Shozaburo Jimi, announced that mandatory adoption of

IFRS for “listed companies” will likely be delayed for 2 to 4 years. Thus, a decision on

adoption is projected to take place sometime between 2013 and 2015. In addition, even

when IFRS is adopted a grace period of five to seven years will be allowed for individual

companies to actually adopt IFRS (HLB International Limited 2011). The Japan Business

Federation (Keidanren) has called for the FSA to postpone adoption of IFRS for another one

to three years (The Nikkei 2011). Mandatory adoption by 2015 has now been abandoned by

the Japanese government and a final decision has not yet been made as to whether or even

when IFRS will be adopted. However, the FSA did say that if IFRS is adopted at some point

in the future there will be a five to seven year transition period.

Three factors influenced the decision to postpone adoption (HLB International

Limited 2011). First, in the aftermath of the March, 2011 earthquake and tsunami a higher

priority is understandably placed on the economic recovery of Japanese industry as opposed

to the adoption of IFRS. A second reason is that independent of disaster recovery there is

separate opposition by some sectors of Japanese industry regarding the mandatory

application of IFRS. Finally, there is the affect foreign influence has on IFRS adoption in

Japan, particularly U.S. plans for adoption. Japan would like to wait and see what other

countries do in regard to IFRS before committing to a course of action. Japanese news

reports indicate that the Japanese government is keeping a close eye on the pending U.S.

decision on whether to adopt IFRS. If the U.S. does adopt IFRS, Japan will consider the path

the U.S. takes in determining its own the course of action (The Accountant 2011).

The last two reasons above, resistance from some industrial sectors in Japan and the

U.S. policy on IFRS adoption are discussed at greater length in this paper. Then, an

approach to IFRS adoption that would be the right fit for Japan.

JAPANESE BUSINESS CONCERNS ABOUT IFRS ADOPTION

Japan is the world’s third largest economy. The establishment of a roadmap for IFRS

adoption by Japan, along with adoption by the European Union and the pending adoption by

the United States, signifies the global relevance of IFRS and the belief in the universal

benefit of a single set of accounting standards.

Though the BAC approved a roadmap, the convergence of Japanese standards with

IFRS will also be developed by the ASBJ. Several entities have a hand in accounting

standards and financial reporting in Japan. “Business Accounting Principles issued by the

Business Accounting Council (BAC), Accounting Standards issued by the Accounting

Standards Board of Japan (ASBJ), and Practical Guidelines issued by the Japanese Institute

of Certified Public Accountants (JICPA) are deemed to be the generally accepted accounting

principles (GAAP) in Japan” (JICPA 2009).

The roadmap is an agreed upon timetable which outlines the steps for IFRS adoption.

According to the original roadmap, mandatory adoption of IFRS in Japan should have

occurred in 2016, with early adoption available to Japanese firms as early as April 1, 2009

fiscal year. In actuality, Nihon Nihon Dempa Kogo voluntarily adopted IFRS for the first

time in 2010. But only a few companies (HOYA and Sumitomo Corporation) followed it.


61

The final decision to commit to IFRS adoption was supposed to be made by 2012. Instead,

no final decision has been made in regard to IFRS as of 2012.

The BAC has expressed concern about several issues. It called for proactive efforts in

Japan and at the IASB as prerequisites for the successful adoption of IFRS. The steps along

the road to IFRS include the education and training of Japanese investors, preparers, auditors

and regulators (Financial Services Agency 2009). In addition, it will be essential for IFRS,

which are promulgated in English, to be converted into an “authentic” Japanese translation.

The BAC also stressed the need for greater involvement by Japan in the development of

IFRS at the IASB and the IASB’s assurance of due process on issues concerning Japan in the

promulgation of IFRS.

However, the BAC also expressed concern about issues that could constitute

obstacles to the actual, as opposed to official, acceptance and application of IFRS in Japan:

“For IFRS to function well at each stage of the financial reporting process, it is important to

ensure that IFRS appropriately reflect business practices in Japan and fairly represent the

economic reality of Japanese businesses (emphasis added)“ (FSA 2009).

These concerns reveal that IFRS might not be applicable or necessary for most of

Japan’s corporations and businesses. This article will explore why the application of IFRS

should be targeted to the type of organization where it would provide a benefit and why IFRS

should not be imposed on those corporations where the cost would exceed the benefit.

COMPANIES ACT AND FINANCIAL INSTRUMENTS AND EXCHANGE ACT

In Japan business is subject to the Companies Act, which prior to May, 2006 was

referred to as the Commercial Code. The Companies Act (CA) prescribes that all businesses

must be categorized into the following four types of companies, described in their Japanese

name and in their English equivalent; the kabushiki kaisha (stock company), the gomei

kaisha (general partnership company), the goshi kaisha (limited partnership company) and

the godo kaisha (limited liability company). This summarized in the Table 1 below.

Table 1 Categorization of Businesses in Japan

Companies Act in Japan requires all businesses be categorized

into four types, in Japanese and (English):

1) the kabushiki kaisha (stock company [emphasis added])

Potentially subject to IFRS.

2) the gomei kaisha (general partnership company)

3) the goshi kaisha (limited partnership company)

4) the godo kaisha (limited liability company).

In Japan it is “stock” companies that are potentially subject to IFRS because, as their

name suggests, their ownership structure consists of shares of stock. Stock companies are

further identified as either “large” companies or “small’ companies. Large companies are


62

then defined as “listed” large companies, and “other” large companies which are defined as

“unlisted” companies.

Stock companies are categorized by type according to the size of their assets and

whether or not their shares are transferable. Article 2(vi) of the CA provides that a company

that has stated capital of at least 500,000,000 yen or liabilities of at least 20,000,000,000 yen

is a "large company." All other stock companies are not considered large, for purposes of

this article, and are henceforth referred to as “small and medium” stock companies. Table 2

summarizes the types of stock companies.

Table 2 Type of Stock Companies in Japan

Type of stock company

Size

Category

Approximate

Number of

Companies

Primary

Financial

Statements

“Listed” large stock companies

subject to FIEA

Large 3,600 Consolidated

“Other’ large stock companies

subject to FIEA

Large 1,000 Consolidated

“All other” large companies

not subject to FIEA

Large 10,000

Parent-only

Stock companies not

considered large (i.e., small

and medium) not subject to

FIEA

Small

and

Medium 2,500,000 Parent-only

In addition to the Companies Act, stock companies in Japan are subject to financial

reporting requirements. Since October, 2007 the Securities and Exchange Act (SEA) has

been referred to as the Financial Instruments and Exchange Act (FIEA). FIEA now requires

that companies file annual and quarterly consolidated financial statements. Also, CA

requires parent-only financial statements as their primary financial statements and

consolidated financial statements as their secondary financial statements for listed large

companies, etc.

Companies traded on exchanges, “listed” large companies, are subject to FIEA,

formerly SEA. They report using consolidated financial statements as their primary financial

statements and parent-only financial statements as the secondary financial statement.

Companies such as Toyota, Nissan, and Sony are classified as this type of company. The

“listed” large companies comprise less than 1% of Japanese companies and yet have the most

significant impact on the Japanese economy. These are the companies often traded on the

stock exchanges (i.e., “listed” companies). The total number of “listed” large companies and

“other” large companies under FIEA is approximately 4,600.


63

Exhibit 1 Transformation of Japanese Triangle Legal System

Japanese Triangle Legal System pre-2000

Commercial Code (CC)

Securities and

Exchange Act (SEA)

Corporation

Tax Act (CTA)

Japanese Triangle Legal System post-2000

Companies Act (CA)

Financial Instruments and

Exchange Act (FIEA)

Corporation

Tax Act (CTA)

TRANSFORMATION OF JAPAN’S TRIANGULAR LEGAL SYSTEM

One of the relatively recent developments in Japan that will make conversion to IFRS

more feasible is the weakening of the links in the financial reporting related to the Triangular

Legal System of Japan. For many years there were three sets of closely intertwined laws that

established accounting objectives in Japan: Securities and Exchange Act (SEA), Commercial

Code (CC) and Corporation Tax Act (CTA) (JICPA 2009). This is referred to as the

Triangular Legal System of Japan (see Exhibit 1). FIEA and CTA now have no relation to

one another. Also of significance is that, unlike in past years, tax-effect accounting is no

longer concerned with potential differences between taxable income and net income.

Financial accounting now tends to be separate from Corporation Tax Accounting (CTA).

The loosening of the Triangular Legal System has implications for the convergences

of IFRS with Japanese accounting standards because Japanese companies can now utilize

IFRS where in the past the legal requirements may have been a barrier to the implementation

of IFRS.

Both CA and FIEA are two parts of what is known as the Triangle Legal System. For

many years prior to the year 2000, the CA, then known as CC, FIEA, formerly SEA, and the

Corporation Tax Act (CTA) formed an interdependent system where ownership, financing,

clients and the tax and legal system were self-sufficient and operated in a closed system, as

shown in the upper half of Exhibit 1. There was little need for financial reporting by any

Japanese company or to issue general purpose financial statements to provide useful


64

information for investors for purposes of evaluating a company’s stock. However, a positive

development is that financial accounting based on the CA and FIEA is now considered to be

similar to one another.

Prior to 2000, banks provided most of the financial capital for Japanese corporations.

Therefore, there was little need for financial statements that met the requirements of typical

stock investors. However, the Triangular Legal System has been transformed over the last

decade. The three laws which used to be linked so closely now have a much looser

relationship. Under the Triangular Legal System, as it existed prior to 2000, there would have

been little justification or purpose in Japanese companies reporting under IFRS or even

bothering to merge Japanese GAAP with IFRS for that matter. The loosening of the

Triangular Legal System has facilitated the convergence of IFRS and Japanese GAAP.

IFRS ADOPTION IN THE U.S.

In the U.S., as of early 2012, a decision will not be made for a “few” more months by

the Securities and Exchange Commission in regard to the adoption of IFRS (Tysiac 2012;

Journal of Accountancy. 2011d). The issue of adopting IFRS in the U.S. has been no less

controversial or unsettled than in Japan. The adoption of IFRS has been an exercise in

“delays and more delays” (PwC 2011). For a number of years the U.S. accounting standard

setting agency, the Financial Accounting Standards Board (FASB), has been engaged in a

convergence effort with the International Accounting Standards Board (IASB) where several

major differences between U.S. GAAP and IFRS have been eliminated through a series of

individual projects, formally known as the Memorandum of Understanding (MoU),

informally the “convergence project” (Journal of Accountancy. 2011d).

Significant progress has been made under the convergence project and many of the

major differences between U.S. GAAP and IFRS have been eliminated. Several major

differences still exist, but there is a commitment to complete outstanding projects by the time

IFRS is ultimately adopted by the U.S. Nonetheless, the FASB and IASB chiefs agree that a

new long-term convergence model is needed (Journal of Accountancy 2011e).

In December 2011 the FASB’s Chair, Leslie Seidman, and Hans Hoogervorst, Chair

of the International Accounting Standards Board (IASB), agreed that the FASB and the IASB

should complete the current priority convergence projects on revenue recognition, leasing

and financial instruments and insurance. However, due to both political and practical reasons

convergence projects cannot continue indefinitely (Journal of Accountancy 2011e).

The IASB chair also stated that while the convergence projects have narrowed the

differences between U.S. GAAP and IFRS, in some instances this will lead the two

independent boards (the FASB and the IASB) to “diverged solutions” and “suboptimal

outcomes.” The project on financial instruments is cited as an example where both boards

arrived at different conclusions, but might try to bridge the gap by requiring disclosures.

Also stressed by the IASB chair is the need for the U.S. to set a date where IFRS

would be used by public companies and accept a model where the FASB would endorse

IFRS for use in the U.S. This is similar to the process in most other parts of the world, such

as Australia, Brazil, Canada, Europe and Korea. Frequent non-endorsements of new IFRS

standards and “carve outs” for exceptions in the U.S. should be avoided. In addition, a high


65

threshold for endorsement in the U.S. should exist so that exceptions or deviations from IFRS

in the U.S. rarely occur.

In May, 2011 an SEC staff paper proposed the concept of “condorsement” which

redefines convergence and transforms the role of the FASB as an endorsement body for

international accounting standards, IFRS (Journal of Accountancy 2011a). Under

convergence, individual countries, and more broad jurisdictions, do not automatically adopt

and incorporate accounting standards into their respective countries precisely “as issued” by

the IASB. Instead, jurisdictions maintain their own local standards but attempt over time to

converge those local standards with IFRS. Under endorsement, jurisdictions incorporate

specific IFRS “as issued.” However, local languages do not always have exact equivalent

words to those used in English IFRS. Thus, IFRS translated into local languages may be

interpreted and applied differently from IFRS as intended in the English language.

The May 2011 SEC staff paper would combine convergence and endorsement into a

hybrid of the two approaches. The FASB would be retained as the U.S. standard setter and

would over a defined time horizon incorporate current IFRS as U.S. GAAP. The first phase

would complete the joint projects the FASB and IASB are currently engaged in. The second

phase would require the FASB to merge active IFRS projects into U.S. GAAP using the

FASB’s traditional due process. The third phase would then require that all remaining IFRS

be incorporated into U.S. GAAP. Moving forward after the third phase, the FASB would

continue as the U.S. standard setter and would ensure that new IFRS and amendments to

existing IFRS would meet the needs of U.S. stakeholders. A goal of this process would be

that any firm in compliance with U.S. GAAP would also be in compliance with IFRS. A five

to seven year time frame is envisioned starting with 2011 as a base line (Journal of

Accountancy 2011a).

Under the condorsement approach the FASB would still have the authority to carve

out differences from any new IFRS before they are incorporated into U.S. GAAP. However,

it is presumed that an exception to IFRS would have to meet an established protocol and

would only occur in unusual circumstances which would be rare and generally avoided.

Condorsement would facilitate the conversion to IFRS, but by the FASB’s role as

endorsement of IFRS would retain jurisdiction over U.S. GAAP and would not entirely

surrender sovereignty over U.S. accounting standards (see Exhibit 2).

The parent organization of the FASB, the Financial Accounting Foundation (FAF),

expressed concern about the “condorsement” approach put forth by the SEC in its May 2011

report (Journal of Accountancy 2011c). The FAF holds the position that the FASB would

still set U.S. standards for topics of considerable importance that are not on the IASB’s

agenda and for topics where the IASB doesn’t provide timely or adequate implementation

guidance (Journal of Accountancy 2011e).


66

Exhibit 2. Comparison of Status of IFRS in the United States and Japan

I N T E R N A T I O N A L U N I T E D S T A T E S

International Accounting

Standards Board (IASB)

Securities Exchange

Commission (SEC)

Financial Accounting

Foundation (FAF) & Financial

Accounting Standards Board

(FASB)

American Institute of

Certified Public Accountants

(AICPA)

The IASB recommends that

individual jurisdictions and countries, including the U.S.

and Japan, transition into

adoption of IFRS.

In May 2011 an SEC staff

report proposes an approach called “condorsement” of

IFRS by the FASB.

In December 2011 SEC

announces a final report on

IFRS adoption will be made in 2012.

FAF, parent board of the FASB,

agree with the IASB that convergence projects should not

be indefinite. However, both

agree current projects should be completed.

AICPA recommends that U.S.

companies be allowed to adopt IFRS immediately.

J A P A N

Minister of Financial

Services Agency Japan

Accounting Standards

Board of Japan (ASBJ)

Japanese Institute of

Certified Public Accountants

(JICPA)

Financial Services Agency (FSA) has abandoned a

decision for Japanese companies to report under

IFRS in 2015 or 2016.

Instead, no decision has been made to adopt IFRS.

Japan is waiting to see whether and how IFRS is adopted in the

U.S. before deciding on adopting IFRS in Japan.

JICPA suggests that Japan should seriously consider the

adoption of IFRS.

Instead, FAF favors a “U.S. Incorporation Commitment” that would provide the

FASB along with other national standard setting agencies two important considerations: 1)

non-voting observer rights on the IASB with the power to participate in deliberations of the

IASB, and 2) the FASB hold due process and post implementation reviews in the U.S. of

IASB-issued standards and agenda items (Journal of Accountancy 2011e).

The FAF does operate on the premise that international accounting standards will

become the foundation of U.S. GAAP. The FAF does not express opposition to the adoption

of IFRS, but more the process by which adoption of IFRS should occur. Under the FAF

position, the FASB would still have the final authority or veto power over the adoption of an

IASB-issued standard before it becomes U.S. GAAP. The FAF position can be summarized

as any new major IFRS rule should be incorporated into U.S. GAAP only if it improves

existing U.S. GAAP. Other less major IFRS would be incorporated that maintain the

existing quality of U.S. financial reporting and also improve global financial reporting

comparability.

The American Institute of Certified Public Accountants (AICPA) has also expressed

its views on adopting IFRS in the U.S. AICPA President and CEO Barry Melancon called

upon the SEC to allow U.S. Companies the option to adopt IFRS as a way for U.S.

companies to more effectively compete with competitors from other countries who are

permitted to use IFRS for listing in the U.S. or overseas (Journal of Accountancy 2011b). A

“tremendous disparity” exists between multinational firms based in the U.S. versus those

based in other countries in terms of freedom to use IFRS.


67

Also indicated by the AICPA is that only a few U.S. firms would initially exercise the

option to adopt IFRS, so it would not initially create a major impact across the U.S. financial

reporting system. However, the small number of firms likely to exercise the IFRS option

would act as a pilot project and provide insights into IFRS adoption in the U.S.

The AICPA accepts an “endorsement approach” for incorporating IFRS into U.S.

GAAP and support keeping the FASB as the standard setter that will facilitate the

incorporation of IFRS into U.S. GAAP. The endorsement approach would give the FASB

and SEC the ability to modify or supplement IFRS, but would not result in dual IFRS and

U.S. GAAP. However, it could result in significant differences in IFRS in the U.S. from

IFRS in other developed countries. As such, the AIPCA hopes the modification of IFRS in

the U.S. is a rare occurrence.

The AICPA recommends that after the completion of the current Memorandum of

Understanding convergence projects an endorsement process should incorporate specific

IFRS, not currently promulgated in the standard setting process, into U.S. GAAP all at once,

instead of a long, drawn out, one-IFRS-at-a-time process. U.S. auditing and regulatory

environments must change to accommodate the principles-based nature of IFRS such that

under IFRS “second-guessing” the professional judgment of auditors and preparers would be

minimized. For private entities the AICPA supports an independent board under the

Financial Accounting Foundation (FAF) to develop exceptions and modifications of IFRS

incorporated into U.S. GAAP. However, the FAF has not proposed such an independent

board. The AICPA calls upon the SEC to declare “dates certain” for adoption of IFRS in the

U.S. to allow preparers and auditors time to plan for the transition.

So, the issue of IFRS adoption in the U.S. is unsettled and divergent points of view,

related to how IFRS should be applied in the U.S., exist.

JAPAN GAAP VERSUS IFRS – A SOLUTION FOR JAPAN

In all likelihood the decision to adopt IFRS in Japan will not be made until after the

effects of the earthquake and the tsunami are more fully assessed. However, IFRS adoption

in Japan can be examined separate from the affect of the terrible natural disaster of 2011.

In theory, the loosening of the Triangular Legal System may facilitate the

convergence of IFRS and Japanese GAAP. However, the mandatory adoption of IFRS as the

accounting standard for all Japanese accounting would not be optimal. Instead of imposing

the burden of IFRS on all Japanese business, a better approach in terms of cost-benefit would

be to impose the full extent of IFRS on only those the 1% of (large) Japanese companies

which raise capital from stock markets. It is among those companies that seek to raise capital

from foreign markets that the greatest need for transparency exists and that the greatest

benefit would be provided by the standardization of accounting methods under IFRS.

The majority of IFRS policies have already been merged into Japanese accounting

with the exception of about five main features (amortization of goodwill, accounting for

actuarial gains and losses, accounting for research and development costs, fair value

measurement of investment property and measurement of fixed assets accounting for

minority interests) which are seen as important for listed companies, but not beneficial to the

other 2,500,000, or so, small and medium companies which raise capital only in Japan and do

not have a corporate form of ownership that involves outstanding shares issued to the public.


68

Table 3 Proposed Japanese Financial Statements under IFRS

Unlisted

companies

Listed

companies

Consolidated financial statements N/A IFRS

Parent-only financial statements J-GAAP J-GAAP

A more optimal cost-benefit application of IFRS is to have two separate sections of

companies in regards to listed and unlisted companies (Table 3). Listed companies should

use IFRS since they raise capital from the stock market, while unlisted companies which

raise capital only in Japan should continue to use Japanese GAAP, which has already

adopted most features of IFRS any way. There is no benefit for unlisted companies incurring

the cost of using IFRS.

If implemented, this suggested policy for listed companies using IFRS, while small

and medium companies of Japan maintain their use of Japanese GAAP, would likely be

effective. Japan would undoubtedly receive criticism for such a policy. However, there is

simply no purpose in requiring small and medium Japanese companies to use IFRS when

they do not seek capital from the international markets. Making a distinction for the

application of IFRS between large listed companies and the small and medium Japanese

companies would constitute an optimal policy for Japan.

SUMMARY

Due to a concern over adding additional costs to Japanese companies already

burdened by the affects of the 2011 earthquake and tsunami, the government of Japan has

decided to proposed a decision on a roadmap to the adoption of IFRS as Japanese accounting

standards. Prior to the natural disaster, Japan had made a commitment to proceed with the

convergence of Japan’s accounting standards with IFRS and to tentatively require IFRS by

2016. Japan has already made some progress in narrowing the differences in Japanese

accounting standards with IFRS and U.S. standards.

At some point in the future Japan will reconsider the adoption of IFRS. When a

decision is made and an adoption date is selected there is expected to be a five to seven year

grace period. Some sectors of Japanese industry are resistant to the mandatory

implementation of IFRS. Japan is also waiting to see how the adoption of IFRS is applied in

other countries, particularly the U.S. However, the decision to convert to IFRS, an adoption

date and time and the role the FASB will play in the adoption of IFRS in the U.S. is still

unsettled as of this writing.

Even if the U.S. arrives at a decision before Japan does, it is in the best interests of

Japan to pursue a path to the adoption of IFRS that is right for Japan. Since the primary

purpose of IFRS is to provide a single set of accounting standards which provide useful

information to investors, IFRS is appropriately applied to those firms that issue publicly

available financial statements. The majority of the firms in Japan do not issue consolidated


69

financial statements to the public and should not have the additional cost and administrative

burden of preparing IFRS’s based financial statements. Perhaps the process of adopting

IFRS in Japan shows that successful development and application of a single set of global

accounting standards is not just an exercise on paper, but in the end must take place within

the context of the economic realities of each country and jurisdiction.

REFERENCES

Accounting Standards Board in Japan (2009). http://www.asb.or.jp/index_e.php.

Financial Services Agency (2009). Tentative and unofficial summary prepared by JFSA staff -June

12, 2009-Application of International Financial Reporting Standards (IFRS) in Japan

(Summary). http://www.fsa.go.jp/en/news/2009/20090612-3/01.pdf.

HLB International Limited (2011). Japanese Government Announces Delay of IFRS Adoption.

HLB Meisei’s website,

http://www.hlbi.com/index.php?option=com_content&view=article&id=567:japanese-

government-announces-delay-of-ifrs-adoption.

International Accounting Standards Board (2009). Japan takes major step towards IFRS adoption

(12 June)

http://www.iasb.org/News/Announcements+and+Speeches/Japan+takes+major+step+towar

ds+IFRS+adoption.htm.

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Japan. http://www.hp.jicpa.or.jp/english/archives/e-account.html.

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to IFRS (August) http://www.journalofaccountancy.com/Issues/2011/Aug/20114208.

Journal of Accountancy (2011b). AICPA: Allow U.S. Companies the IFRS Option Now (October

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Journal of Accountancy (2011e). FASB, IASB Chiefs Agree New Convergence Model is Needed

(December 6) http://www.journalofaccountancy.com/Web/20114869.

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financial-news.com/accounting/the-accountant/issues/ta-2011/ta-6091/japan-delays-ifrs-

road-map.aspx.

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http://www.journalofaccountancy.com/Web/20125186.htm


Vol. 5, No. 1; Fall 2012

70

ISSUES WITH MANDATORY AUDIT FIRM ROTATION

Homer L. Bates

Bobby E. Waldrup

David G. Jaeger

University of North Florida

Vincent Shea

St. Johns University

ABSTRACT

Mandatory audit firm rotation has been discussed by accounting academics,

regulators and practitioners for decades. Recently, the Chairman of the PCAOB and the

former head of the SEC have stated support for the concept because of the perception that

long-term auditor/client tenure may signify decreased objectivity. This paper examines the

rotation issue from a historical and international perspective. The background of the rotation

issue is discussed along with a brief sample of the mixed prior research findings. Auditor

rotation rules and laws in countries with the largest GDP are also examined and discussed.

Finally, as a result of this examination, the authors recommend a very long mandatory

auditor rotation period of 12 to 20 years in order to increase the perception of objectivity

without significantly increasing long-term costs. A potential future research topic would be

to examine the present status of the mandatory audit firm rotation issue by accounting rule

makers in other large industrialized countries.

INTRODUCTION

Mandatory auditor rotation has been discussed by members of the accounting

profession and by the various users of accounting information for decades. Congress

considered including mandatory audit firm rotation in the Sarbanes-Oxley legislation, but

instead opted for partner-in-charge rotation. In the United States, Sarbanes-Oxley requires

that the in-charge partner be rotated every five years but does not require the audit firm to be

changed. Last August, James R. Doty, the Chairman of the five-member Public Company

Accounting Oversight Board (PCAOB), proposed mandatory auditor rotation as a means of

enhancing “… auditor independence, objectivity and professional skepticism.” Arthur

Levitt, former SEC head, in a recent Wall Street Journal interview (2011) expressed his view

that audit firms should be rotated every ten years. Michel Barnier, the European Union’s

commissioner for the internal market, has also raised the issue of requiring mandatory audit

firm rotation among European Union member countries, along with splitting up the top four

international audit firms (Huw Jones, Reuters, 2011).

The rotation issue has also received considerable recent attention in the financial

media. In the September 3, 2011 issue of The Economist (author unknown), the reporter

showed ambivalence by stating: “Mandatory rotation would probably not do much harm;

but it might well not do much good either.” (2011). The issue was also discussed by a

columnist for The New York Times in the August 17, 2011 issue (author unknown) in an

article with the headline “Accounting Board to Seek Comments on Rotating Auditors.”

(2011).


71

Elected politicians have also got involved in the mandatory auditor issue.

Representative Michael Fitzpatrick (R, Pa.) introduced legislation in March 2012 that would

prohibit the PCAOB from requiring the use of different auditors on a rotating basis.

Representative Fitzpatrick’s argument is that rotation would increase audit costs and would

deprive the company of the auditor’s company-based knowledge that comes from a long-

term audit-client relationship.

One of the primary rationales for the increased interest in mandatory rotation is the

perception that a long, close relationship between the audit firm and the company being

audited may lead to significantly decreased objectivity. In the United States, for example,

GE, Proctor and Gamble, Dow Chemical and four other corporations in the Standard and

Poor’s 500 index have used the same audit firm for over 100 years. Nearly 175 companies in

the index have had the same audit firm for 25 years or more. For companies included in the

Russell 1000, over 36 percent have retained the same external auditors for 21 years or more

(Brookings Institute, 2012). On the international front, the average tenure for an audit firm of

a company in the British FTSE 100 is 48 years. In Germany, over 60% of the companies in

the DAX 30 index have used the same audit firm for over 20 years.

Ghosh and Moon (Ghosh and Moon, 2005) examined the perception of audit tenure

by investors and financial analysts. Their results show that investors and analysts view long

audit tenure as favorably impacting earnings quality. They argue that since stock market

participants view long tenure as a positive that mandatory audit firm rotation might result in

unnecessary additional costs without any substantial additional benefits.

The primary argument against mandatory auditor rotation is the cost of a new auditor.

CFO.com (Johnson, 2012) reported that in 2003 it was estimated that a change in auditors

can add 20% to the initial cost of an audit. Another argument against rotation is that a

company’s auditor choice would be decreased. Most large corporations prefer to be audited

by one of the Big Four audit firms. Sarbanes-Oxley requires that the company select another

accounting firm for nonaccounting consulting services. If a company is being audited by one

of the Big Four and another Big Four firm is providing consulting services, then the choice

when changing auditors would be between only two audit firms.

The first section of this paper will examine the historical perspective of the audit firm

rotation issue. The second section will view audit firm rotation from an international

perspective. The third section will examine a small sample of the empirical research

regarding audit firm rotation. The two major issues are: whether rotation decreases audit

failure and whether the benefits of rotation are greater than the incremental costs. The final

section will be conclusions, recommendations and suggestions for future research.

BACKGROUND

The auditor rotation issue has been examined by accountants and accounting

researchers for decades. In 1961, Mautz and Sharaf suggested that a long association with

the same client may lead to problems with auditor independence. The U.S. Senate examined

the issue in 1976 and proposed a mandatory change of auditors after a period of time. No

actions were taken by Congress. In the mid-1990’s, the SEC examined the adverse effects of

long term auditor tenure but, again, took no action.

Bates, Waldrup, Jaeger, and Shea

72

During the Sarbanes-Oxley (SOX) discussions of 2002, mandatory auditor rotation

was considered, but it was ultimately decided that mandatory audit partner rotation was

sufficient. The Act requires that the chief decision maker on an audit engagement of a public

company rotate off of the audit every five years and remain off the audit for a five year

“cooling-off” period. The Congress did direct the General Accounting Office (GAO) to

prepare a report on mandatory audit firm rotation, and the 2003 report noted that the SEC

would need several years of SOX reforms data to determine if further actions were necessary.

As of June, 2011, the PCAOB created by SOX had conducted annual inspections of

the largest audit firms for eight years, reviewing over 2,800 engagements. They also

conducted over 1,500 inspections of smaller domestic and non-U.S. firms. Jim Doty, the

PCAOB Chair, stated that “Based on this work… it is incumbent on the PCAOB to take up

the debate about firm tenure and examine it with rigorous analysis…” (2011). Other

members of the Board had doubts about the concept because of the additional costs of getting

new auditors up to speed. Member Daniel L. Goelzer stated, “I have serious doubts that

across-the-board mandatory rotation is a practical or cost-effective way of strengthening

independence.” (2011) He argued instead for a more tailored approach, perhaps requiring

rotation when a PCAOB inspection finds a lack of auditor skepticism.

INTERNATIONAL PERSPECTIVE

Audit firm rotation has been examined by the accounting regulatory agencies in most

large industrialized countries and has been rejected. As shown in Table 1, only four of the

largest fifteen countries ranked by GDP have a requirement that audit firms be rotated.

Brazil, Italy, India and South Korea require audit firm rotation; the other eleven countries

including the U.S. and the United Kingdom do not. It is interesting to note that Canada and

Spain required mandatory audit firm rotation at one time, but subsequently repealed the

requirement.

One factor in Spain’s decision was the lack of evidence of the benefits of rotation.

Ruiz-Barbadillo, Gomez-Aquilar, and Carrera (2009) examined Spain’s mandatory audit firm

rotation policy from 1988 to 1995. They found no evidence in favor of mandatory audit

rotation and concluded that, “… our results provide empirical support for the arguments put

forward by opponents of mandatory rotation.”

Kwon, Lim and Simnett (2010) examined the results of the mandatory audit firm

rotation policy in South Korea. They looked at over twelve thousand firm-years of

observations between 2000 and 2007. Since mandatory audit firm rotation began in 2006,

they found that audit hours have increased, audit fees have increased, and audit quality has

remained unchanged or decreased slightly. They concluded that “… mandatory audit firm

rotation … (has) no discernible positive effect on audit quality.”

AUDIT ROTATION RESEARCH FINDINGS

Research into the effects of auditor rotation has had contradictory results. In 1982,

Bates, Ingram and Reckers (1982) conducted a behavioral study using sixty-seven practicing

CPA’s operating in the U.S. and found that “… the rotation of audit firm employees was

found as effective … as audit firm rotation. This study showed the need for auditor rotation

to offset the psychological effect resulting from a long-term auditor-client relationship.


73

However, partner rotation was found to be as effective as audit firm rotation. Those findings

support the accounting profession’s position against mandatory audit firm rotation.” In a

2006 study, Gates, Lowe and Reckers found opposite results and reported “… audit firm

rotation incrementally influenced individuals’ confidence in financial statements. However,

audit partner rotation did not have a similar effect” (2006).

Table 1

Auditor Rotation Rules1 for Largest Countries by GDP

2

Country Ranked by GDP Audit Firm Rotation Rule

1. United States No Mandatory Audit Firm Rotation

2. China No Mandatory Audit Firm Rotation

3. Japan No Mandatory Audit Firm Rotation

4. Germany No Mandatory Audit Firm Rotation

5. France No Mandatory Audit Firm Rotation

6. United Kingdom No Mandatory Audit Firm Rotation

7. Brazil Yes, Banks and Listed Companies every 5 years

8. Italy Yes, Listed Companies and Other Firms Identified

by Law every 9 Years

9. India Yes, Banks, Privatized Insurance Companies and

Government Companies every 4 Years

10. Canada No Mandatory Audit Firm Rotation, Until 1991,

Banks were required to Rotate Audit Firms

11. Russia No Mandatory Audit Firm Rotation

12. Spain No Mandatory Audit Firm Rotation, From 1988 –

1995, Listed Companies were Required to Rotate

Audit Firms every 9 Years

13. Australia No Mandatory Audit Firm Rotation

14. Mexico No Mandatory Audit Firm Rotation

15. South Korea Yes, Listed Companies are Required to Rotate Audit

Firms every 6 Years

1 Wikipedia, List of Countries by GDP (PPP), accessed February 5, 2012.

2 Deloitte LLP, Letter to PCAOB 12/8/11 regarding Public Comment on Concept

Release on Auditor Independence and Audit Firm Rotation. Appendix 2, pages 1-4.

Audit quality may be indirectly measured by the number of audit restatements. If

auditor rotation brings new eyes to the audited company, one would anticipate new findings

and therefore increased restatements. In a 2003 study (Myers, et al, 2003), the authors

examined 562 companies that announced restatements between January 1997 and October

Bates, Waldrup, Jaeger, and Shea

74

2001. They concluded that “…our results do not support arguments made by proponents of

mandatory rotation – that auditor expertise or incentives to detect or reveal misstatements

decline with the lengthening of the auditor-client relationship” (p. 24).

Stefaniak, et al. (2009) examined all different types of auditor switching including

mandatory audit rotation. They summarized nineteen different studies and examined

evidence in support of and against mandatory auditor rotation. They concluded that “… the

majority of the evidence does not support the implementation of a mandatory audit firm

rotation regime in the U. S.”

CONCLUSIONS AND RECOMMENDATIONS

Mandatory audit firm rotation has been a hotly debated issue in the United States for

decades. There is a paucity of published research which shows that mandatory rotation has a

positive effect on the quality or the costs of audits. However, it is the belief of the authors

that the public views very long audit – client relationships negatively. An auditor for 50, 75,

100 consecutive years cannot be viewed as a completely independent examiner of a firm’s

financial records. Such a long-term auditor is more like a subsidiary of the audited firm, than

a professional independent examiner. For perception’s sake, audit firms should be rotated

periodically, but not every 5, 6, 9 years. We propose a mandatory rotation every 12, 15, or

20 years.

This proposal is consistent with a recommendation made by the Brookings Institute

(Pozen, 2012). They refer to their approach as an “Intermediate Approach to the Auditor

Rotation Issue.” Their proposal is that the firm’s independent audit committees periodically

issue a request for proposal (RFP) for the audit engagement. The existing auditor would not

be excluded from bidding on the RFP. They propose that the RFP be issued every 15 years.

The additional long-term costs incurred would be minimal because of the 15 year rotation

period. This proposal would also more closely tie the external auditor to the audit committee

rather than corporate management.

In light of the SEC’s proposed convergence between GAAP and IFRS, mandatory

audit rotation in other industrialized countries would be of considerable interest and should

be examined in more depth. Only four of the largest fifteen countries require mandatory

audit firm rotation. An issue of considerable interest would be the present status of the

mandatory audit firm rotation issue in the other large industrialized countries. This is of

particular interest because of the U. S.‘s convergence to International Financial Reporting

Standards. We did not examine whether the other industrialized countries are presently

considering this important issue as seriously as is the United States.

REFERENCES

Bates, H., Ingram, R., & Reckers, P.M.J. (1982) Auditor-Client Affiliation: The Impact on

Materiality. Journal of Accountancy, 153, April, 1982, pp. 60-63.

Cameran, M., Merlotti, E., &Di Vincenzo, D. (2005) The Audit Firm Rotation Rule: A Review of

the Literature. Working Paper, SDA Bocconi School of Management. September, 2005.

Deloitte & Touche LLP. (2011) Letter to Mr. J. Gordon Seymour. “Re: Request for Public Comment

on: Concept Release on Auditor Independence and Audit Firm Rotation (PCAOB Release

No.2011-006, PCAOB Rulemaking Docket Matter No. 37).” December 8, 2011.


75

Doty, J. (2011). Speech before SEC and Financial Reporting Institute Annual Conference, Pasadena,

California. June 2, 2011.

Gates, S. K., Lowe, D. J., & Reckers, P.M.J. (2006). Restoring Public Confidence in Capital

Markets Through Auditor Rotation. Managerial Auditing Journal, 22, 5-17.

Ghosh, A. & Moon, D. (2005). Auditor Tenure and Perceptions of Audit Quality. The Accounting

Review, 80, Issue 2, 585-612.

Goelzer, D. L. (2011). Speech before Association of Audit Committee Members Annual Meeting,

New York, NY. June 2, 2011.

Huw, J. (2011) Big Four Auditors Face Breakup to Restore Trust. Reuters. November 30, 2011.

Johnson, S. (2012) CFOs Shout Down Idea of Mandatory Auditor Rotation. CFO.com. Auditing.

March 14, 2012.

Kwon, S.Y., Lim, Y.D., & Simnett, R. (2010). Mandatory Audit Firm Rotation and Audit Quality:

Evidence from the Korean Audit Market. Working Paper, November 2010. 1-41.

Levitt, A. (2011) Wall Street Journal Interview, p. B5, October 19, 2011.

Myers, J., Myers, N. L., Palmrose, Z., & S. Scholz, S. (2003) Mandatory Auditor Rotation: Evidence

from Restatements. Working Paper, University of Illinois at Urbana-Champaign. December,

2003.

Pozen, R. C., (2012) An Intermediate Approach to the Auditor Rotation Issue. Brookings Opinion.

April 9, 2012.

Ruiz-Barbadillo, E., Gomez-Aquilar, N., & Carrera, N. (2009). Does Mandatory Audit Firm

Rotation Enhance Auditor Independence? Evidence from Spain. Auditing, 28, Issue 1, 113-

135.

Stefaniak, C., Robertson, J., & Houston, R. (2009). The Causes and Consequences of Auditor

Switching: A Review of the Literature. Journal of Accounting Literature, 28, 4-121.

Unknown Author. (2011) Musical Chairs: Auditor Rotation. The Economist, p. 73. September 3,

2011.

Wikipedia, the free encyclopedia. List of Countries by GDP (PPP), accessed February 5, 2012.

Wyatt, E. (2011) Accounting Board to Seek Comments on Rotating Auditors. The New York Times,

New York Edition, page B3. August 16, 1011.


Vol. 5, No. 1; Fall 2012

76

THE IMPACT OF TAX INCENTIVES ON THE LOCATION OF

MANUFACTURING FACILITIES

Juan Luis Jay Ramirez

CPA, Master of Business Taxation from University of Southern California

Anwar Y. Salimi

Hassan Hefzi

California State Polytechnic University, Pomona

ABSTRACT

This paper illustrates the factors considered by U.S. manufacturing corporations in

determining where to locate a new manufacturing facility. The U.S. government, state

government, local governing bodies, and foreign governments offer a variety of incentives to

persuade companies to locate manufacturing facilities within their borders. The American

Jobs Creation Act is an example of an incentive at the federal level that was put in place to

trigger investment within the U.S. Many states have their own incentives, such as

California’s Manufacturer’s Investment Credit (MIC), which offers a credit against

California income tax based on the purchase and use of property in a manufacturing process

in California. Foreign countries are also involved in similar practices. They negotiate

specific incentive packages in the form of tax breaks or government grants in order to attract

multinational manufacturers and the multitude of jobs that a manufacturing facility can bring.

Contrary to the expectations, this paper shows that taxes and government incentives appear to

be only one of the factors considered by U.S. manufacturers in deciding where they will

locate their manufacturing operations. The choice of location appears to be driven by a

variety of business factors, and taxes are only one such factor. Taxes and incentives

definitely appear to be contributing factors but they are not the most important factors in the

decision making process.

INTRODUCTION

Many governing jurisdictions including the U.S. federal government, state

governments, and foreign governments have recognized the benefits of having manufacturing

facilities within their borders. Manufacturing facilities offer a variety of benefits to the

government and its constituents. These benefits include additional income tax revenue,

property tax revenue, sales tax revenue, jobs for a wide range of constituents from the highly

educated to the unskilled or semi-skilled, and personal income tax revenue for the additional

jobs created within the government’s borders. Governments have been faced with the tax

version of the chicken or egg question. In order to increase tax revenue, more businesses

need to be attracted into the area. However, in order to attract new businesses, the

government needs to reduce taxes. Different governments have chosen to answer this

question in very different ways. The U.S. has a different situation compared to other

countries because only in the last few decades has the U.S. chosen to consider that its

constituents may choose to invest outside its borders. This is due to the fact that U.S. has the

benefit of owning the single largest industrial capital base along with the world’s largest

single consumer market. As a result, the tax history of the U.S. has been based on internal


77

politics rather than reacting to or anticipating external forces. Current U.S. tax legislation

still mirrors this focus on internal politics and the use of incentives to deliver on the wants

and desires of certain interests.

In a global economy that is shrinking on a daily basis, manufacturers have a wide

array of factors to consider in determining where to locate a manufacturing facility. Some

factors will definitely be more important than others depending on industry. For instance, a

steel manufacturer will need to be closer to customers than a semiconductor manufacturer.

Another factor to be considered is the cost of labor. Though low labor rates are considered

universally important, they are much more important in low technology industries which rely

on manual labor than they are to high technology industries which rely on automated labor

(robot assembly lines).

Given the wide variety of factors which impact a corporation’s manufacturing costs,

taxes and government incentives may or may not be an important enough factor to alter a

company’s decision making in determining where to put a manufacturing facility.

Manufacturers may consider more direct costs such as labor rates or availability of labor to

be more important in considering where to make the large investment of building a factory.

The global economy has set governments to compete against each other for

investment dollars. There are various factors at work which will impact a manufacturer’s

decision on where to locate its next plant.

By having a better understanding of what motivates manufacturers, a government

(federal, state, or foreign) can focus the actual incentive dollars that it gives out or it can

better focus the time spent on pursuing potential investors. A better focus of actual incentive

dollars is important to avoid programs that do not actually generate additional investment. A

better understanding of the manufacturers’ motivations can allow governing bodies to focus

their efforts on industries in which they can be competitive. This means that the state seeks

out companies in industries that might find them as an attractive location even if there were

no incentive.

Results of this study may be important to governments as they try to tailor their

incentives. What is important to one type of manufacturer may not be important to another

type of manufacturer.

The remainder of the paper is organized as follows: Section 2 provides review of

existing literature addressing incentives to manufacturing facilities and develops the

hypothesis. Section 3 presents the methodology of the study. The results are presented in

section 4 and a summary, conclusion, and recommendations are included in section 5.

LITERATURE REVIEW AND HYPOTHESIS

Manufacturing Incentives: Few existing studies have investigated the decision-

making process for locating manufacturing facilities. Ondrich and Wasylenko (1993)

reviewed actual foreign direct investment (FDI) activity in the U.S. from 1978 to 1987 and

drew conclusions from that activity. They investigated the factors that are important to

foreign companies when determining where to build a factory in the U.S. They concluded

that foreign investors located new factories in places where a similar factory (though owned

by the competition) already existed. The reason for this appeared to be that foreign investors

chose to take advantage of existing infrastructure and a workforce which was already

Ramirez, Salimi, and Hefzi

78

experienced in their particular industry. Also, foreign investors favored lower tax

jurisdictions over higher tax jurisdictions. However, they did not favor lower labor rates over

higher labor rates. In our study, all participants had chosen to manufacture in the U.S. and

the labor rates within the U.S. vary only to a small degree from one state to the next. When

comparing the labor rates of the U.S. to those of other countries, there is a great deal of

variety. Therefore, we expect that labor rates should prove to be an important criterion in

determining where to build a manufacturing facility for the participants in the proposed

study.

MacCarthy and Atthirawong (2003) asked participants about the main motivation for

seeking to manufacture internationally. The results were to have access to low cost labor and

specific labor skills; to have access to foreign markets; to get tax incentives and benefits; to

have access to host raw materials and technology; and to counterattack against competitors

Two key differences exist between this study and our study. The first difference is

that the initial question made in this study presupposes a desire to manufacture abroad. In

our research, we ask about the factors that are important in determining where to build a new

facility. Though the results listed above may be important to the participants in our study, all

factors may be outweighed by some other factor that necessitates manufacturing within the

U.S. The survey conducted above would have missed this other possibility completely

because it never considered the possibility of manufacturing in the U. S. instead of abroad.

The second difference is that this study limited itself to participants that are doing

business or considering doing business in Asia (may or may not have been U.S.

corporations). In our study, this is not the case. The participants are U.S. corporations that

may or may not ever choose to manufacture in Asia.

State Incentives: The literature has a multitude of examples of state incentives. One

of the most newsworthy incentives was the one given by the state of Alabama to Mercedes

Benz in order to host the first Mercedes plant outside of Germany (Myerson, 1996). This

incentive was newsworthy because it was very large. The total incentive including land,

worker training, site improvement, purchase of Mercedes Benz vehicles and other incentives

was over $500 million.

Foreign Strategies: Dorgan (2006) outlined Ireland’s rise from “one of the poorest

countries in Western Europe to one of the most successful.” The study credits sensible and

pragmatic policies for Ireland’s rise with three key factors at the heart of these policies.

These policies were belief in economic openness to global markets, low tax rates, and

investment in education. Ireland’s historic policy of low taxes was a key in its economic

climb. Currently, Ireland has one of the lowest corporate standard tax rates in Europe. Its

corporate tax rate is a maximum of 12.5%.

Teoh and Seah (2009) provided substantial background on Singapore’s business

climate and its use of tax incentives to drive the Singapore economy in specific directions.

“Foreign direct investment in Singapore was valued at S$363.9 Billion [approximately U.S.

$260B] as of the end of 2006, with the bulk of the direct investment being in financial

services and manufacturing.” Singapore has focused tax incentive program, which negotiates

tax incentives for favorable industries or activities. These tax incentives are generally in the

form of exemption from income tax and reducing tax rates to between 5 percent and 10


79

percent. Singapore not only drives foreign investment through specific tax incentives, it also

drives foreign investment through its development of Singapore’s infrastructure.

Greider (1997) discussed globalization and the way that states and countries have

dealt with that globalization. He specifically discussed the Malaysian semiconductor

industry as an example of both the benefits and detriments of globalization. In the early

1970’s American semiconductor companies made the decision to move to Malaysia as a new

low wage locale for final assembly of products. Japanese firms followed as they were

seeking to move manufacturing costs offshore to offset the rising yen. Malaysia established

“Pioneer” status for the semiconductor industry in order to secure its status as a major export

platform. This status meant no income tax for 5 to 10 years, exemption from import duties,

and other forms of state subsidies. The benefits would expire but could be renegotiated and

extended if the company promised to make new investments such as plant expansions and

new jobs within Malaysia.

Another key attraction of Malaysia, though a controversial one, was the government’s

guarantee that electronics workers would be prohibited from unionizing.

Hypothesis: Based on the previous discussion, this paper states its hypothesis in the

null format:

“Tax and other government incentives are not the first factor considered when

corporations decide where to locate a manufacturing facility.”

METHODOLOGY

Sample and Procedure: This study focuses on large manufacturers headquartered

within the U.S. Publication and library research was conducted from September 2008 to

January 2010. Data research is the primary method used for this study.

Research Design: Data analysis is the primary method of strategy used for this study.

The main research data consists of primary data. The purpose of the study is to gather

feedback from U.S. headquartered manufacturers on what they consider to be the most

important factors in determining where to locate a manufacturing facility.

Research Method: A survey was administered to large U.S. manufacturers. The

survey consists of a list of 14 factors considered to be common factors in determining where

to locate a new manufacturing facility. In addition to the factors included in the survey, an

additional blank is added labeled “Other” which gives the participant the ability to add any

other factors that they think are relevant. The participants are asked to rank each criterion in

order of importance in determining where to locate a manufacturing facility. The survey

included the following criteria for the consideration of the participants:

1. Customer demands Proximity to customer facilities

Proximity to customer’s 3rd party logistics service

Proximity to customer designated suppliers

2. Supply Inputs Cost of local workforce

Proximity to raw materials


80

Proximity to supplier

Cost of local raw materials

Quality of local infrastructure (i.e., dependable energy supply)

3. Facility requirements Cost of land

Cost of building a facility (local construction costs)

Cost of available facility (purchase or rent from third party)

Proximity to transportation services (shipping, air or train)

4. Government and Regulatory Issues Favorable government regulations or requirements

Tax rates, credits or negotiated tax holidays

Population: The survey questionnaire was sent to 99 corporations identified as the

largest manufacturers in the U.S. For purposes of this study, a list of “large” U.S.

manufacturers was generated using the list of the 500 largest manufacturers in the U.S., as

determined by Industry Week magazine. The list used for this study was for the year 2003 to

2004. The corporations on the list from the states of California, Texas, and Washington

were originally used for this study. The original mailing took place on September 15th 2009.

The survey was sent soliciting anonymous responses in order to increase the response rate

and allow for more candid responses from participants. The original 99 mailings resulted in

only 19 responses.

A second set of mailings was sent to 54 more corporations. Fifty-one of these

corporations were selected at random from Industry Week’s top 500 manufacturers list. The

population for random selection excluded manufacturers in California, Washington and

Texas because corporations from these states were already captured in the first mailing. An

additional three were sent to manufacturing corporations in which the researcher has personal

contacts. An additional 13 responses were received from this second set of mailings.

RESULTS

Descriptive information: Results of this study show that although tax is one of the

factors that is considered by decision makers, it is not the most important factor considered in

determining where to locate a new facility. Table 1 lists the factors used in the survey along

with their Average Importance Score, Highest Score on any Survey, Lowest Score on any

Survey, Geometric Mean and Standard Deviation.

Order of Results: Each criterion shows a separate theme in the decision making of

the participants in the survey. The fact that the cost of labor and infrastructure are ranked

first and second is important to analyze because in some ways these two criteria can be

considered inversely related. The cost of labor seems like a likely choice for the most

important criteria as most corporations seek to cut costs, cost of labor is likely to be a very

large component of overall costs. The requirement for infrastructure seems to go hand in

hand with higher labor costs, not lower labor costs.

Labor tends to be less expensive where populations are higher. Two examples are

China and India. An abundance of available labor keeps labor rates low under the simple


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rule of supply and demand. Higher populations have a supply of labor that outweighs

demand. This tends to push labor costs down.

Table 1: Table of Findings Rank Factor Category Average

Importance

Score

Highest

Score

on any

Survey

Lowest

Score on

any Survey

Geometric

Mean

Standard

Deviation

1 Cost of local

workforce

Supply Inputs 3.17 1 7 2.5276 2.0372

2 Quality of local

infrastructure (ie

dependable

energy supply)

Supply Inputs 4.74 1 10 3.8871

2.7172

3 Favorable

government

regulations or

requirements

Government

and

Regulatory

Issues

5.35

1 13 4.2319

3.4851

4 Tax rates, credits

or negotiated tax

holidays

Government

and

Regulatory

Issues

6.13

1 14 4.5435

4.1812

5 Proximity to

transportation

services (shipping,

air or train)

Facility

requirements

6.78 2 15 6.2676

3.5444

6 Cost of available

facility (purchase

or rent from third

party)

Facility

requirements

7.00 1 13 5.9879

3.8593

7 Proximity to raw

materials


3.6799

8 Cost of local raw

materials


4.5774

9 Proximity to

supplier


3.7506

10 Cost of land Facility

requirements

8.65

1 15 7.5283

3.7125

11 Cost of building a

facility (local

construction

costs)

Facility

requirements

8.74 2 15 7.7105

3.7805

12 Proximity to

customer facilities

Customer

demands

9.09 1 15 7.2393

4.2844

13 Proximity to

customer’s 3rd

party logistics

service

Customer

demands

10.83 3 15 9.8148

3.8097

14 Proximity to

customer

designated

supplier

Customer

demands

11.26 3 15 10.2597

4.0589

Table 1 above shows multiple points that need to be identified and explored.


82

Low labor rates tend to lead to less investment in fixed assets such as machinery.

Less investment in machinery over time leaves a country behind in terms of infrastructure.

Therefore, the lowest labor rates usually come in areas with substantially less infrastructure.

Since labor and infrastructure are required for successful manufacturing activities, a

manufacturer must choose the correct mix between the two inversely related criteria. The

lower the labor rates, the lower the level of infrastructure. Low labor rates may be enticing

to a manufacturer but only if there is sufficient infrastructure to guarantee a consistent flow

of products. For example, regular power shortages and lack of maintained roads for

transporting goods will sway corporations away from a location regardless of how low the

labor rates may be.

Even for low technology manufacturers, the push for lower labor rates can have

catastrophic results if it is pursued without concern for the product consistency generated in

countries that have a proven infrastructure. Manufacturers that require higher technology

will tend to limit their search for lower labor rates in order to maintain high levels of

infrastructure. The fact that cost of labor and infrastructure ranked first and second shows

that manufacturers are searching for the proper mix between the two factors.

Favorable government regulations or requirements took the third rank in the list, and

it is exemplified in the Malaysia example discussed in the Literature Review. One of the

reasons the semiconductor industry flocked to Malaysia was the Malaysian government’s

guarantee that unions would not be allowed to enter the semiconductor industry. This was a

big concern for the industry because their experience was that unions negatively impacted

profits by increasing wages. Another favorable regulation could be the lack of fixed pension

laws in Malaysia which could make the cost of labor much higher. Favorable government

regulations also applied in the case of the auto industry in the South. Manufacturing in

Germany is very expensive not only because of the wages earned by German workers but

also because of the mandatory pension funding requirement for German workers. These

requirements make German manufacturing much more expensive and are likely a big reason

that Mercedes and BMW chose to build plants outside of Germany. Taxes and incentives

took the fourth spot and are discussed at length in a later section.

Proximity to transportation services was ranked fifth and it is a factor that is likely to

have high importance to some industries while having a much lower importance to others.

There is a cost to moving manufactured goods however for some products which are heavy,

perishable or dangerous to move, transportation is a much higher cost of delivering the

products to customers.

The cost of an available facility took the sixth rank. The cost of a facility can be very

important especially in cases in which a facility has strict requirements. One case is the

manufacture of power management chips (example International Rectifier). These chips are

manufactured with clean rooms in ways that are very similar to memory chips manufactured

by companies like Intel but they require a lower level of precision. This industry uses

technology that is behind that used in memory chips. The result is that this industry tends to

move into former memory chip facilities as these facilities become obsolete for the

manufacture of memory chips. The power management chip manufacturers buy these

facilities for a dramatically lower cost than the cost of building a brand new factory. The

availability of these facilities dictates where they will manufacture.


83

Proximity to raw materials came in at rank seven. This could be very important in an

industry where the goods manufactured are much cheaper and easier to transport than the raw

materials. In this case, the manufacturer will locate its facility near the raw materials in order

minimize the cost of moving the raw materials. One example could be the timber industry

which cuts trees then cuts them into usable planks. Uniform planks are the product that will

be delivered to the customer. It is much easier, and therefore cheaper, to create the product

near the source of the raw material (trees) than to move large logs to a factory that is closer to

the customers.

Cost of local raw materials came in eighth place. It is very important to industries in

which the fluctuations in one cost can make or break the manufacturer’s profitability. This is

the case with the aluminum smelting industry, which tends to locate itself in areas in which

the main input is inexpensive.

Proximity to supplier was ranked nine. This is likely important to companies in

which the supply of inputs is scarce or the inputs are more expensive to move than the

finished products. The manufacturer will choose to locate itself near its suppliers in order to

reduce costs. A manufacturer could also get a competitive advantage by being close to many

suppliers. In some cases this is very similar to being close to raw materials. One example

could be paper mills which tend to be located in areas where the timber industry is prevalent.

In some cases, they may be linked directly to a logging company as a separate division or a

company with joint ownership.

The cost of land ranked tenth, and although it is not the main motivation for most

manufacturers, it can be a factor. Manufacturers tend to never be located where land is

expensive because of the large amount of land they usually require in order to run their

operations. Manufacturers tend to located in more rural areas. Note that all of the foreign

auto industry plants that have arisen in the U.S. have been built in the South where land is

relatively inexpensive. In addition, most of these manufacturers were able to get local

governments to acquire the land for them.

The cost of building a facility ranked eleventh among the factors. This factor can be

linked with the cost of buying a facility. In cases in which a facility has expensive

requirements, the manufacturer will consider the cost of building very important if there is no

readymade facility available to purchase. This is the case for most specialized high

technology industries

Proximity to customer facilities ranked twelfth. This factor is considered important

for manufacturers that are required to deliver their product under time constraints as part of

the customer’s manufacturing process. An example might be a company that manufacturers

sterilized bottles for a pharmaceutical company. The sterilized bottles need to arrive at a key

point in the customer’s manufacturing process. As a result, proximity would be a coveted

attribute of any location for a new manufacturing facility. Greater distances lead to larger

risks of late deliveries or contamination of the product. This could also be the case for

manufacturers of automobile inputs.

Proximity to a customer’s third party logistics service ranked thirteenth. It could be

important to a customer that is manufacturing perishable goods for a large customer that uses

those goods throughout the world. For example, a company that manufactures products for a

customer that uses FedEx as its logistics service provider might want to locate its


84

manufacturing location near FedEx’s Tennessee hub regardless of the cost of manufacturing

there. It may well be that the customer demands that manufacturing be conducted in

Tennessee and is willing to pay a premium to make sure that it is properly supplied.

Proximity to a third party supplier ranked last and it is conceptually similar to the

requirement to be close to the customer. In the case of the auto industry and its movements

to just-in-time, many auto manufacturers such as Ford have chosen to have their vendors

move into tiers in order to streamline their procurement process. A first tier provider may

manufacture a whole steering housing which may require inputs from a second tier provider.

The first tier provider becomes the customer of the second tier provider in place of Ford. In

this case, a second tier provider that manufactures a part of the steering housing may need to

locate its facilities near the first tier provider.

Distribution of Results: Among a wide variety of manufacturers, a wide variety of

criteria are the most important in the decision making process. Note that among the 14

criteria for decision-making, nine of the criteria were ranked first for at least one company.

Even the criteria that ranked fourteenth, the proximity to customer designated supplier,

ranked as high as third for at least one company. This shows that different industries have

very different decision making criteria. This fact may be important to governments as they

try to tailor their incentives. What is important to one type of manufacturer may not be

important to another type of manufacturer.

The means and the standard deviations offer some additional insight into the

consistency among the respondents. The lower the standard deviation of the factor, the

greater the consistency among respondents for this factor. The first criteria considered for

locating a manufacturing facility - the cost of the local workforce - had the lowest standard

deviation of 2.0372. This means that it was consistently ranked as important by responders.

The same is true for the criteria which ranked second, quality of local infrastructure. It had

the second lowest standard deviation of 2.7172. These two factors were the clear leaders in

consistency as well as ranking.

The highest standard deviation was generated by the eighth ranked criteria, cost of

local raw materials. This criteria ranked anywhere between 1 and 15 by the responders and

its standard deviation of 4.5774 indicated that it had much less consistency in its rank among

the respondents than any other criteria. This may be linked to the wide array of

manufacturers used in the survey. As explained above, the value of this criterion can be

industry specific.

Tax rates, credits, or negotiated tax holidays had a surprisingly high standard

deviation considering that it placed fourth in importance among all criteria. Its standard

deviation was 4.1812, which means that it was valued very differently by most respondents.

This standard deviation was third highest of all criteria behind cost of local raw materials and

proximity to customer facilities. This may be due to the varying tax positions of the

responders. Corporations with high net operating losses or large amounts of tax credit carry-

forwards may not value tax benefits as highly as those that are currently paying taxes.

Lack of Importance of Customer Demands: Among the 14 criteria offered to

survey participants, it is important to note that the three criteria categorized as Customer

Demands resulted as the least important factors in the survey. This may be the case for

various reasons. The first possibility is that large manufacturers tend not to be tied to one


85

customer. If any of the manufacturers were tied to a limited number of customers, then we

would expect that the proximity to the customer, its logistics service, or its suppliers would

be much more important on this list.

The second possibility is that in tougher economic times, all parties are seeking lower

costs. Customers are likely to accept less convenience in return for lower prices. The

manufacturer is given the task of pushing down costs through greater efficiencies in order to

reduce prices to customers. It is also likely that the customers will make fewer demands with

regard to their overall convenience when they are much more concerned with lower costs. In

selecting a site for a manufacturing facility, the manufacturer might not choose to reduce the

convenience that has been provided to its customers in the past but it probably will not

choose to increase conveniences either. This will definitely be the case when the

manufacturer feels that any additional conveniences it provides will not be coveted enough

by the customer sufficiently to generate higher prices from the customer. Higher prices for

more convenience may not be well received by customers in tough economic times.

The Importance of Tax: The above results show that, among a wide variety of

manufacturers, tax is important as a criteria but it is not the most important criteria

considered when choosing a manufacturing facility. Government investment in tax credits,

deductions, grants and tax holidays are well founded because they are attempting to influence

a key factor for manufacturers. Each government knows that if all else is equal, tax

incentives may tip the decision scale in its favor. Governments can identify the above factors

that would describe their jurisdiction and focus their incentives to work in conjunction with

those factors. As an example, a state within the U.S. may have substantial infrastructure but

also have high wages when compared to locations outside of the U.S.. It might consider

offering a wage credit to manufacturers for wages above a certain level. This would help

offset its high labor costs and also promote the hiring of college graduates within its

jurisdiction.

When considering the above results in conjunction with the growth strategy employed

by Ireland, one can derive a better focus for tax incentives. Ireland is not a country that can

compete with Asia on labor rates. It did not try to attract low technology manufacturers

because this fact was apparent. Ireland was the poorest country in Western Europe and its

strategy focused on differentiating itself from its Western European neighbors. It focused on

attracting high technology investment by using a highly educated and youthful population

(providing more young technical professionals than its neighbors) in conjunction with a tax

rate that is dramatically lower than its competition. Ireland’s focus was on taking

manufacturers from its neighbors rather than taking manufacturers away from global

competitors.

A similar analogy can be drawn with Singapore’s economic strategy. Singapore has

not and will not compete for low tech manufacturing with its Asian neighbors. It does not

have the resources to compete in this environment. It has instead focused on its highly

educated population and its historic role as a logistics hub to build additional foreign

investment. Today, Singapore focuses on being a treasury hub in order to supplement its

central role in logistics.

The same is not the case with Malaysia which has competed for low labor cost jobs.

Malaysia did not have the highly educated population that is available in Singapore and


86

Ireland. It marketed its low labor rates and the result was investment from companies that

coveted low labor rates. Although the standard of living has improved dramatically in

Malaysia though foreign investment, additional prosperity can only be generated through

higher wages for the general population. However, higher wages will only drive away the

foreign investment that Malaysia requires to fuel its economy.

The strategies of Ireland and Singapore can provide a substantial amount of input to

an overall strategy for developing manufacturing in the U.S.

Competition at the Federal Level: For the U.S., competition for manufacturers

through tax legislation and other factors must take place at a federal level, not a state level.

The main reason is that the federal government controls the major part of the tax base. It is

an unreal expectation for the state of Utah, for example, to compete with Malaysia or China

for investment dollars when the state of Utah controls a relatively small portion of the tax

burden that a manufacturer would face for locating in Utah. The federal government controls

most of the tax burden so it is the federal government’s job to compete for manufacturers at a

global level.

Focused Incentives: Specific types of manufacturers must be targeted similar to the

Irish example. Based on labor rates, a tax rate of zero would not be sufficiently low to attract

certain types of manufacturers. The U.S. must purge itself of concerns over low wage rate

jobs leaving the country and going offshore. These jobs pay low wages and they should be

allowed to leave or even promoted to leave. A move must be made to focus on attracting or

maintaining high technology manufacturers which rely on an education level in the local

population and infrastructure that the U.S. can already provide.

The next key step for the U.S. is to incentivize manufacturing in which the U.S. can

be competitive. One major change would be a §199 type incentive with dramatically higher

benefits. As stated earlier, the §199 incentive provides a deduction equal to 9% of income

derived on U.S. production activities. As an example, if a taxpayer only manufactures in the

U.S. and earns $100 from those activities, its incentive benefit is as shown in Table 2. The

entire benefit derived from §199 is only 3.15 percent of taxable income before taking other

limitations into account. §199 is a very meager incentive for purposes of competing with

countries like Ireland or Singapore. An increased incentive would be one that offers a tax

rate of 12.5% to all qualifying manufacturers on manufacturing activity. This would produce

a benefit to manufacturers of 22.5% (35% less 12.5%) of taxable income. This is a benefit

worth around six times that of §199. This type of incentive would make the U.S. highly

attractive to high technology investors. As in the case of Ireland, the U.S. needs to compete

with other countries with similar living standards and infrastructure (mainly Europe). It

should focus on taking manufacturers away from this peer group rather than worrying about

countries with labor rates so low that employment in these industries in the U.S. would result

in a large class of “working poor.”

State Competition: Once the U.S. is established as a more dominant site for

manufacturing, the states can compete with each other on a much more level playing field.

States would be allowed to focus on the attributes that they bring to the table when compared

to other states. This competition would be for higher technology jobs which would mean that

states with weak education systems would be at a severe disadvantage. These states would

be forced to make dramatic improvements in their education systems in order to generate


87

investments within their borders. The states that properly consider the economic

ramifications of their incentive decisions would prosper in this environment. The states that

did not properly budget or forecast the benefits of new incentive deals would be forced to

improve or miss the influx of manufacturing plants which migrate to U.S. shores.

Table 2: Net Benefit of §199

Without §199 With §199 Difference

Taxable income

before §199

100 100

§199 deduction (9)

Taxable Income 100 91 9

Tax Rate 35% 35% 35%

Tax 35 31.85 3.15

SUMMARY

This study presents some of the incentives offered by various governments (foreign

and domestic) and examples of companies that have taken advantage of these incentives.

Governments spend a great deal of resources trying to attract manufacturers into their

jurisdictions in the hopes of generating corporate income taxes, jobs for their constituents,

sales taxes, and personal income taxes. An issue that these governments face is that in order

to attract manufacturers, governments have given incentives to manufacturers in the form of

reductions to the taxes that they seek to collect.

The importance of this study is that it can offer a better understanding to governments

of the motivating factors for manufacturers in deciding where to locate a new facility. This

may assist governments in the types of incentives that they offer and the way in which they

sell them.

A wide variety of rankings were reported by the surveyed participants. Cost of Labor

was the most important factor based on the average importance score. However, it was

ranked as low as seventh by one of the participants. This variety is reflected for the entire list

of criteria offered to participants. Of the 14 criteria offered to the participants, 12 of the

criteria were ranked first or second by at least one participant. Quality of local infrastructure,

which ranked second, was ranked as low as tenth by one of the participants. By analyzing

the standard deviations related to each criterion, it became clear that although the first two

criteria were ranked in a variety of levels by the responders, they had the lowest standard

deviations among all criteria. This means that they were ranked more consistently by the

responders than any other criteria.

The survey offered all participants to add in any criteria that they felt were important

but not offered as part of the original survey. Two participants added “local higher

education” as an additional criterion. One participant added “supply of qualified labor.”

Another participant added “proximity to existing facilities.” The fact that out of the 32

participants only 4 used the “Other” indicates that the list sent to the participants offered

sufficient variables to all participants.


88

CONCLUSIONS

In reviewing the results of the survey and the supporting research, the following

observations and conclusions may be made:

The U.S. has a very weak track record in offering incentives that are actually geared

toward changing behavior. Of all the major incentives outlined in this body of research, only

one, the research and development credit, actually required a change in behavior in order to

obtain a tax benefit. The rest of the incentives offered benefits which were available to

companies which continued to conduct activities that they were already conducting. In

addition, the incentives offered only provided minor benefits to constituents which were

unlikely to generate an influx of investment from U.S. multinationals or foreign

multinationals. An example is the Section 199 manufacturing benefit offered by the U.S.

This benefit offers a benefit of 3.15 percent of taxable income. The same activity conducted

in Ireland is taxed at a rate so much lower than the U.S. that when measured in the same

terms as the Section 199 benefit, it provides a tax benefit that is equal to 22.5 percent of the

U.S. taxable income.

Part of the reason for this shortfall in U.S. incentives is the U.S. political system. In

various cases, including the Investment Tax Credit under the Kennedy Administration, the

political system in the U.S. does not allow for meaningful bills to pass. Tax benefits are

usually “watered down” and expanded to benefit more of the existing population and in

effect lose their effectiveness in generating their desired results. Another result of the U.S.

political process is that the U.S. federal government has never offered negotiated tax benefits

in return for specified foreign investment. This is something that the U.S. political landscape

would likely never allow because of its focus on fairness and equality.

The result of the lack of flexibility in the federal government is a “bend over

backward” approach by states. States only control a small portion of the tax burden carried

by a manufacturer and since there is no flexibility on the federal side, the states find

themselves competing vigorously in an attempt to get companies to invest within their

borders. As was the case when Alabama landed Mercedes, this competition can have

negative consequences and result in substantial criticism for state officials.

The survey results show that although governments spend a great deal of money in

attracting manufacturers into their jurisdictions, they are focusing on something that is,

according to this study, the fourth most important factor. Manufacturers appear focused on

two factors which can have an inverse relationship with each other. The first is the drive to

reduce costs, which caused “cost of labor” to be the first criterion in considering where to

locate a factory. The second is the drive to maintain quality which caused “quality of local

infrastructure” to be ranked second in the survey. Countries with the lowest labor rates tend

to be countries with low rates of fixed asset investment and therefore the countries with the

lowest infrastructure. The manufacturer needs to consider infrastructure in order to gain

some assurance on product quality along with timely production through dependable access

to resources such as energy. In order to assure that these concerns are met, the manufacturer

may not go to the very lowest wage area available.


89

RECOMMENDATION

Given that the U.S. political process would never allow federal negotiated incentives,

the U.S. should drop its tax rate for all manufacturers to 12.5 percent following the Irish

example. This incentive would combine a favorable federal tax policy with factors that the

U.S. already has which are coveted by multinationals. These factors include a strong and

politically stable infrastructure, which facilitates the movement of goods within and outside

the country, one of the largest consumer markets in the world, and a strong education system.

The political challenge in the U.S. is that the tax rate would apply to manufacturers only.

This would generate substantial opposition from the large service sector in the U.S.

A reduced federal tax rate for manufacturers would serve to compete with developed

countries for high paying jobs, while shunning away the manufacture of low cost labor

intensive products. Companies that covet low cost labor would continue to manufacture in

Asia rather than bring their manufacturing operations to the U.S. Products manufactured

with low cost labor would stay in Asia no matter how low the U.S. drops its tax rate. Labor

rates are too high a factor in their decision making criteria.

States could continue their negotiated incentive programs in this new environment. If

the U.S. is considered the manufacturing destination of choice, the states would only be in

competition with each other. All states would be forced to improve their education systems

because the types of jobs attracted into the U.S. under this new federal policy would require a

well-educated workforce. States that failed to improve their education systems would likely

miss the industry boom triggered by the federal governments new tax policy. The benefit to

the states is that they would no longer be competing for jobs against other countries;

however, they would only be competing against each other.

REFERENCES

Dorgan, S. (2006), How Ireland became the Celtic Tiger, Backgrounder - The Heritage Foundation,

(June 23), 1–15.

Greider, W. (1997), One World, Ready or Not. New York, New York: Simon & Schuster.

MacCarthy, B.L. & Atthirawong, W. (2003), Factors affecting location decisions in international

operations – A Delphi study, International Journal of Operations and Product Management,

23 (7), 794 – 818.

Myerson, A. R. (1996), O governor, won’t you buy me a Mercedes plant? The New York Times, 3

(September 1,).

Ondrich, J. & Wasylenko, M. (1993), Foreign direct investment in the United States: Issues,

magnitudes, and location choice of new manufacturing plants, Kalamazoo, Michigan: W.E.

Upjohn Institute.

Teoh, L. & Seah C. (2009), Business operation of Singapore, Washington, D.C., Tax Management,

Inc. a subsidiary of Bureau of National Affairs, Inc.


Vol. 5, No. 1; Fall 2012

90

TAX PRACTITIONERS AND ORDERING EFFECTS OF

INFORMATION IN AN ETHICAL DECISION

Scott Andrew Yetmar

Cleveland State University

Peter Poznanski

Cleveland State University

Elizabeth Koran

Meaden & Moore

ABSTRACT

This study investigates the ordering of information (pro-client or pro-IRS) and its

effect on the tax professional’s belief of whether to disclose the tax position taken on behalf

of the client to the IRS. Tax professionals were assigned to one of two groups. Each group

was given the same initial scenario which took a neutral position. Then, Group 1 first

received information that is classified as pro-client while Group 2 first received information

that is classified as pro-IRS. The information order was then reversed with Group 1

receiving the pro-IRS information and Group 2 receiving the pro-client information. The

results indicate that there is an information ordering effect for both groups. The tax

professionals’ decision to disclose or not disclose to the IRS significantly changed as each

piece of information was given to them. The mean score for both groups converged after

being given the first piece of information contrary to the information previously received.

INTRODUCTION

There are times when tax professionals are faced with having to take a position on a

“grey” tax area. They can take a position of client advocacy which may subject the client to

an IRS challenge (pro-client), or one in which leans towards an IRS challenge less likely

(pro-IRS). The tax professional has to work within the bounds of the tax code, but the client

may (or may not) be willing to play the “audit lottery” that is, take a position which is

financially in their interest but may lead to an audit or judicial proceeding. Will the tax

professional’s judgment be influenced by the order of the information presented, if their

client is willing to play the “audit lottery?”

The belief-adjustment model was proposed to explain “a theory of belief updating

that explicitly accounts for order-effect phenomena as arising from the interaction of

information-processing strategies and task characteristics” (Hogarth and Einhorn, 1992, p. 1).

Ordering-effects can influence decisions based on the sequence in which the information is

presented. By changing the order of the information presented, will an individual process the

information differently and make a different decision? Does the order the information is

presented make a difference in the decision? Does presenting information early on result in a

primary effect, or does presenting it later result in a recency effect? Are there instances when

the ordering of information becomes irrelevant? Hogarth and Einhorn (1992) showed that

the sequencing of events and the magnitude of currently held beliefs can ultimately impact

the decision.


91

In accounting, research studies have investigated the belief-adjustment model (belief-

revision model) and its impact on decision making by professional accountants in the fields

of auditing, tax, and managerial accounting. The way in which accountants synthesize

evidence and integrate it with their prior beliefs can impact their ultimate decision. Using

Hogarth and Einhorn’s (1992) belief adjustment model, studies have presented a scenario to

subjects and then provided additional evidence to confirm or disconfirm their initial beliefs.

The general model developed by Hogarth and Einhorn (1992) proposed an anchoring of

beliefs followed by an adjustment process which leads to belief revision.

The general model is presented as:

Sk = Sk-1 + wk[s(xk) – R]

where

Sk = revised belief after evaluating k pieces of evidence (0 < Sk < 1).

Sk-1 = anchor or prior opinion; the initial strength of belief is denoted S0.

Wk = adjustment weight for the kth piece of evidence (0 < wk < 1).

s(xk) = subjective evaluation of the kth piece of evidence.

R = the reference point which the impact of the kth piece of evidence is evaluated.

There are three subprocesses that are within the model. The first deals with how the

evidence is encoded relative to a reference point. The encoding process can either be an

evaluation or an estimation task. If it is an evaluation process, the encoding can be measured

along a scale of “0” (false) to 1 (true). For estimation processes Hogarth and Einhorn (1992)

define those as a process which involves assessing a type of moving average based on prior

beliefs. In this case the scale will be a continuum, for example on a scale of 0 to 1, rather

than a value as in the estimation scale, for example 0 or 1. The second subprocess within the

general model is how evidence is processed. Does belief revision occur after each new piece

of evidence is given, the Step-by-Step (SbS) process, or does it occur after all evidence is

given, the End of Sequence (EoS) process? The SbS process is used when the response

mode is SbS. However, when the response mode is EoS, the SbS process may be used when

the amount of evidence is too demanding to use the EoS mode. The third subprocess

considers how the adjustment is accomplished. The first consideration is the strength of the

anchoring belief. Given a significant positive (negative) piece of additional information, the

belief revision will be greater if the anchor is currently at a “strong” level than if the anchor

is at a “weaker” level. The more sensitive an individual is to positive and negative

information the greater will be the belief adjustment. The second consideration is based on

both individual and situational variables. Some individuals may be more sensitive to positive

(negative) information than others. However, once a belief becomes more firmly rooted, the

value of positive and negative evidence would decline given significant amounts of

additional evidence.

In this study we use a sample of tax professionals to investigate belief-adjustments in

a situation which initially does not take a client advocacy position and then considers

additional information classified as pro-IRS, more pro-IRS, or pro-client situations. We use

an evaluation-type scenario where the evidence to be processed is sequential so that the

ultimate decision should be made on a SbS basis. After each piece of additional information

the tax professional has to make a decision on which position s/he should take, a pro-client or

Yetmar, Poznanski, and Koran

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pro-IRS position. The subjects in the study are employed at “Big 4” (the four largest public

accounting firms) and non-“Big 4” public accounting firms.

This study will not use a specific tax situation to investigate the role of the belief-

adjustment, but rather general statements which require no specific knowledge of particular

items in the tax code. There are countless tax scenarios that can be developed for use in a

study but we are interested in the tax professionals overall belief-adjustments given pro-client

or pro-IRS evidence. We believe that this will avoid any confounding effects that may occur

given a subject’s level of expertise with any particular area of the tax code, and make the

results more generalizable.

LITERATURE, MOTIVATION, AND HYPOTHESIS DEVELOPMENT

The belief-adjustment model has been used in accounting research to evaluate

decision making influenced by ordering effects in financial and managerial accounting, taxes

and auditing. Kahle, Pinsker, and Pennington (2005) presented a literature review of 25

studies in accounting which used the belief-adjustment model, and since their review there

have been other studies published using the belief-adjustment model. The authors present a

general framework based on Robert’s (1998) categorization from which to view the belief

revision process. Robert’s (1998) organized the factors into (1) individual psychological

factors, (2) environmental factors, (3) input task factors, (4) processing factors, and (5)

output task factors. They posit that “the factor categories be thought of as an overall

framework where each category influences other categories within the model” (p. 35).

Dillard, Kaufmann, and Spires (1991) tested order effect using consistent information

(all negative or all positive) and the recency effect for mixed information (both negative and

positive), using generic and accounting scenarios. The accounting scenarios involved

managerial accounting situations. There were no order effects for consistent information in

the generic scenarios and minor effects in the accounting scenarios. Recency effects were

reported in both the generic and accounting scenarios that used mixed information. When

the negative evidence was presented last the “mean belief change is more negative than when

positive evidence processed last, indicating recency effects” (p. 627).

Pinsker (2011) studied the order effects of a long series of information (cues) is

presented to subjects regarding a (fictitious) semi-conductor company. The disclosure

information was presented either sequentially or simultaneously, in a positive-negative, or

negative-positive pattern. He reports that prior accounting studies which used four to eight

cues led to recency effects; to see at what point a long series of cues can lead to primacy

effects, cues of 20 and 40 items were presented to different groups of subjects. Recency

effects were reported for both groups of subjects in both the sequential and simultaneous

pattern, but in both groups (20 and 40 cues) there were no primacy effects noted. However,

exacerbated recency effects were reported in the 40 cue sequential ordering versus the

simultaneous ordering. .

Kerr and Ward (1994) tested the manner in which auditors integrate information and

the manner it can affect subsequent belief revision. They hypothesized that in audit

judgments tasks, auditors would use averaging models for tasks requiring estimations and

summation models for audit tasks requiring evaluations. Hogarth and Einhorn (1992)

describe evaluation tasks where evaluative evidence will be encoded as positive or negative


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to the original belief. Supporting evidence will increase belief whereas nonsupporting

evidence will decrease belief. Estimation tasks differ in that the evidence will be considered

based on the current level of belief, with an overall weighting affect based on the prior belief

and additional information. For example, under the averaging model the introduction of new

moderately favorable information when a highly favorable situation is already present will,

overall, make the situation less highly favorable. Under the summation model given the

same highly favorable situation the addition of moderately favorable information will,

overall, make the situation even more highly favorable. The results supported the hypotheses

in which they proposed the manner information would be integrated. When planning the

extent-of-testing of account balances, subjects used a non-additive, differential–weighting

averaging procedure and summated rule when given an evaluation task.

Krishnamoorthy, Mock, and Washington (1999) used auditors as subjects to test four

different model approaches (Cascade Inference Theory Model, Dempster-Shafer Belief

Function Model, and two versions of the Hogarth-Einhorn Belief Adjustment Model) on the

direction and magnitude of belief revision. One version of the Hogarth-Einhorn Belief

Adjustment Model was used to provide information as negative evidence while the other

provided information as positive evidence. A scenario was provided which gave background

information and required the auditors to assess the probability of no material error in pricing

the inventory. Then additional information was provided requiring the auditors to reassess

the probability of no material error in pricing the inventory. While all four models correctly

predicted the direction of the auditor belief revision, only the ordering effect on the direction

and magnitude was only present in the Hogarth-Einhorn Belief Adjustment Model which

provided negative evidence. This was attributed to the way the subjects interpreted a cue as

providing negative evidence.

The belief revision model has been used to investigate tax professionals’ belief

revisions in client preference scenarios. Pei, Reckers, and Wyndelts (1990) based their study

on the Contrast-Inertia model proposed by Einhorn and Hogarth (1987), a descriptive model

of belief revision. The model posits that three principles predict that belief revision will be

influenced by the order of information presented (Pei, et al., 1990). These principles are (1) a

sequential process of anchoring and adjustment, (2) the evaluation of information as either

positive or negative evidence relative to the belief, and (3) conflict (reconciliation) between

forces of adaption and inertia (Pei et al., 1990, p. 122). They hypothesized that (1) Under

conditions of mixed evidence regarding a tax treatment, the judgments of professional

taxpayers will exhibit recency effect. These effects will be depend on the order of the

information presented; negative information preceded by positive information will yield

negative effects; positive information preceded by negative information will yield more

positive effects. They also hypothesized that (2) Tax professionals judgments (and

recommendations) will be reflective (statistically and positively associated with) clients’

stated preferences, and (3) Tax professionals judgments (and recommendations) will be

reflective (statistically associated with) selected individual differences among tax

professionals.

Subjects were given a scenario in which their client preferred to be treated as either a

real estate investor or a real estate dealer, an area where the “tax law where unambiguous

guidance is lacking” (p. 134). Subjects were asked to recommend the tax treatment for their


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client. The ordering of the information within each group was either positive evidence

(supporting the dealer treatment), or negative evidence (supporting the investor treatment).

The results showed that the ordering effect was significant supporting hypothesis 1.

Hypotheses 2 and 3 were not supported indicating that client’s preference and tax

professionals’ judgments did not influence the tax preparer’s decision. As the authors point

out, the decision processes of the professional needs to be given greater consideration.

Pei, Reckers, and Wyndelts (1992) considered not only the decision maker’s leaning

towards client preference but also the decision maker’s level of experience in tax. They

hypothesized that (1) the tax preparer decision will be influenced by the order the

information is presented and (2) that there will be a larger order effects for experienced

versus inexperienced tax preparers. The dependent variable was the tax preparer’s decision

after seeing the information related to the scenario. Six factors were selected for tax

preparers to analyze in order to classify their client as a real estate investor or a real estate

dealer. The choice of classification would impact the client’s tax position. One-half of the

tax preparers were told their client preferred the real estate investor classification, while the

other half preferred the real estate dealer classification.

Order effect was significant for experienced tax preparers but the client preference

was not, nor was the interaction between client preference and the order the information was

presented. The insignificant client preference could have occurred because experienced tax

preparers weighed the information in a client-neutral manner. The recency effect was a

result of “(1) an anchoring and adjustment strategy used by the decision maker and, (2) the

contrast implications from processing a mixed series of positive and negative evidence” (p.

190). For inexperienced tax preparers order effect was not significant but client preference

was significant. As with the experienced tax preparers there was no significant interaction

between client preference and the order the information was presented.

Interestingly, prior studies using auditors as subjects reported significant recency

effects contrary to this study. In their study inexperienced tax preparers final decision was

based more on the negative evidence that opposed their client’s preference. The authors

explain this as a perception held by inexperienced tax preparers for the potential for legal

liability against the tax preparer, and therefore were overly conservative toward the client’s

preference (p. 191). It is also noted that the “subject’s attitude towards the evidence is

inferred rather than directly measured” (p. 194) which can contribute to the results. Also, tax

preparers differ from auditors in that tax preparers are much more an advocate of the client

than auditors whereas auditors maintain a level of professional skepticism.

Kahle and White (2004) used tax professionals to investigate their belief revisions on

the combined effects of evidence direction and client preference. Evidence presented was

either confirming or disconfirming to the tax professional’s initial beliefs. Their first

hypothesis was that magnitude of the belief revision will be evidenced by the confirming or

disconfirming evidence. The second hypothesis proposed was that since tax preparers are

client advocates (compared to auditors used in similar studies) belief revisions will be greater

when the client preference effect is positive rather than negative.

If the tax professional has an initial belief towards the client preference, it is difficult

to determine if the tax preparer exhibits confirmation bias or if the bias is due to their bias

towards the preference of the client. Kahle and White then hypothesized (in null form as the


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client preference cannot be stated a priori) that there will be no interaction between evidence

direction and client preference effect on the magnitude of the tax professionals’ belief

revisions.

The first two hypotheses were supported. The effect of evidence direction on the

magnitude of belief revisions was significant supporting the first hypothesis. For the second

hypothesis the tax professionals had a greater belief revision when the evidence presented

was confirming rather than disconfirming. The third hypothesis was not supported as there

was no significant level of interaction effects between client preference and the magnitude of

the tax professional’s belief revision. However, effects were found that showed tax

professionals were influenced by client preference when the information presented opposed

their initial beliefs but supported their client’s preference. When the information presented

confirmed their initial belief but opposed their client preference there were only minor belief

revisions. This supports the premise that tax professionals tend to be client advocates and

exhibit client preference.

Our study compares the belief-adjustment of tax professionals given an initial opinion

of the work situation followed by four additional pieces of information regarding the work

situation. The initial opinion is a neutral statement stating that the client has an IRS issue

that is considered a “grey” area. The additional information is categorized as pro-IRS or pro-

client. Pro-IRS information makes it more likely that the tax professional will not advocate

the position of the client and consider disclosure, whereas pro-client information makes it

more likely the tax professional will be an advocate of the client and less likely to disclose

the information to the IRS. Table 1 presents the initial information classification and the

ordering and type of additional pieces of information given to each group. Table 1

Ordering of the additional information

Group 1 Group 2

Initial Information Neutral Neutral

Situation (Additional information)

One Pro-Client1 Pro-IRS

2

Two Pro-Client Pro-IRS

Three Pro-IRS Pro-Client

Four Pro-IRS Pro-Client 1 A Pro-Client position is not disclosing information to the IRS

2 A Pro-IRS position is disclosing information to the IRS

The pro-client and pro-IRS additional information are identical in all of the

questionnaires. The client preference in both questionnaires is that the client is willing to

take the risk of having the tax professional reduce their tax liability, thereby increasing the

possibility of their client’s tax return being audited by the IRS. The pro-IRS information

informs the practitioner that there are disclosure requirements that should be considered

when the tax situation is considered a “grey” area.


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The ordering of the information should lead to effects within groups. As each

additional piece of information is provided it should lead the tax preparers to become more of

a client advocate (less of a client advocate) and less likely to disclose the information to the

IRS (more likely to disclose the information to the IRS) compared to their prior attitude.

Since the ordering of the information between the groups is reversed, we are not doing a

between-group comparison. Rather, we are seeing if the ordering effects of the additional

information (more/less of a client advocate) will make a significant difference. Based on the

Contrast-Inertia model proposed by Einhorn and Hogarth (1987) we propose the following

hypotheses:

H1 – Tax professionals in Group 1 will take more of a client advocacy position (less

pro-IRS) after given the first piece of additional information compared to their initial

assessment, while tax professionals in Group 2 will take less of a client advocacy position

(more pro-IRS) after given the first piece of additional information compared to their initial

assessment.

H2 – Tax professionals in Group 1 will take more of a client advocacy position (less

pro-IRS) after given the second piece of additional information compared to their assessment

after the first piece of additional information, while tax professionals in Group 2 will take

less of a client (more pro-IRS) advocacy position after given the second piece of additional

information compared to their assessment after the first piece of additional information.

H3 – Tax professionals in Group 1 will take less of a client advocacy position (more

pro-IRS) after given the third piece of additional information compared to their assessment

after the second piece of additional information, while tax professionals in Group 2 will take

more of a client advocacy position (less pro-IRS) after given the third piece of additional

information compared to their assessment after the second piece of additional information.

H4 – Tax professionals in Group 1 will take less of a client advocacy position (more

pro-IRS) after given the fourth piece of additional information compared to their assessment

after the third piece of additional information, while tax professionals in Group 2 will take

more of a client advocacy position (less pro-IRS) after given the fourth piece of additional

information compared to their assessment after the third piece of additional information.

In many cases, tax preparers are given an inordinate amount of information to make a

decision for the tax treatment for their client. The decision should be based on all available

information. The tax preparer considers information in the U.S. tax code, the information

presented by their client, and their own level of expertise based on their training and

experience. We negated the effects of the tax law by referring to the situation as being a

“gray area,” rather than a specific aspect of the tax code.

RESEARCH DESIGN

Subjects. Subjects were chosen using a random sample of Certified Public

Accountants (CPA) that belong to the American Institute of CPAs’ Tax Division. The

questionnaire was mailed to 1,200 CPA tax practitioners. The response rate was 35.08%.

Nonresponse bias was tested by comparing the standard deviations of the responses from the

first and last 41 questionnaires received. A one-tailed F-test was used comparing the Fcalc to

the Ftab. The results indicate that there is no statistically significant difference between the

early and late respondents (F40,40 = 1.242, p < .01; Ftab = 2.114).


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Methodology. Subjects were randomly assigned one of two questionnaires. (See

Appendix A for the research instruments). The initial work situation for each of the four

questionnaires was identical: “A CPA (Certified Public Accountant) tax practitioner has a

client with a gray tax area. The position may not have a realistic possibility of being upheld

if challenged. Should the CPA tax practitioner require disclosure to the IRS before signing

the return?” The work situation poses an issue with the tax practitioner because of the

potential for the tax position not being upheld if challenged by the IRS. The subjects were to

assign a ranking of 0, the pro-client position (absolutely do not require disclosure before

signing the return) to 100, the pro-IRS position (absolutely require disclosure before signing

the return). Situations (additional information) 1 and 2 for Group 1 are presented as

situations (additional information) 3 and 4 for Group 2. Situations (additional information) 3

and 4 for Group 1 are presented as situations (additional information) 1 and 2 for Group 2.

Subjects were required to indicate on the scale of 0 to 100 what they would do after being

given the initial scenario and each additional piece of information.

RESULTS

The mean score for the initial information for each of the groups is presented in Table

2. Table 2

Mean scores for the initial work situation

Group 1 Group 2 Total

Number of respondents 203 218 421

Mean score 65.41 60.16

The mean scores between the two groups were insignificant, t (419) = 1.71, p >.05.

This indicates that the subjects’ opinion with the initial information between the groups were

not significantly different. A mean score of 50.00 would indicate indifference to the initial

information. The respondents leaned slightly towards a conservative, Pro-IRS position

which would require disclosure. Given that conservatism is an acceptable constraint in

accounting practice, it is not surprising that their initial assessment leans towards the pro-IRS

position. However, we are interested in the extent and direction of the deviation from the

initial position (mean score) based on the initial information for the two groups.

Pearson correlations among the initial information and additional information for both

groups are presented in Table 3. All items are significantly correlated (p < .01). Given that

the study is using the same initial information for both groups, and the same questions it

would be assumed that the items would correlate significantly.

Following the initial work situation subjects were asked to respond to four pieces of

additional information which is classified as pro-client or pro-IRS (see Table 1). For all four

pieces of the additional information the subjects were again asked to respond on a ranking of

0 (absolutely do not require disclosure before signing the return) to 100 (absolutely require

disclosure before signing the return). The mean scores for paired samples for each of the

four pieces of additional information for Group 1 are presented in Table 4.


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Table 3

Pearson Correlations1

Initial Info. Sit. 1 Sit. 2 Sit. 3 Sit. 4

Initial Info. 1.00

Situation 1 .766 1.00

Situation 2 .626 .940 1.00

Situation 3 .790 .735 .656 1.00

Situation 4 .732 .400 .242 .800 1.00 1n = 421; p < .01

Table 4

Mean scores for the situations (additional information) group 1

Paired

Samples

Test

Mean N t df

Sig.

p <

Pair 1 Initial Opinion 65.42 203

Situation 1 52.91 203 14.340 202 .01

Pair 2 Situation 1 52.91 203

Situation 2 46.45 203 11.690 202 .01


Situation 3 68.14 203 -16.619 202 .01


Situation 4 82.44 203 -14.975 202 .01

The same procedure was undertaken with Group 2. The additional information was

reversed compared to Group 1, that is, Group 2 was presented with the Pro-IRS information

first, followed by the Pro-client information. The mean scores for paired samples for each of

the four pieces of additional information for Group 2 are presented in Table 5.

Discussion. The first hypothesis posits that Group 1 would take more of a client

advocacy position (less pro-IRS) after the first piece of initial information while Group two

would take less of a client advocacy position (more pro-IRS). The analysis supported this

hypothesis, with each group moving from their initial (neutral) position towards the

hypothesized direction (Group 1, t (202) = 14.340, p < .01; Group 2, t (217) = -14.851).

Group 1 took a more risky shift away from disclosure based on the possibility of losing the

client if their position was not supported, and the tax practitioner’s firm willing to take a

chance of not being audited. Group 2 moved more towards disclosing the information based

on the guidance given by the American Institute of Certified Public Accountants (AICPA)

Standards for Tax Services (SSTS), which states that disclosure should be made if the tax

position does not have a realistic possibility of being sustained administratively or judicially

if its’ merits are challenged.


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Table 5

Mean scores for the situations (additional information) group 2 Paired

Samples

Test

Mean

N t df

Sig.

p <

Pair 1 Initial Opinion 60.16 218

Situation 1 77.72 218 -14.851 217 .01


Situation 2 82.71 218 -6.833 217 .01


Situation 3 66.12 218 17.309 217 .01


Situation 4 52.91 218 15.786 217 .01

Hypothesis 2 put forth that both Groups positions would become even more polarized

after the second piece of additional information compared to their position after the first

piece of additional information. That is, Group 1 would take more of a client advocacy

position and recommend not disclosing, while Group 2 would take more of an IRS position

and recommend disclosure of the tax position. Hypothesis 2 was also supported (Group 1, t

(202) = 11.690, p < .01; Group 2, t (217) = -6.833). Group 1 took even more of a client

advocacy position after being told that the client is willing to take on risk in order to reduce

their tax liability. Group 2 took even more of an IRS advocacy position to disclose the

information after being informed that penalties could be imposed on their firm if they failed

to disclose a position that does not have a realistic possibility of being upheld.

After the first two additional pieces of information, the third and fourth pieces

changed for each Group. Group 1 was given the same information that Group 2 had already

received, and vice- versa. Hypothesis 3 states that Group 1 will take less of a pro-client

advocacy position (move towards a more pro-IRS position), while Group 2 will take less of a

pro-IRS position (move towards a more pro-client position). Hypothesis 3 was supported for

each group (Group 1, t (202) = -16.619, p < .01; Group 2, t (217) = 17.309), indicating a

change in beliefs on whether or not to disclose (not disclose) the client’s tax position.

Hypothesis 4 posited Group 1 to move towards more a pro-IRS position and Group 2 to

move towards a more pro-client position after the fourth piece of information was presented.

The hypothesis was supported (Group 1, t (202) = -14.975, p < .01; Group 2, t (217) =

15.786) with both groups shifting their prior level of belief to disclose or not disclose the tax

position based on the additional piece of information.

At this point it is interesting to note the degree of percent change in mean scores of

the subjects. After the subjects were given the first piece of additional information, Group 1

changed their initial position to a more client advocacy position by approximately 20%.

After the second question their position changed even more to a client advocacy position but

this time by only approximately 10% of their initial position. Group 2 experienced similar

changes from their initial position. After being given the first piece of additional information

their position changed by approximately 28% of their initial opinion to one favoring the IRS.


100

After the second piece of information they became more inclined to disclose the tax position

(more pro-IRS) but by only approximately 8%.

The same occurred after the third and fourth pieces of information were presented.

Group 1 shifted to a more pro-IRS position by approximately 47% after the third piece of

information, and approximately 21% after the fourth piece of information. Group 2 shifted to

a more pro-client position by approximately 21% after the third piece of information and

approximately 20% after the fourth piece of information.

It appears that for both groups, after being given the first piece of additional

information, the subjects were inclined to take a “larger” shift towards a greater advocacy

position for the client (Group 1) or IRS (Group 2) compared to their initial opinion. But after

the second piece of information was given, the shift occurred to a lesser extent than after the

first piece of additional information. As each group approached their limit (0 for a complete

client advocacy position or 100 for a complete IRS position) the magnitude of the increase

diminished, indicating a possible trend towards a more conservative client or IRS advocacy

position. Also, given the subjective nature of whether or not to disclose (the scenario is a

“grey” area), tax professionals may be unwilling to take a stand which places them in a

position completing advocating the client or the IRS. At some future point in time they may

have justify their decision to their client or the IRS.

To determine if there is a significant effects between the groups’ mean scores on the

initial scenario and each additional piece of information, we calculated Cohen’s d to

determine the effect size in a two-group experimental design. We used an average of the

standard deviations of the two groups given the similarity of the groups, and the random

assignment to each group. Since there is no restriction on the sign of the deviation we used a

two-tailed test (µ1 - µ2/σ). Small effects are designated by a result of d = 0.2; medium effects

by d = 0.5; and large effects by d = 0.8.

Table 6

Cohen’s d scores

Average σ Cohen's d

Initial scenario 31.5135 .873

Situation 1 28.3945 1.360

Situation 2 26.7320 .073

Situation 3 27.6595 1.090

Situation 4 27.0650 .167

The effects are significant for situations one, two, and four. There is strength in the

relationship between the responses of the two groups for these situations. There is no

significant effect between the groups in the initial scenario, signifying no difference in their

risk beliefs after given the neutral scenario. What is interesting is the similar risk-belief

position between the groups after responding to situation three.

The mean score for Group 1 after the initial scenario is 65.42. Given the first two

situations Group 1 moves towards the hypothesized direction (pro-client). Situation three,

the first of two pro-IRS situations, moves them towards a pro-IRS position and their mean


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score shifts to 68.14. The same occurs with Group 2. Their mean score after the initial

scenario is 60.16. After their pro-IRS shift given the first two situations, their mean score is

66.12 after the first pro-client situation. Both groups have near identical mean scores (68.14

and 66.12) after each group was given one piece of information contrary to the two pieces of

information previously given.

CONCLUSION

The ordering effects of the situations based on the initial information and subsequent

information given, moved the subjects’ initial belief towards a more pro-client (do not

disclose) or pro-IRS (disclose) position in the hypothesized direction. Their final position

was based on the last two pieces of information given. The final mean scores, compared to

their initial mean score after being given a neutral scenario, indicated to disclose the

information to the IRS if the last two situations were pro-IRS, or to not disclose the

information if the last two situations were pro-client.

After being given the third situation which was contrary to the situations the subjects

already received, both groups converged to an almost identical position, close to their initial

opinion. It took only one piece of contrary information for the subjects’ to shift to their

initial position, one that is neutral, and a near-identical position for the groups, regardless of

whether they were previously in a pro-client or pro-IRS position.

Tax professionals have to make decisions where the tax laws are considered “grey,”

or information from their clients is subject to interpretation. If a client is attempting to sway

a tax professional to take a specific position (client advocacy) the results indicate that

information contrary to that position be given first, followed by information to support the

clients position. Tax professionals should also be aware that the ordering of the information

can lead them to make decisions based on the effects of ordering, rather than the information

itself. The accounting firm, if risk-averse, may want to remind the tax practitioner of his or

her professional ethics responsibilities at the end of each tax engagement (i.e., prior to

making a decision on the tax position the firm will take).

Financial Accounting Standards Board (FASB) Interpretation 48 (FIN 48, effective

2007) requires the tax preparer to analyze and disclose income tax risks. An entity can only

recognize an income tax benefit if it is more likely than not (defined as a probability of

greater than 50%) that the tax position chosen will be sustained upon an audit by taxing

authorities. This rule applies to all entities that are required to adhere to US GAAP

(generally accepted accounting principles). This rule makes it more important for tax

preparers to understand that the ordering effects, especially when favoring a client advocacy

position, be considered when making their decision on the tax position they will take for their

client. If a tax preparer is aware of the potential impact of the ordering effects on their

decision, they may consider an additional review by another firm member with the

information presented different order. While there is no guarantee that the ordering effect

impact on the tax position decision can be eliminated, every attempt should be made to

minimize them.

Future research should consider differing quantities of additional information

(situations) both pro-client and pro-IRS. For example, would three pieces of pro-client

information followed by one piece of pro-IRS information result in a significant shift towards


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a pro-IRS position (or vice versa)? When difficult tax decisions have to be made it is often

done by more than one person. Would the ordering of the information have any effect on

group dynamics, such as groupthink or a risky shift?

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Effects of Information Presentation Sequence, Client Preference, and Domain Experience’,

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Synthesis’, Journal of the American Taxation Association, 20, 78-121.


Vol. 5, No. 1; Fall 2012

103

ANOMALIES OF TAX LEGISLATION: THE FIRST-TIME

HOMEBUYER CREDIT

Sheldon R. Smith

Amourae Riggs

Utah Valley University

ABSTRACT

The first-time homebuyer tax credit was first legislated in 2008. It was amended in

early 2009 and again in November 2009. Previous papers have explained the limitations of

and qualifications for the credit, both as originally legislated and as amended in 2009. This

paper extends the prior research by detailing the amendments and then describing several

situations in which the credit can create anomalies where taxpayers in almost identical

situations are treated very differently because of the rules for this particular credit. Some of

these situations are full of irony, as there is no way taxpayers could have known in advance

that this credit would be created or amended. Therefore, there is no way that appropriate tax

planning could have taken place to take advantage of this tax credit. Whether or not the tax

credit stimulated the economy as intended, the possible anomalies and ironies that have been

created can be seen as unfair. These situations are the result of hurried legislation attempting

to resolve an economic recession rather than the result of good, long-term tax policy.

INTRODUCTION

The first-time homebuyer tax credit was originally created by the Housing and

Economic Recovery Act of 2008, signed by President Bush on July 30, 2008 (P.L 110-289).

This law created a refundable tax credit of up to $7,500 for first-time homebuyers in the U.S.,

but it also included a recapture provision which required the taxpayers to repay the credit

over 15 years as an addition to those years’ taxes. Curatola (2009) described the provisions

of this credit. Smith (2009a) also described the provisions of the credit and included a

discussion of some ambiguities in the credit limitations based on the wording of the original

law.

This credit was amended early in 2009 when President Obama signed the American

Recovery and Reinvestment Act of 2009 on February 17 (P.L. 111-5). This law increased

the possible amount of the credit up to $8,000, extended the timeframe when the home could

be purchased to qualify, and removed the recapture provision. Smith (2009b) discusses the

original provisions as well as the new provisions provided by the amendments.

A law signed by President Obama on November 6, 2009, the Worker,

Homeownership, and Business Assistance Act of 2009 (P.L 111-92), further amended this

credit. It extended the deadline for home purchases which can qualify for the credit and

made several other changes.

The qualifications and limitations on this credit with its amendments have led to

many possible anomalies—situations in which taxpayers in almost identical circumstances

are treated differently because of the timing of the original legislation and its amendments.

Some of these situations are full of irony, as there is no way taxpayers could have known in

advance that this credit would be created or amended. Therefore, there is no way that

Smith and Riggs

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appropriate tax planning could have taken place to take advantage of this credit. In fact,

some may have relied on the original credit to make tax planning decisions, only to find out

later that the amendments would have given them better tax benefits had they made different

decisions.

This paper reviews some of the qualifications and limitations for the original first-

time homebuyer credit and how those qualifications and limitations changed with the

amendments. Some of the possible anomalies and ironies will then be illustrated.

Implications will be included in the conclusion.

FIRST-TIME HOMEBUYER TAX CREDIT

When created on July 30, 2008, the first-time homebuyer tax credit was a refundable

credit for 10 percent of the purchase price of a principal residence purchased by a first-time

homebuyer in the U.S. (P.L. 110-289). The credit was limited to $7,500 ($3,750 for someone

married filing separately). It also had a phaseout provision such that it phased out over a

$20,000 range for taxpayers with modified AGI above $75,000 ($150,000 for a joint return).

The credit was only available for the purchase of a principal residence on or after April 9,

2008 and before July 1, 2009.

A first-time homebuyer was defined as someone who had not had an ownership

interest in a principal residence during the three-year period prior to the date of purchase of

the principal residence for which the credit would apply. The credit was not available if (1)

the property was acquired from a related person, (2) the taxpayer (or spouse) was eligible for

the first-time homebuyer credit in the District of Columbia for that year or any prior tax year,

(3) the residence was financed by tax-exempt mortgage interest bonds, (4) the taxpayer was a

nonresident alien, (5) the taxpayer disposed of the property before the close of the year of

purchase, or (6) the home ceased to be the principal residence of the taxpayer (and, if the

taxpayer was married, the taxpayer’s spouse) before the close of the year of purchase.

The credit was required to be recaptured—repaid as an additional tax of 6⅔ percent

of the credit amount each year for 15 years starting in the second year after the year in which

the principal residence was purchased. In essence, this made the credit an interest-free loan

from the government rather than a traditional credit which permanently reduces a taxpayer’s

tax liability. An accelerated recapture provision applied if the principal residence was sold or

ceased to be the principal residence before the end of the 15-year recapture period. In these

cases, the remainder of the credit had to be repaid in the year of the sale or cessation of use.

However, the accelerated recapture was limited to the gain on the sale of the residence and

applied differently if the taxpayer died, if there was an involuntary conversion, or if there

was a transfer between spouses or incident to a divorce. For a principal residence purchased

in 2009 (before the July 1 deadline), the taxpayer could elect to take the credit in 2008, either

on the original return or on an amended return if the original return had already been filed.

The credit was amended on February 17, 2009, with the amendments applicable to

homes purchased after December 31, 2008 (P.L. 111-5). The amendments increased the

dollar limit on the credit to $8,000 ($4,000 for someone married filing separately). The

deadline was extended such that homes purchased before December 1, 2009 could qualify for

the credit. The credit was allowed on homes purchased with tax-exempt mortgage interest

bonds. A change was enacted making the first-time homebuyer credit take priority over the


105

first-time homebuyer credit in the District of Columbia. Some of these amendments may

seem relatively minor. However, one amendment fundamentally changed the nature of the

credit. For homes purchased on or after January 1, 2009 and before the extended deadline of

December 1, 2009, the recapture provision was waived such that the credit does not have to

be repaid over 15 years. The only time it has to be repaid under the new rules is if the home

is sold or ceases to be the principal residence within 36 months of the date of the purchase.

Further amendments were made in November 2009 (P.L. 111-92). One amendment

was to extend the credit to first-time homebuyers who purchased a new principal residence

prior to May 1, 2010. However, if a taxpayer entered into a written binding contract by May

1 to close on the purchase of a principal residence before July 1, 2010, the deadline for that

taxpayer moved to July 1, 2010 (the purchase deadline was extended through September 30,

2010 by P.L. 111-198, signed by President Obama on July 2, 2010). The ability to take the

credit in the year prior to the purchase was also extended such that a first-time homebuyer

who purchased a qualifying home in 2010 could claim the credit on a 2009 tax return. A new

requirement was added such that a copy of the settlement statement for the purchase of the

residence must be attached to the tax return.

Additional taxpayers qualified for the credit under the November 2009 amendments if

the new residence was purchased after November 6, 2009. A taxpayer (and spouse, when

applicable) who has owned and used the same principal residence for any 5-consecutive-year

period out of the last 8 years can sell the house and qualify as a first-time homebuyer on the

purchase of a new principal residence. However, the maximum credit for these long-time

owners of a prior residence is only $6,500 ($3,250 for married filing jointly).

The credit still has a modified AGI phaseout range of $20,000, but the range now

starts at $125,000 ($225,000 for married filing jointly). A new limit on the purchase price of

the home was created. The credit is not available if the purchase price of the home exceeds

$800,000. Additionally, the taxpayer (or taxpayer’s spouse, if married) must be at least 18

years old and must not be a dependent of another taxpayer to claim the credit. Previously,

the qualifying home could not be purchased from a relative. Under the amendments, it also

cannot be purchased from a spouse’s relative. These amendments were all effective for

homes purchased after November 6, 2009, the date of enactment.

Some special rules were added for those who are on or ordered to qualified official

extended duty as members of the uniformed services, members of the U.S. Foreign Service,

or employees of the intelligence community. If a residence purchased in 2009 or 2010 which

otherwise qualifies for the credit is sold or ceases to be the principal residence in connection

with Government orders for the taxpayer or the taxpayer’s spouse for qualified official

extended duty service, the credit can still be taken even if the sale or cessation is in the year

of the purchase; also the credit does not have to be recaptured if the sale or cessation occurs

within 36 months of the purchase in these cases. If a residence purchased in 2008 which

qualified for the credit is sold or ceases to be the principal residence in connection with

Government orders as mentioned above, the taxpayer does not have to recapture any

remaining credit.

Taxpayers who are on qualified official extended duty service outside of the United

States for at least 90 days between January 1, 2009 and May 1, 2010 get an extension on the

deadline to purchase the qualified residence. They qualify for the credit if they purchased a

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principal residence as a first-time homebuyer before May 1, 2011 (or entered into a written

binding contract before May 1, 2011 to close the purchase before July 1, 2011).

ANOMALIES AND IRONIES

Because of the creation of and amendments to this first-time homebuyer tax credit,

many anomalies or ironies can occur due to specific timing or other differences in taxpayers’

situations. Some of these anomalies and ironies will be illustrated in this section.

Situation 1: Mr. and Mrs. A had never owned a home. Mr. and Mrs. B had never

owned a home. Both couples had modified AGI of $120,000. Both couples started looking

near the end of 2008 at homes they could purchase. Mr. and Mrs. A found a home, made an

offer, and purchased the home, closing the purchase on December 27, 2008. Mr. and Mrs. B

found a home, made an offer, and purchased the home, but because of some escrow delays,

they were unable to close on the purchase until January 3, 2009. Although both couples may

qualify for the first-time homebuyer credit, Mr. and Mrs. A can only get a $7,500 credit and

have to repay this amount over 15 years. In addition, if they sell the home within that 15-

year period or cease to use it as their principal residence, they have to repay the remaining

credit in the year of the sale or cessation. Mr. and Mrs. B can get an $8,000 credit which

does not have to be repaid as long as they own the home as their principal residence for at

least 36 months. Mr. and Mrs. A had no notice that they could have improved their credit

immensely by waiting to close until after January 1, 2009, as the amendments increasing the

credit to $8,000 and eliminating the recapture provision were not legislated until February

17, 2009.

Situation 2: Mr. and Mrs. C had never owned a home. Mr. and Mrs. D had never

owned a home. Both couples had modified AGI of $120,000. Both couples were looking to

buy homes in the early months of 2008. Mr. and Mrs. C purchased a home, closing the

transaction on April 1, 2008. Mr. and Mrs. D purchased a home but closed the transaction on

April 20, 2008. While Mr. and Mrs. D will qualify for a $7,500 credit (as an interest-free

loan) because they happened to close the purchased after April 9 (the effective date for the

credit), Mr. and Mrs. C will get no credit. Neither couple knew anything about the

possibility of a credit until after their purchase because the credit was not initially legislated

until July 30, 2008.

Situation 3: Mrs. E, a widow with five children, has never owned a home. She has a

pretty good job and has a modified AGI of $100,000. Mr. and Mrs. F, a couple with four

children, have never owned a home. They have modified AGI of $145,000. Both families

buy essentially identical homes next door to each other in the same neighborhood. Both

transactions were closed on July 8, 2009. Mrs. E gets no credit because the credit phased out

completely when her modified AGI exceeded $95,000. However, Mr. and Mrs. F will get an

$8,000 credit (because the credit phaseout for their joint return would have started at

$150,000) even though their modified AGI is much higher than Mrs. E’s modified AGI and

both families have the same number of members to support.

Situation 4: Mr. and Mrs. G have never owned a home and have a modified AGI of

$175,000. Mr. and Mrs. H have never owned a home and have a modified AGI of $175,000.

Knowing they cannot qualify for the first-time homebuyer credit because it was completely

phased out at $170,000 for joint returns under the original provisions, Mr. and Mrs. G buy a


107

home in August 2009. Mr. and Mrs. H started looking for a home at the same time but took

longer to agree on a home and close on the purchase transaction. Because Mr. and Mrs. H

closed on November 10, 2009 after the credit was amended, they qualify for the $8,000 credit

even though Mr. and Mrs. G do not because their modified AGI was too large based on when

they purchased their home.

Situation 5: Mr. I and Ms. J are both single and each has a modified AGI of $72,000.

They work for the same company and are frequently transferred from one city to another

because of the nature of their jobs. Therefore, they have both owned multiple homes in the

past eight years. Early in 2007, they are both promoted and transferred to Dallas, each of

them selling their prior home as part of the transfer. Thinking they may be transferred again

within a year or two, they both decide to rent for a while instead of buying other homes.

However, by early 2009, the home office is moved to Dallas, and they feel they will not be

moving again. Knowing that he will not qualify for the first-time homebuyer credit because

it expires before he could qualify as a first-time homebuyer, Mr. I goes ahead and purchases

a home in August 2009. Ms. J was a little slower in finding what she wanted, and by the

time she was ready to buy, the first-time homebuyer credit had been extended into 2010.

Therefore, Ms. J postponed the purchase of her home until early 2010 after she had been out

of her prior home for three years. Thus, she qualified for the first-time homebuyer credit

when Mr. I did not.

Situation 6: Mr. and Mrs. K have never owned a home. They have modified AGI of

$145,000 and have saved toward a down payment on their dream home for many years. Mr.

and Mrs. L also have never owned a home. They also have modified AGI of $145,000 and

have saved toward a down payment on their dream home for many years. Mr. and Mrs. K

buy their dream home on October 23, 2009, paying $850,000, most of it in cash. They

qualify for an $8,000 first-time homebuyer credit. Mr. and Mrs. L also buy their dream

home, paying $850,000, most of it in cash. However, Mr. and Mrs. L do not close on the

home purchase until November 9, 2009. Because they were unable to close before

November 6 when the $800,000 purchase price limitation was enacted, they will get no first-

time homebuyer credit even though Mr. and Mrs. K did.

Situation 7: Mr. and Mrs. M have never owned a home. Their modified AGI is

$145,000, and they have saved for a down payment on their dream home for several years.

Mr. and Mrs. N also have never owned a home. Their modified AGI is $145,000, and they

have saved for a down payment on their dream home for several years. These two couples

buy essentially equivalent homes, closing on November 15, 2009. However, because they

are living in different areas of the country, Mr. and Mrs. M are able to buy their home for

$550,000 while Mr. and Mrs. N have to pay $850,000 for theirs. Mr. and Mrs. N do not

qualify for a first-time homebuyer credit because their home price was over $800,000, but

Mr. and Mrs. M qualify for an $8,000 credit simply because they live in an area where homes

do not cost as much.

Situation 8: Ms. O has never owned a home. Her modified AGI is $70,000. Mr. P

has never owned a home, and his modified AGI is $70,000. Each party contracts for

construction of a new home, each signing a purchase contract designating that the

construction is to be completed by June 20, allowing each home to be occupied prior to the

July 1, 2010 credit deadline. Ms. O is able to move into her home on June 28, 2010, so she

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qualifies for the $8,000 credit. However, due to construction and inspection delays outside

of his control, Mr. P is unable to occupy his house until October 6, 2010. He is not eligible

for the credit since he did not move in by the credit deadline.

Situation 9: Mr. and Mrs. Q have owned a home for the last eight years. They have

modified AGI of $140,000. They have lived in their home for most of the eight years, but

they were living overseas on a work assignment during the fifth year of their ownership.

While they were overseas, they rented their house to another family. Mr. and Mrs. R have

also owned a home for the last eight years and have modified AGI of $140,000. The home

has been their principal residence for the last seven years. They rented the home out the first

year they after they bought it because they were assigned overseas by Mrs. R’s employer for

one year right after they purchased the home. If both couples sell their homes and buy other

houses on November 15, 2009, Mr. and Mrs. R will qualify for the $6,500 first-time

homebuyer credit since they owned a home and used it as a principal residence for a 5-

consecutive-year period during the last eight years. However, Mr. and Mrs. Q will not

qualify for any credit, as they did not occupy their home as their principal residence for any

5-consecutive-year period in the last eight years.

Situation 10: At the beginning of November 2009, Mr. and Mrs. S have owned a

home for the last eight years. They first rented it out for almost three years. But they have

now lived in their home as their principal residence for slightly longer than the last five

consecutive years. Their modified AGI is $145,000. Mr. and Mrs. T have also owned a

home for the last eight years. They have modified AGI of $145,000. They lived in their

home for the first five consecutive years and one month, but then they rented it out. On

November 15, 2009, Mr. and Mrs. S sell their house and buy another. They qualify for the

first-time homebuyer credit of $6,500 for long-time residents. Mr. and Mrs. T could also sell

their home and buy another on November 15, 2009 and qualify for the $6,500 credit for long-

time residents. However, if they wait until December 15, 2009 to sell the home and buy

another principal residence, they will now qualify as first-time homebuyers because they

have not had an ownership interest in a principal residence for three years rather than because

they qualify as first-time homebuyers as long-time residents. Thus, they could qualify for the

$8,000 credit in December 2009 whereas they would only qualify for the $6,500 credit in

November.

Situation 11: Mr. and Mrs. U had owned their principal residence for one month

short of five years when they sold it and bought a new home in mid-November 2009. Their

modified AGI is $200,000. Mr. and Mrs. V have owned their principal residence for slightly

over five years when they sold it and bought a new home in mid-November 2009. Mr. and

Mrs. V also have modified AGI of $200,000. Because Mr. and Mrs. V owned and occupied

their home for at least five consecutive years out of the last eight, they will qualify for the

$6,500 credit. However, Mr. and Mrs. U will not qualify for any credit, as they sold their

home before they had been in it for five consecutive years. Had they known the law changed

on November 6, they could have postponed the sale and purchase to December, thus

qualifying them for the $6,500 credit.

Situation 12: Mr. and Mrs. W have owned and lived in their house for the last thirty

years. Their modified AGI is $140,000. Mr. and Mrs. X have also owned and lived in their

house for the last thirty years. Their modified AGI is also $140,000. Mr. W and Mrs. X had


109

worked for the same company, but they both retired in July 2009. Both couples are also

empty nesters, so they have decided to move to smaller homes in warmer areas of the

country. Mr. and Mrs. W were able to sell their home and purchase a new one in October

2009, but Mr. and Mrs. X closed later in November 2009. Mr. and Mrs. W will not qualify

for any first-time homebuyer credit since they sold their home and purchased a new one in

October. However, Mr. and Mrs. X will qualify for a $6,500 credit as first-time homebuyers.

The difference in this situation comes simply because of the small timing difference between

each couple’s sale/purchase. Mr. and Mrs. W could not have known in October that they

would be better off if they would have closed after the amended legislation on November 6,

2009.

Situation 13: Col. and Mrs. Y qualified for the $8,000 first-time homebuyer credit in

2009 by buying their first home. Mr. and Mrs. Z also qualified for the $8,000 first-time

homebuyer credit in 2009 by buying their first home. Col. Y was called to qualified official

extended duty in 2010, so Col. and Mrs. Y ceased to use their home as their principal

residence. Even though their home is no longer their principal residence and they have not

used it as such for 36 months, they do not have to recapture the credit because of the waiver

due to the qualified official extended duty. Mrs. Z was employed by a defense contractor and

was required by her employer to move in 2010 to directly support the maneuvers of Col. Y’s

military unit. Thus, Mr. and Mrs. Z ceased to use their home as their principal residence.

Although Mrs. Z’s move tied directly to a military mission, Mr. and Mrs. Z will have to pay

back the $8,000 credit since they did not own the home as their principal residence for at

least 36 months after its purchase.

Situation 14: Lt. AA is single and has never owned a home because of extended and

geographically varied service assignments in the military. His last assignment was a

qualified official extended duty assignment outside of the U.S. which lasted from April 25,

2009 to April 25, 2010. Lt. BB is single and has never owned a home because of extended

and geographically varied service assignments in the military. Her last assignment was an

official extended duty assignment in the U.S. which lasted from April 25, 2009 to April 25,

2010. Lt. AA and Lt. BB both retired at the end of their extended duty on April 25, 2010.

Both have modified AGI less than $125,000. Each buys a principal residence for retirement

in the same neighborhood in the summer of 2010. Lt. AA can claim an $8,000 first-time

homebuyer tax credit, but Lt. BB cannot because her extended duty assignment was in the

U.S. which does not allow her an extension to the deadline for the credit.

Situation 15: Mr. and Mrs. CC bought their first home in July 2009 and qualified for

an $8,000 first-time homebuyer credit. Mr. and Mrs. DD also bought their first home in July

2009 and qualified for an $8,000 first-time homebuyer credit. Mr. and Mrs. CC had a job

transfer in June 2012, so they ceased to use their home as their principal residence at that

time. Thus, they have to pay back the entire $8,000 credit under the accelerated recapture

provision because they did not use the home as their principal residence for at least 36

months. Mr. and Mrs. DD also had a job transfer, but they did not have to move until August

2012. Although they only lived in their home for two months longer than Mr. and Mrs. CC,

since Mr. and Mrs. DD have used their home as their principal residence for at least 36

months, they do not have to pay back any of the credit under the accelerated recapture

provision.

Smith and Riggs

110

Situation 16: Mr. and Mrs. EE claimed a $7,500 first-time homebuyer credit in 2008.

Mr. and Mrs. FF also claimed a $7,500 first-time homebuyer credit in 2008. Both couples

resold their homes in 2010 because of job transfers. Although the home market had softened

between 2008 and 2010, because of the location of their home, Mr. and Mrs. EE were able to

sell their home for a $7,500 gain, but they had to immediately recapture the entire $7,500

credit in 2010 because they sold their home before the end of the 15-year recapture period.

However, Mr. and Mrs. FF did not have to recapture any of their credit because they sold

their home for no gain or loss, even though they also sold their home before the end of the

15-year recapture period.

In addition to the specific situations detailed above, other hypothetical situations

could be created that would lead to inequities. Some of these might involve the requirements

that the first-time homebuyer not be a dependent on another taxpayer’s return or that the

homebuyer must be at least 18 by the date of the home purchase. It might be more

acceptable to think that taxpayers who are first-time homebuyers of their own principal

residence should be at least age 18 and not dependent on someone else. These changes in the

limitations for the credit were likely made more to close unanticipated loopholes in the

original law rather than just to arbitrarily change the timing or general limitations and

qualifications on claiming the credit.

Other examples could relate to the changing limitations relating to homes financed by

tax-exempt mortgage interest bonds or the new rule that a home cannot be purchased from a

spouse’s relative (in addition to the existing rule that a home cannot be purchased from a

taxpayer’s relative). These situations are not detailed because they are probably not as ironic

according to public policy, although they could still result in similar cases being treated

differently.

CONCLUSION

As can be seen by the many situations illustrated above, the first-time homebuyer

credit can create situations that seem ironic or inequitable. These anomalies can arise

because of the timing requirements of the original law and the amendments or because of

other qualifications and limitations legislated in this credit. Other hypothetical situations

resulting in ironies could be created. While the first-time homebuyer credit may have

stimulated the economy, specifically the housing sector, it may be seen in many cases as

unfair. The anomalies and ironies are the result of hurried legislation attempting to resolve

an economic recession rather than the result of good, long-term tax policy. Congress should

reconsider the implications of this credit with respect to the situations mentioned before

creating other, similar tax credits.

REFERENCES

Curatola, A.P. (2009). Housing Assistance Tax Act of 2008. Strategic Finance, 90(7), January, 10-

12.

Public Law 110-289. (2008). Housing and Economic Recovery Act of 2008, July 30.

Public Law 111-5. (2009). American Recovery and Reinvestment Act of 2009, February 17.

Public Law 111-92. (2009). Worker, Homeownership, and Business Assistance Act of 2009,

November 6.

Public Law 111-198. (2010). Homebuyer Assistance and Improvement Act of 2010, July 2.


111

Smith, S.R. (2009a). The First-Time Home Buyer Credit: Technical Correction Needed. Tax Notes,

122(3), January 19, 405-409.

Smith, S.R. (2009b). The First-Time Homebuyer Tax Credit. Journal of Business and Accounting,

2(1), Fall, 171-178.


Vol. 5, No. 1; Fall 2012

112

ACCOUNTING FOR SUSTAINABILITY

Mehenna Yakhou

Georgia College & State University

ABSTRACT

Environmental sustainability has gained importance across the globe due to the

increased concern for externalities that companies’ activities place on society. Government

and other stakeholders are putting pressure on businesses for greater transparency regarding

social and external performance and impacts. Accountants have an important role to play in

identifying, measuring and allocating sustainability-related costs, developing and reporting

sustainability performance metrics and helping corporations formulate and implement

environmental strategies. The purpose of this paper is to provide insight into contemporary

understanding of the new dimension of accounting for sustainability.

CORPORATE SUSTAINANBILTY

In recent years, sustainable development has become a significant part of the

objectives of many organizations. In general, corporate sustainability can be considered as a

broad approach, integrating financial, economic, environmental, and social aspects that can

assist firms achieve a more holistic level of accountability (Schaltegger and Burritt 2005).

The United Nations (UN) World Commission on Environment and Development gave the

initial definition of the term, “the ability to meet the needs of the present without

compromising the ability of future generations to meet their own needs,” (Bruntland, 1987).

Dixon and Fallon (1999) describe the development of sustainability concept, from single

resource, to the multiple resource ecosystems, and expanded to integrated social-physical-

economic systems. They provide an operational definition of sustainability as six socio-

economic questions:

How should equity, both intergeneration and intergenerational, be handled with respect

to resource management decisions?

What do we leave to future generations to ensure that they are not worse off?

Will there be enough to go around?

How far into the future do we worry about (next week, next year, next century)?

Are there some patterns of resource use that should be accepted irrespective of losing

or saving the resource?

To what extent can market forces (and technology) intervene in the process of

development vis-a-vis resource use (the conservationist versus possibilist debate?

CORPORATE SUSTAINABILITY AND ACCOUNTING

Gray (1992) provides a structured view of sustainability, as a theoretical foundation

to “sustainability accounting” based on a systems view of the environment. Initially, the

relationship between management accounting and economics fails to notice the environment

and biosphere as relevant to costing. Birkin and Woodward (1997) define essentials to move

management accounting from its economic basis and internal focus, to sustainable

development. Two steps are identified, one from economic efficiency, to environmental


113

efficiency; the other from environmental efficiency to ecological efficiency. To make the

first step, environmental issues must overcome environmental biases and shift to a prime

emphasis. A basic need is to introduce environmental statutory language and concepts into

the language and expertise of management accounting. That shift of focus assures non-

marginal consideration of environmental impacts of corporate activities. Step two is sizable,

to consider the ecosystem in an interconnected, interdependent manner. A basic need here is

to adopt total cost assessment in management accounting. That approach requires measures

of cost of processes, products, and services reflected in managerial decisions and corporate

behavior. Milne (1996) suggests that techniques and tools from other disciplines, such natural

and social sciences, should be integrated into management accounting systems. Bartolomeo

et al. (2000) define environmental management accounting as: “The generation and use of

financial and related non-financial information, in order to support management within a

company or business, in integrating corporate environmental and economic policies and

building sustainable business)”. Main features of environmental management accounting are

described (Birkin, 1996):

setting boundaries for an eco-balance, including life-cycle accounting of product and

process;

appraising performance of technologies and technological change;

recording corporate environmental liabilities;

appraising environmental performance from long-term perspective on environmental

indicators; and

establishing budget planning and control at the detail level of management accounting

The range of extension is described as four levels:

exploitationist, not accounting for nature with economic goals including efficiency;

conservationist, accounting for externalities with goals reflecting values for

recreation, future use and preservation implemented for operational and financial

feasibility;

naturalist-preservationist, recognizing impacts on the ecosystem with

intergenerational issues and technological substitutions considered and constraints on

local projects integrating social/economic/ecological impacts, specifically resource

use and environmental degradation;

extremist-preservationist, on a non-anthropocentric basis with ecological priorities

superior to social, and focusing on the intrinsic value of nature

This overall movement is said to expand the organization’s obligation, to

environmental accountability (Birkin and Woodward, 1997). Effects of expansion are to

improve environmental performance, specifically environmental aspects of industrial

performance and to involve all aspects of the accounting discipline.

Environmental management accounting relates to social accounting and “green”

accounting as well. “Green” accounting is described (Atkinson and Hamilton, 1996) as a

level of accounting based on environmental indicators namely, pressure on companies, state

of the environment and companies’ response. Pressure is both direct and proximate causing

change; state of the environment includes loss from pollution and waste, due to human

activity; and response is from government policies, individual and business practice and

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environmental activism. From this paradigm, “green” accounting appears to become an

essential adjunct to management accounting. Social accounting includes, among other areas,

reporting data related to effects of global warming, raw material use, solid waste and water

pollution, human toxicity, and ecosystem degradation. As described by Pestoff cited in Gray

(2010), social accounting is concerned with:

the social and environmental (including sustainability) impacts and effects arising

from conventional accounting practice;

ameliorating the social and environmental impacts arising from conventional

accounting practice (including seeking ways to reduce the negative impacts and

looking for ways to encourage positive social and environmental effects;

deriving and developing new methods of accounting that might be implicated in more

benign social and environmental effects and which, typically would advance the case

of accountability

Lamberton (2005) notes: “The provision of sustainability accounting information to

internal users would focus on the provision of relevant and decision useful information to

management. For example, an array of performance indicators and lifecycle data compared to

relevant sustainability targets would assist the internal management of the organization

toward the multidimensional sustainability objective.”

Hence at the business level, long-term effects are focused among others on costs and

revenues, assets and liabilities of the firm. The difficult extension of firm-level accounts is in

introducing the additional performance indicators and lifecycle data, including costs,

revenues, assets, and liabilities. Accounting for effects of environmental compliance must

recognize the regulatory boundaries which represent a variety of costs and expenses and

potential penalties and liabilities. Environmental regulations pose a range of costs and

liabilities, including normative conditions and fees (start-up under environmental regulation,

such as permit fees, and on-going such as permit renewal); incidents of environmental

violations and on-going violations; economic loss due to interference with business activities,

both limitations and cessation; penalties (civil type fines and administrative orders to “cease

and desist” and criminal type fines); costs of complying with environmental regulations in

future; cost of cleaning contaminated sites; revaluation of assets depreciation; potential

liabilities from safety hazards to workers and the community at large, health and ecological

risks arising from operational emissions of pollutants and hazardous materials, and product

safely related issues; and other contingent liabilities arising from environmental exposures.

While environmental accountability is broadly considered as imposing burdens of

compliance, the activities associated with environmental protection also generate assets of

value. For example, under the Clean Air Act, an under-discharge provides salable emissions

rights transferrable to others which are discharge-limited. These rights are viewed as

“intangible operating assets” (Ewer et al., 1992). Cleanup expenditures of joint-hazardous

waste are recovered under the right of contribution. Estimates of these expenditures along

with the contributions of other firms are also recognized as assets in the firm’s balance sheet.

Other recognized assets are premiums paid on liability policies that safe guard business from

environmental claims (Surma, 1992). Also, compliance with environmental regulations


115

requires internal expertise in applying environmental standards and control technologies to

the local emission sources. Such expertise can result in “intellectual property”, as patents for

unique control/removal processes, and as “know how” on applying control to a local or

general situation. An environmentally managed company, and a system to assure

environmental compliance, can add value and hence generate goodwill of being “green”

(Willits and Giuntini (1994)).

Obviously an expanded conventional balance sheet does not fully capture all

environmental impacts. Hawken, et al., (1999) highlight the limitations of the conventional

balance sheet, arguing that current accounting systems do not include environmental and

social impact of corporate activities. Gray (2010) suggests a “system theory” approach, to

provide a rational for subdividing without introducing gross distortions. Systems theory

provides tools in the subdividing (boundary setting, problem definition and analytical

formulae) that form a body of principles. Gray states “At the heart of much of what

comprises social accounting currently is a concern over the impacts and development of

sustainability, accountability and large organizations, a matter within which social

accounting has a considerable potential. If sustainability is the “elephant in the bedroom” (the

issue which so dominates all other issues but still too rarely spoken of analytically) then

social accounting is one- but only one- of the means by which the serious exigencies of

sustainability might be addressed and ameliorated”.

The result is a structured approach to extending the boundaries of accounting and

reporting for determining the environmental, ecological, and social effects, or as Eccles et al.,

(2010) put it:

“The result is improved information provided to stakeholders about the company’s

performance and how it is being achieved – including its costs and benefits – that can

ultimately lead to ..“ the creation of an internal discipline necessary for embedding

sustainability into a company’s strategy and operations; better company understanding that

governance, strategy, and sustainability are inseparable; acknowledgement that a company is

responsive to the risks and opportunities created by the need to ensure a sustainable society;

and enhanced corporate disclosure and transparency.”

Milne (1996) suggests that this extreme extension of management accounting is not

favored by the accounting profession. Indeed, current accounting practice does not

require/allow business to record the consequences of its operations on factors that are

external to it. However, Gray (1992) argues and establishes such extension as certain

information requirements, namely accountability and transparency. Environmental

accountability is based on the social relationship of firm to community. To represent that

relationship, the structure of environmental accounting systems should incorporate a

specified identification of environmental impacts, and the content of environmental law and

quasi-law (regulation). Transparency of the environmental accounting system should be

based on a stewardship notion of providing information on compliance, along with

communication of the information, as a duty of the firm. Gray recognizes that availability

and duty to inform is not necessarily self-imposed, but may be responsive to pressure groups

(as the community), to influence the business firm in its decision-making and financial

assessment processes.

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TOOLS FOR SUSTAINABILITY ACCOUNTING

Sustainability Reporting: Corporate social disclosure, also called social accounting,

responds to influences by “external pressure groups” (Tilt, 1994). Social disclosure centers

on environmental protection, product quality, and product safety. “Community interest

groups” are the main source of influence on initiating and maintaining social disclosure.

Environmental groups are the most active, and environmental data are the most commonly

demanded (Birkin and Woodword, 1997). A paradigm of community interest groups is

proposed as “pressure groups” (Tilt, 1994). That is the group must be an involved group, able

to exert influence directly or by indirect action, and impose disclosure, at least, at minimum

levels for evaluation as understanding, sufficiency, and credibility. The group has a stake in

making information public, and so takes a penetrating approach (negotiation, analysis,

lobbying) on the disclosing company.

A central issue then for the business firm is how to integrate the range of

stakeholders. A four-step stakeholder management process has been suggested (Freeman,

1984):

identify the relevant stakeholder groups in relation to the issue being addressed;

determine the stake and importance to each stakeholder group (stake is diffuse but is

specific for each group, here considered as “needs” and “expectations);

determine how effectively the “needs” or “expectations” of each group are presently

being met (how a stake is met is diffuse but again specific to a group);

modify corporate policies and priorities to take into consideration stakeholder

interests

The stakeholder management process allows the firm to examine all strategic issues

facing it: economic, direct and secondary stakes, and to develop one or more strategies to

meet issues (stakes) in total and within priorities as set by resource limitation (amount and

return). Perrini and Tencati (2006) believe that “A sustainability-oriented company is fully

aware of its responsibility towards the different stakeholders and adopts methods and tools

that allow it to improve its social and ecological performance”.

So far the most common organizational response to reporting on sustainability

performance has been to publish corporate stand-alone-reports (KPMG, 2008). Examples of

proposed frameworks that have been developed to embed sustainability measurement and

reporting within the organizational structures include:

the Global Reporting Initiative, (GRI), developed by a United Nations affiliate

organization;

the SustainAbility framework developed by an international accounting firm;

the Environment Sustainability Index, developed by the World Economic forum;

the performance criteria framework developed by Figge et al. (2002)

All these frameworks take a multi-disciplinary and stakeholders perspective and show

that the range of issues that can be addressed is extremely broad. The primary goal of these

reports is to communicate the overall ecological, social, financial, and economic impacts of

the corporation; and business risk factors arising from environmental and social issues (Joshi


117

and Krishnan, 2010). However, there is a general consensus that the frameworks do not fully

integrate sustainability considerations in decision-making, accounting, and reporting

processes. Some critics indicate that disclosures of social accounting related information is

motivated by the desire to legitimize organizational actions (legitimacy theory, Deegan,

2002). Hubbard (2009) raises several concerns about these frameworks:

lack integration with conventional economic reports;

focus mostly on positive image of corporate performance;

focus on description outcomes, with no or little benchmarking;

do not involve the users (management and other stakeholders) in the collection,

analysis, reporting and audit of the information provided;

do not provide details as to what is reported, how, and why; and focus on

environmental issues, excluding social sustainability

Milne et al. (2008) have also been critical of these frameworks, arguing they

[frameworks] are “insufficient conditions for organizations contributing to the sustaining or

the Earth ecology. Paradox ally, they may reinforce business-as-usual and greater levels of

un-sustainability”. Ehrenfeld (2005), Bebbington et al., (2007) also note that current

corporate sustainability reports do not in any way come close to representing the

requirements of true social sustainability. Most sustainability accounting systems, as Joshi

and Krishnan (2010) put it “do not provide comprehensive, decision-relevant information to

meet the goal of becoming an environmentally sustainable and socially responsive

organization”. To remediate these shortcomings, new sustainability accounting tools, and full

business attitudes (and or organization culture) will need a “quantum jump” adjustment

[Mathews 2009), Hubbard (2009), and Bennett et al. (2011)].

Sustainability Management Accounting: A number of sustainability management

accounting tools can be used to integrate sustainability measures in traditional accounting

systems in order to influence strategic and operational decisions, improve the environmental

and economic performance of a company, and contribute towards a sustainable business

(Bennett et al., 2011). Modern accounting tools provide the necessary links between business

activities and reducing products and distribution costs, and enhancing revenue through

environmental quality appeal. Extending the intended effect of the environmental product is

to consider the full life of the product. Life-Cycle Costing approximates the expanded

product distribution chain, identifying all cost-bearing activities throughout the product life

cycle (Zach, 1992). That analysis incorporates the “cradle-to-grave” environmental

responsibility. The related benefits are product price reduction, reduction/elimination of

defects, by non use of hazardous materials and environmentally unsafe processes and more

use of recycled materials and/or recycling of materials (Strachan 1999).

Activity-Based-Costing has integrated cost-design drivers to product features

(function, reliability, quality, environmental features and its success in the market (price)

(Navinchandra, 1991). From Activity-Based-Costing, environmental activities can be related

to product/distribution channel/consumer over the business chain (Brooks, 1993).

The balanced score card (BSC) was introduced by Kaplan and Norton in the 1990’s to

improve traditional performance measurement system, a response to a reaction against

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business’s strict reliance on financial performance and physical asset for measuring success.

Kaplan and Norton (2004) base their framework on stakeholder theory. The BSC identifies

four perspectives (customer, process, organizational learning, as well as financial

perspective), which are broken down into goals, indicators, targets and tasks. The authors

propose strategy maps as a way of visualizing causal links, via cause and effect, of the

performance measures in each of the four perspectives. A modification of the BSC

framework is the S-BSC (Moller and Shaltegger, 2005; Figge et al., 2002). The original BSC

has been extended to include sustainability objectives (such as the environmental or social

impacts of a firm’s operations) in order to influence management’s decision making. As

Joshi and Krishnan (2010) put it “Developing sustainability maps is an essential first step in

visualizing and clarifying the causal links as to how external natural and social capital

resources together with an organization’s internal resources and processes help drive

organizational value creation and performance. These exercises will also help communicate

how various decisions and organizational processes can affect the flow of these ecosystem

and social services and thereby impact long-term performance of the firm. S-BSC can also

help develop strategically important sustainability performance indicators.”

CONCLUSION

The accounting profession’s increasing responsibility is in meeting requirements for

reporting and disclosure of environmental activities. Applicability of present accounting

standards, and the coming direction of environmentally-specific standards, represents a

formidable challenge. Mathews (2009) poses a pertinent question related to the standards

issue: “How should reports be constructed? If the expanded reports are to earn any credibility

amongst users…..there must be a degree of standardization and uniformity, which is also

required if the reports are to be audited”. Mathews (2009) points out that “there are several

issues that must be addressed before more far-reaching changes can be achieved. These

include the development of conceptual frameworks, standards and independent audits to

improve current disclosures. These areas indicate a research agenda for the next period of

development of social and environmental accounting”. There is also a need for discipline-

based environmental sustainability accounting models to develop standards in less developed

areas, value of “being green”, value of management time, and value of lost business

opportunity. The standards menu needs to be extended into these value areas of

environmental management – particularly as specific obligations under sustainable

development actuate in decisions of the firm.

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Vol. 5, No. 1; Fall 2012

121

A FACTOR ANALYSIS OF THE SKILLS NECESSARY IN

ACCOUNTING GRADUATES

Suzanne N. Cory

Kimberly A. Pruske

St. Mary’s University

ABSTRACT

This study obtains the opinions of two important constituent groups for higher

education accounting programs: (1) public accountants and (2) non-public accountants,

regarding the importance of accounting-related skills and topics to be covered in

undergraduate curricula. Factor analysis was used to determine common factors for each

group. The level of importance of factors was then compared within each group.

INTRODUCTION

Dissatisfaction with the level of accounting knowledge and skills exhibited by new

hires has been of concern by employers for a number of years. According to Nelson (1995)

impassioned cries for changes in accounting education have come from the accounting

profession since the “inception of university programs.” As accounting has moved beyond

the use of pencils, erasers, and 12-column worksheet paper toward embracing today’s

technology, these concerns have become more apparent. In short, accounting graduates need

to understand and master accounting-related skills and topics associated with technological

innovations including hardware and software in order to be productive starting with their first

day on the job. Further, in order to function in today’s diverse business environment, other

accounting-related skills and topics may be essential, such as proficiency in a second

language, creativity in problem solving and internet research.

In order to address these issues, accounting curricula may now incorporate business

classes that help students obtain skills in software such as Excel, Word, and Access, and

learn about technology such as telecommunication software, intranets, and client/server

management. Other business courses help students become aware of the impact of diverse

workplaces, as well as global, ethical, and environmental issues. Even so, accounting

programs have been especially inundated in the past two and a half decades with studies and

position papers addressing the quality of education available for accounting students and

recommending changes in educators’ approach to providing a more comprehensive

knowledge of accounting. As recently as 1998 the AICPA issued their top five issues for the

public accounting profession in their Vision Project, also offering guidance for changes in

higher education for aspiring CPAs.

Some practitioners and academicians seem to feel that academic accountants have

addressed only some of the issues raised with only a limited amount of success. The 2000

Albrecht and Sack (A&S) seminal study reporting that, in general, accounting education had

not changed substantively in response to the demands of accounting practitioners which

expresses concern about the future of accounting programs provided further food for

discussion. Albrecht (2002) also took his concerns to the American Association of

Collegiate Schools of Business (AACSB), causing substantial upheaval in accredited

Cory and Pruske

122

institutions. To illustrate the impact of Albrecht and Sack’s research, Johnson and Halabi

(2009) determined that A&S was cited in over 29% of published research papers during the

seven-year period between the beginning of 2001 and the end of 2007, which is certainly

evidence of a strong reaction to their concerns on the part of the professoriate.

Others have expressed concern that accounting programs in general have geared their

accounting curricula solely for students interested in public accounting, excluding students

who are more interested in the non-public accounting arena (Ahadiat, 2008). However, there

does not seem to be a consensus about the courses that should be completed in order to

ensure success in the non-public accounting arena (see, for example, Hurt, 2007). The

purpose of this paper is to report the findings of a study examining the viewpoints of public

accounting and non-public accounting professionals regarding accounting-related skills and

topics they feel students should have prior to employment. Perspectives of practicing

accountants, both in public accounting and in other areas of accounting, were gathered in

order to gain insight into this question.

METHOD

Currently practicing accountants should be well-informed about the skills that are

critical for new hires to possess in order to ensure success in their respective fields and topics

that should be part of an accounting program. Lending further support to this methodology,

A&S indicate that each accounting program has the responsibility of determining the needs

of its own key stakeholders, incorporating internal and external environments that are unique

to each. Finally, AACSB accreditation standards reinforce the concept that curricula must

consider constraints and opportunities that may be specific to a particular business program

based on its mission.

Surveying local accounting professionals regarding perceptions as to the importance

of accounting-related skills and topics needed by their new-hires should provide valuable

insight into the curriculum required of accounting programs in the local area. Cory (2009)

reported results of her study about course topics and degree preference but limited the

analysis of responses from her survey participants to only those currently practicing public

accounting. Similarly, Cory and Huttenhoff (2011) based their analysis solely on responses

from non-public accountants. This study compares perspectives of both groups of external

stakeholders and focuses on accounting-related skills and topics which may also lend support

to a successful accounting career.

The survey was distributed to 2,300 individuals who were either members of a large,

regional CPA society in south Texas, members of the Institute of Management Accountants

in the same area, or employers who had interviewed on a South Texas university campus

during the previous three years. A total of 464 usable surveys were returned which is a

response rate of approximately 19%. This rate is comparable to that reported in similar

studies. Approximately 46% of the surveys were completed by individuals currently

practicing public accounting and 54% by individuals who were employed in the non-public

accounting arena.

Respondents were asked to indicate, from the standpoint of their organization’s

business, how important it was for accounting students to have obtained certain accounting-

related skills prior to graduation. Respondents were provided with a list of 34 skills and


123

asked to rank each one on a three-point scale, with one indicating “not important,” two

indicating “important, but not critical” and three indicating “critical.” If the respondent did

not know how critical a skill was, they chose “4” as the answer. The responses were coded

according to the number chosen for each skill and any response in the “Do Not Know”

column was eliminated from analysis.

RESULTS

Given the amount of information collected (34 skills), principal components factor

analysis was used to determine common factors for each group. This made the analysis more

manageable (Pedhazur and Schmelkin, 1991) and resulted in ten factors for each group. For

the CPAs, six factors consisted of multiple skills, each loading at .45 or above. For the Non-

CPAs, eight factors consisted of multiple skills, each loading at .45 or above. No skills cross

loaded for either group. The next step in the analysis was to compute the average for each

factor. The factors for each group were then compared from one to the next, starting with the

most important factor (e.g. the factor with the highest average). Keeping in mind that a

rating of “2” indicates that the skill is “important, but not critical,” four factors for CPAs

averaged in excess of 2 and four factors for the non-CPAs averaged more than 2. The lowest

mean for CPAs was 1.45883 and the lowest mean for non-CPAs was 1.36618.

The 34 skills are listed in Table 1 and the factor on which each skill loaded is

indicated for each group of respondents. Four skills (Operating Systems other than

Windows, Collaboration Software (e.g. Lotus notes), Process/Operational Improvement and

Sales/Marketing) did not load on any factor for the CPAs. Two skills (Telecommunication

software and Programming Languages) did not load on any factor for the non-CPAs.

As indicated in Table 1, means were then computed for each factor and are shown in

Table 2 for CPAs and in Table 3 for non-CPAs. Finally, t-tests were computed to determine

significant differences between factors, from highest to lowest ranked from one to the next

for each group. The results are shown for the factors for CPAs and for non-CPAs in Tables 4

and 5, respectively.

As Table 2 indicates, CPAs ranked Factor 9 (Problem Solving), as the highest,

followed by Factor 10 (Ethics), Factor 6 (Software), Factor 7 (Technology), Factor 5 (Audit),

Factor 3 (Computers), Factor 2 (Softer Skills), Factor 8 (Language), Factor 4 (Nets) and

finally Factor 1 (Information Systems). Non-CPAs, as shown in Table 3, listed Factor 6

(Software 1) as having the highest importance, followed by Factor 5 (Software 2), then

Factor 8 (Technology), Factor 7 (Projects/Problem Solving), Factor 2 (Softer Skills), Factor 3

(Computer/Nets), Factor 9 (Audit/Language/Sales), Factor 1 (Systems), Factor 10

(Collaboration), and finally, Factor 4 (Web).

Cory and Pruske

124

TABLE 1

Skills and Factor Loadings

Skill/Topic

Factor,

CPAs

Factor,

Non-CPAs

Auditing through the computer 5 9

Telecommunication software 3

Computer hardware 3 3

Database software (e.g. Access) 3 5

Data analysis/use of Audit Command Language 3 5

Web design 1 4

Graphics software (e.g. Adobe) 3 4

Intranets 4 3

Extranets 4 3

Windows 6 6

Presentation Software (e.g. PowerPoint) 6 5

Programming languages 1

Spreadsheet software (e.g. Excel) 6 6

Technology security and controls 7 8

Technology terminology 7 8

Operating systems other than Windows. 1 1

Word processing software (e.g. Word) 6 6

Internet research 6 8

Client/Server management 1 1

Information systems planning 1 1

Information systems auditing 5 1

Project management 1 7

Systems analysis 1 1

Technology management and budgeting 1 1

Collaboration software (e.g. Lotus notes) 10

Process/Operational Improvement 1

Foreign language 8 9

Awareness of global issues 2 2

Sensitivity to cultural diversity 2 2

Awareness of changing demographics 2 2

Awareness of ethical issues 10 7

Sensitivity to environmental issues 2 2

Creativity in problem solving 9 7

Sales/Marketing 9


125

TABLE 2

Factors: CPAs

In order of importance

Factor Mean Description

9 2.67005 Problem Solving

10 2.64975 Ethics

6 2.46276 Software

7 2.04381 Technology

5 1.92204 Audit

3 1.85143 Computers

2 1.82219 Softer Skills

8 1.53030 Language

4 1.50843 Nets

1 1.45883 Information Systems

In order to determine whether these factors were statistically significantly different

from one to the next rank for each group, t-scores were determined. As shown in Table 4,

CPAs ranked Problem Solving and Ethics in that order, but there was no statistical difference

between the two factors. However, there were significant differences when comparing Ethics

with Software factors, Software with Technology factors, Technology and Audit factors,

Audit and Computers factors, and Softer Skills with Language factors. There were no

significant differences between Computers and Softer Skills factors, Language and Nets

factors or Nets and Information Systems factors, which was rated the least of the ten factors

by the CPAs. As shown in Table 5, non-CPAs ranked the Software 1 factor, which consists

of Windows, Spreadsheet Software (Excel) and Word Processing (Word), the highest. This

ranking is statistically higher than the Software 2 factor, which consists of Database Software

(Access), Data Analysis/Use of ACL, and Presentation Software (Powerpoint). No

significant differences were found in the rankings of Software 2 and Technology factors,

Technology and Projects/Problem Solving factors, Audit/Language/Sales and Systems

factors, or Systems and Collaboration factors. However, in addition to the significant

difference found between the two highest ranked factors, significant differences were found

between the Projects/Problem Solving and Softer Skills factors, the Softer Skills and

Computer/Nets factors, the Computer/Nets and Audit/Language/Sales factors and the

Collaboration and Web factors, which were ranked the lowest of the ten by the non-CPAs.

There may be several reasons for these differences in factor loadings between the two

groups and the related perception of how critical these accounting-related skills and topics

are for new hires in accounting. This outcome is not surprising, given that previous research

(Cory & Pruske, 2012) determined that public accountants and non-public accountants

ranked individual skills required of recent accounting graduates differently. For example,

CPAs ranked Creativity in Problem Solving highest, but the non-CPAs ranked it fourth

highest. The second highest ranked skill for CPAs was ethics, but for non-CPAs, that skill

was included in their fourth highest ranked factor. However, in both of the aforementioned

cases, the factor for CPAs had only one skill loaded on it, and the related factor for the non-

CPAs included a total of three skills. Both groups rated software skills highly, with CPAs

ranking them third and non-CPAs ranking them first and second. This is a clear indication

Cory and Pruske

126

that both groups perceive the need for new accounting graduates to have mastered certain

software packages. The technology factor and the computer factors are ranked in similar

positions in the two groups, although certain skills associated with factor 1 (ranked tenth) for

the CPAs are ranked lower than for the non-CPAs’ factor 1 (ranked eighth). It is logical that

CPAs would value their Factor 5, Audit, ranked fifth, more than the non-CPAs. The non-

CPAs included auditing skills in their Factor 9, ranked seventh. The factor associated with

Softer Skills is ranked lower for CPAs (seventh) than non-CPAs (fifth).

TABLE 3

Factors: Non-CPAs

In Order of Importance

Factor Mean Description

6 2.79549 Software 1

5 2.26876 Software 2

8 2.18611 Technology

7

2.17969

Projects/Problem Solving

2 1.92946 Softer Skills

3 1.77976 Computer/Nets

9 1.69198 Audit/Language/Sales

1 1.69089 Systems

10 1.65702 Collaboration

4 1.36618 Web

TABLE 4

Differences in Factors

CPAs

Factors T-Test Significance

Factors 9 and 10 0.35 n/a

Factors 10 and 6 4.49 <.0001

Factors 6 and 7 12.93 <.0001

Factors 7 and 5 2.31 .0221

Factors 5 and 3 2.18 .0308


Factors 2 and 8 6.96 <.0001


Factors 4 and 1 -0.14 n/a


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TABLE 5

Differences in Factors

Non-CPAs

Factors T-Test Significance

Factors 6 and 5 16.60 <.0001



Factors 7 and 2 10.35 <.0001

Factors 2 and 3 3.50 .0006

Factors 3 and 9 2.04 .0430

Factors 9 and 1 -0.14 n/a


Factors 10 and 4 5.93 <.0001

CONCLUSION

Implications for accounting educators are interesting. The statistical differences

between factors also provide interesting results. CPAs basically ranked Creativity in

Problem Solving and Awareness of Ethical Issues equally (first and second, respectively, no

statistical difference between them). Therefore, these would seem to be the top two skills on

which accounting educators should focus when working with students headed for a career in

public accounting. Yet these two are probably the most difficult to convey to students and

also the learning outcomes related to each the most difficult to measure. The non-CPAs’ top

two ranked skills are associated with software, which do not have the same difficulties of

conveyance and learning outcome measurement. Further, CPA candidates are expected to

pass the CPA exam, and creativity in problem solving is not tested on it. Should educators

focus on teaching software aspects, to the exclusion of creativity in problem solving or ethics

when working with students destined for a non-public accounting career? Most would reply

in the negative.

Finally, this study has some limitations that should be addressed. Responses were

obtained from individuals in only one geographical area, which may make findings difficult

to generalize to a wider population. Only 34 skills were listed on the survey, but additional

information could have been gathered with the research instrument. Further, information

about the viewpoints of recently hired accounting graduates regarding the skills they feel are

necessary for a successful career in accounting and whether they had those skills upon arrival

to their first accounting position could be gathered. These can certainly be the seeds for

future research.

REFERENCES

Ahadiat, N. (2008). In Search of Practice-Based Topics for Management Accounting Education.

Management Accounting, 9 (4), 42-53.

Albrecht, W.S. (2002). Accounting Education on the Edge. BizEd, March/April,

41-45.

Albrecht, W.S. & Sack, R.J. (2000). Accounting Education: Charting the Course through a Perilous

Future. Accounting Education Series, 16. Sarasota, FL: American Accounting Association.

Cory and Pruske

128

American Institute of Certified Public Accountants (AICPA) (1998). CPA Vision Project Identifies

Top Five Issues for Profession. The CPA Letter, 1 (12), 1.

Cory, S.N. (2009). What Do Public Accounting Practitioners Really Want? An Exploratory

Investigation. Journal of Business Issues, 1, 47-56.

Cory, S.N. and Huttenhoff, T.F. (2011). Perspectives of Non-Public Accountants about Accounting

Education and Certifications: An Exploratory Investigation. Journal of Finance and

Accountancy 6, 77-89.

Cory, S.N. and Pruske, K.A. (2012). Necessary Skills for Accounting Graduates: An

Exploratory Study to Determine What the Profession Wants. Proceedings of the American

Society of Business and Behavioral Sciences, 19 (1), 208-218.

Hurt, B. (2007). Teaching What Matters: A New Conception of Accounting Education. Journal of

Education for Business, 82 (5), 295-299.

Johnson, G.F. & Halabi, A.K. (2009). A Citation Analysis Measuring the Impact of Albrecht &

Sack (2000). Journal of Modern Accounting and Auditing, 5 (9), 21-29.

Nelson, I.T. (1995). What’s New about Accounting Education Change? An Historical Perspective

on the Change Movement. Accounting Horizons, 9 (4), 62-75.

Pedhazur, E.J. and Schmelkin, L.P. (1991). Measuring, Design and Analysis. Lawrence Erlbaum

Publishers, Hillsdale, N.J.


Vol. 5, No. 1; Fall 2012

129

THE EFFECT OF TIMING ON STUDENT SATISFACTION SURVEYS

Pierre L. Titard

James E. DeFranceschi

Eric Knight

Southeastern Louisiana University

ABSTRACT

This study is based on surveys of student satisfaction of a management accounting

simulation, used in a sophomore/junior-level managerial accounting course, required for all

non-accounting business students. The simulation requires that students, in teams of three,

make decisions to earn a profit for a hypothetical manufacturing firm over a simulated year.

Students’ simulation grades are based on the amount of net income earned by the team.

Students can earn a maximum of 50 points out of 500 course points, plus possible bonus

points. Instructors administer a survey each semester to determine student satisfaction with

the simulation, as well as to determine whether students believe that they have a better

understanding of the subject matter that had been discussed in class.

In previous semesters, some instructors administered surveys on the last day of class,

and some on the day of the final exam. This study was conducted to determine whether there

is a difference in student satisfaction, depending on when the survey is administered. Results

of a t-test show that for most items on the survey, there is a statistical difference.

Specifically, students who completed the survey on the day of the final exam indicated more

satisfaction with the simulation than those who completed it on the last day of class.

INTRODUCTION

At a regional university in the southeastern United States, a management accounting

simulation is used in a sophomore/junior-level managerial accounting course, required for all

non-accounting business students. The simulation (also referred to in this paper as the

“game”) requires that students work in three-person teams to make decisions with the goal to

earn as much profit as possible over a simulated year for a hypothetical manufacturing firm.

The year is divided into four quarters for decision-making purposes. The game is not

interactive; one team’s decisions do not affect the results of any other team. However, the

students do compete to earn a higher net income than their classmates. Simulation grades are

assigned on the basis of cumulative four-quarter net income. The higher the net income, the

more points the team earns, and vice-versa. In addition there are bonus points for the two

highest ranking teams each quarter and at the end of the game.

Not considering bonus points, students can earn a maximum of 50 points out of 500

course points, based on their cumulative net income for the four quarters. In previous

semesters, students were required to submit decisions for each of the four quarters in order to

earn any points. In other words, if a team did not submit decisions for each of the four

quarters, it received a grade of 0 out of 50.

Instructors administer a survey (described below) at the end of the semester to

determine student satisfaction with the simulation. The instructors also want to know whether

Titard, DeFranceschi, and Knight

130

students believe that the simulation has helped in their understanding of managerial

accounting, as discussed in class, and whether it helped in understanding other business

courses and “real world” problems.

PURPOSE OF STUDY

Recently, the authors changed the requirements by making submission of fourth

quarter decisions optional. Since there is a pre-determined grade scale based on cumulative

net income, students who decide to stop after three quarters of play know exactly what grade

they will receive. For example, if a team had a cumulative net income at the end of three

quarters that provided a grade of 40 points, the team could accept those points and not submit

another decision which would earn additional points. Students who elect to play a fourth

quarter know the minimum grade they will receive by using that same scale. Students were

told that in the past, playing the fourth quarter had always increased a team’s game points

and had never decreased the number of points from what the team had earned after three

quarters.

The purpose of the study was to determine whether student satisfaction differs

depending on the timing of the survey. That is, are students who complete the survey later

more satisfied with the simulation than those who complete it earlier? Intuitively, the authors

believed that there should be no significant difference. Students know their grades at the end

of three quarters, and can only increase their grades if they continue. Therefore, the authors

believed that students would have already been satisfied (or not) by the end of three quarters

and that whether the survey were administered earlier or later would make no difference in

the results. Regardless of whether or not students played the fourth quarter, all students in a

specific section completed the survey at the same time–either on the last day of class, or on

the day of the final exam.

PREVIOUS STUDIES

There is a dearth of literature on this topic. In fact, the authors’ literature review

found no previous studies directly related to their study. Previous research on surveys and

timing relate primarily to consumer research. Faught, et al (2004) determined the best time

for Internet surveys was Wednesday mornings. Bassili and Fletcher (1991) researched

methodology for measuring accurately the timing of respondents answers to questions in

computer-assisted telephone surveys. Severson (2002) states that timing is everything in

surveys and the worst timing is after a bad ice storm, weeks of major holidays, county fairs,

or a big local rodeo.

Interestingly, the one study that may have some relevance to our findings is one

related to the timing of paying physicians for their response to a mail survey (Berry and

Kanouse, 1987). This relevance is described in the Conclusions section of this paper.

METHODOLOGY

The population for the study consisted of 140 students in nine sections. Instructor 1

had two sections with 34 students; Instructor 2, four sections with 54 students; and Instructor

3, three sections with 52 students. A fourteen-item survey was administered to each student

at the end of the course to determine their satisfaction with the simulation. The instrument


131

used a five-point Likert scale, with possible responses from Strongly Disagree (1) to Strongly

Agree (5). The survey instrument also provided a space for students to write additional

comments if they desire. A copy of the survey instrument is included as Appendix A to this

paper. The survey was voluntary and anonymous. Instructors 1 and 2 administered the

survey to one and two of their sections, respectively, on the last day of class and to their

remaining three sections on the day of the final exam. Instructor 3 conducted the survey for

all three sections on the day of the final exam. Sections that completed the survey on the last

day of class are referred to as “early” sections; those who completed it on the day of the final

exam are referred to as “late” sections. Note that the difference in timing between early and

late is just one class day, that is, from the last day of class until the day of the final exam,

although it does range from four to seven calendar days.

The methodology used to conduct the research was as follows:

1. The mean for each survey item was calculated for the early sections.

2. The mean for each survey item was calculated for the late sections.

3. A t-test was used to determine whether any differences in means between the early

and late sections were statistically significant.

RESULTS

The results are shown in Table 1.

Table 1

T-Test of Means between Early and Late

Early Late

Item (N = 40) (N = 100) T-Test

1. Understand text 2.85 3.73 .01

2. Understand Managerial Accounting 2.88 3.70 .01

3. Understand other business courses 2.85 3.64 .01

4. Understand “real world” problems 3.60 4.00 .05

5. Liked the game 2.78 3.50 .01

6. Enjoyable experience 2.73 3.36 .01

7. Appropriate weight 3.10 3.54 .05

8. Prefer relative ranking for grade 2.87 2.56 N/S

9. Prefer predetermined grade scale 3.34 3.88 .01

10. Too time-consuming 3.16 2.87 N/S

11. Team did equal work 3.71 3.72 N/S

12. My contribution was greater 2.55 2.05 N/S

14. Include game in the future 3.03 3.80 .01

As shown above, the differences were significant at the .01 level for seven items and

at the .05 level for two items. There were no significant differences for five of the items.

Items 11, 12, and 13 are not totally relevant to the study because those items relate more to

satisfaction with the other team members than with the game itself.

Approximately 24% of the students also wrote comments regarding the simulation.

Although the comments cannot be measured statistically, more positive comments came from


132

those who took the survey on the day of the final exam; and more negative comments came

from those who took the survey on the last day of class. A summary of the comments are

shown in Table 2. Table 2

Summary of Comments

Early Late

(N= 11) Percent (N= 23) Percent

Positive 2 18% 10 43%

Negative 7 64% 2 9%

Neutral 2 18% 11 48%

11 23

Sample comments are included as Appendix B.

CONCLUSIONS

As indicated earlier, at the outset of the research the authors would not have expected

to see significant differences between “early” and “late.” They have no explanation for the

reasons for these differences. One possible explanation (untested) is that many of the “late”

students improved their grades by playing the fourth quarter of the game. They knew

precisely how much their grade had improved from the third quarter. Consequently, they

may have been more satisfied than they might have otherwise been. The “early” students

who planned to continue knew that their grade would improve, but did not know exactly by

how much it would improve. Perhaps they ended up more satisfied at the end of the fourth

quarter than they were at the end of the third quarter, but they had already completed the

survey.

This possible explanation relates somewhat to the physician research ( Berry and

Kanouse, 1987). In that study, one-half of the physicians were given $20 along with a

survey. The other half were sent the survey and were promised $20 upon completion of the

survey. The physicians receiving payment up-front had a higher response rate than the other

group. That study parallels to some extent the fact that at the time of the final exam, all

students knew exactly what grade they would receive for the simulation. However, on the

last day of class, students planning to continue knew approximately, but not exactly. Perhaps

this makes a difference.

Students who stopped at the end of three quarters knew their grade regardless of

when the survey was taken. At that point, they were either already satisfied or not, but

nothing else was going to change their opinion. Because the surveys are anonymous, we are

unable to separate the opinions of those who completed three quarters from those who

completed four quarters.

The authors recognize that this survey was specific to the management accounting

simulation used in their class. However, based on the results, they have arrived at the

following two conclusions.

1. More meaningful data may be obtained from administering student surveys as late

as feasibly possible.


133

2. More meaningful data may be obtained for evaluations, such as student

evaluations of teaching, when administered as late as feasibly possible.

Regarding the second conclusion, the authors note that in their experience, some

schools have gone to earlier requirements for student teaching evaluations from times when

they could be administered on the last day of class. While this is probably done for certain

administrative reasons within the university, it may, in some cases, be detrimental to the

instructor’s evaluation.

The authors believe that this study could serve as a basis for additional research in

this area.

REFERENCES

Bassili, J., & Fletcher, J. (1991). Response-Time Measurement in Survey Research. Public Opinion

Quarterly, 55 (3), 331-346.

Berry, S., & Kanouse, D. (1987). Physician Response to a Mailed Survey: An Experiment in Timing

of Payment. Public Opinion Quarterly, 51 (1), 102-114.

Faught, K., Whitten, D. &. Green, Jr., K. (2004). Doing Survey Research on the

Internet: Yes, Timing Does Matter. Journal of Computer Information

Systems, 44 (3), 26-34.

Serverson, J. (2002). What Every Manager Needs to Know About Consumer Research.

Management Quarterly, 43(2), 17-35.

APPENDIX A

MAS SURVEY

Circle the letter than best describes your attitude about each of the statements

regarding the Management Accounting Simulation (MAS game) used in ACCT 225 this

semester. Your responses should be anonymous, so do not write your name on the response

sheet.

1. The game helped me to understand better some of the concepts described in the text.

1 2 3 4 5

Strongly Disagree Neutral Agree Strongly

Disagree Agree

2. I have a better understanding of Managerial Accounting as a result of playing the game.

1 2 3 4 5


Disagree Agree

3. I have a better understanding of concepts learned in other business courses as a result of playing

the game.

1 2 3 4 5


Disagree Agree


134

4. The game gave me a better understanding of “real world” problems faced by business firms in

trying to make a profit.

1 2 3 4 5


Disagree Agree

5. I like the fact that the game was a required element of this course.

1 2 3 4 5


Disagree Agree

6. Playing the game was an enjoyable experience.

1 2 3 4 5


Disagree Agree

7. The weight of the game as a percentage of the total course, 10 % (50 points out of a total of 500

points) is the appropriate weight to assign to the game.

1 2 3 4 5


Disagree Agree

8. Points should be awarded based on relative competitive ranking of teams without a predetermined

scale. (For example, the highest team gets 50 points regardless of cumulative net income; the 2nd

highest gets 49 points, etc.)

1 2 3 4 5


Disagree Agree

9. Points should be awarded based on a predetermined scale. (For example, $15,000,000 or greater

cumulative net income is 50 points; $14,000,000--$14,999,999 is 49 points, etc.)

1 2 3 4 5


Disagree Agree

10. Considering what I learned from the game, it was too time-consuming.

1 2 3 4 5


Disagree Agree

11. All members of my team did approximately the same amount of work.

1 2 3 4 5


Disagree Agree


135

12. My contribution to the team was significantly more than that of any other team member.

1 2 3 4 5


Disagree Agree

13. My contribution to the team was significantly less than that of any other team member.

1 2 3 4 5


Disagree Agree

14. The game should be included when the course is offered again.

1 2 3 4 5


Disagree Agree

In the space below, please provide any additional comments, recommendations, or criticisms you may

have about the game.

APPENDIX B

Sample Students Comments–Early

• Good times!

• As a sophomore, I would have hated the game. But as a senior, I realize how important

the concepts that it teaches are.

• This “game” was EXTREMELY difficult and time consuming. I have missed work and

spent countless hours at home dealing with it. My other grades in my other classes

suffered. Not beneficial for learning at all in my opinion,! Nothing but STRESS over

something I will NEVER use!!!!

• Not worth it. NOT a game! Does not relate to anything I know. It’s retarded!

• The game was OK.

Sample Student Comments–Late

• The game was challenging but fun at the same time and it really helped me understand

the material better.

• It was a good learning experience.

• It got stressful and time consuming.

• A little too time consuming.

• Extend the game and make it worth more.

Authors’ Note: The third and fourth Late comments were the only two negative comments

from the Late students. Compare the difference in tone to the negative comments by the

Early students. We cannot make any statement that the differences resulted from

administering the survey earlier or later, but it is an interesting observation.


Vol. 5, No. 1; Fall 2012

136

STUDENT PLAGIARISM AND

ECONOMIC VERSUS MORAL BASED

PEDAGOGY

James Tackett

Raymond Shaffer

Fran Wolf

Gregory Claypool

Youngstown State University

ABSTRACT This study examines the relationship between incidents of

plagiarism and ethics pedagogy in a 2x2 full factorial, between subjects, quasi-

experimental design using the General Linear Model. An objective surrogate is

used to approximate the level of plagiarism in student writing assignments and

then compared between classes which emphasized an altruistic approach to ethics

versus a purely pragmatic view of ethical behavior (ethical egoism). The results

show that ethical egoism may be a more effective pedagogy for teaching college

ethics than pure altruism in terms of reducing the incidence of student plagiarism.

INTRODUCTION

Every college professor knows of the Internet's positive impact

on the learning environment in higher education. Powerful search engines enable

students to find large amounts of relevant material for their assignments in a

manner of seconds. Faculty are, however, also painfully aware of the stunning

rise in cut-and-paste plagiarism that is a direct result of these Internet search

engines. This plague of student plagiarism has been documented as a widespread

problem from high school all the way through graduate studies at both public and

private institutions across the globe (Blum, 2009; Comas and Sureda 2010;

Harding et al., 2004; Sunderland-Smith 2008). This creates a paradox because

extensive ethical preparation is required by virtually all business and most other

college curriculums.

The chasm between ethical education and student behavior is

troubling. Some studies have demonstrated that academic dishonesty in college

is a precursor to deceit in the workplace (Harding et al., 2004; Nonis & Swift,

2001). If such is the case, then the widespread prevalence of plagiarism is even

more disturbing because there will be costly consequences to society as students

graduate and enter the workforce.

Unfortunately, it is difficult to measure the impact of ethical

education on student behavior. Ethics questions and examinations can test a

factual knowledge of ethical rules and how a student would respond to a

hypothetical ethical dilemma; but, such artificial measurements will not


137

necessarily be representative of student behavior when they confront real choices

that pit honest scholarship against shady shortcuts. Some studies have directly

queried students about the prevalence and methods of plagiarism (Antenucci et

al. 2009). Such investigations provide useful insights into the problem of

plagiarism, but they fail to adequately measure the real cause-effect relationships

because of potential bias in student perceptions of the problem. Students may

also use the survey as a means to further their own agenda by providing

responses that would cultivate instructor approval. Accordingly, there is a

genuine need for going beyond traditional ethics examinations, case studies, and

honesty surveys; higher education needs to assess the true impact of ethical

preparation on student behavior.

This study examines the relationship between incidents of

plagiarism and ethics pedagogy in a 2x2 full factorial, between subjects, quasi-

experimental design using the General Linear Model. An objective surrogate is

used to approximate the level of plagiarism in student writing assignments and

then compared between classes which emphasized an altruistic approach to ethics

versus a purely pragmatic view of ethical behavior (ethical egoism). The results

show that ethical egoism may be a more effective pedagogy for teaching college

ethics than pure altruism in terms of reducing the incidence of student plagiarism.

THE NATURE OF PLAGIARISM There has been considerable discussion and research into the

various types of student plagiarism as well as the factors that are purported to

cause this form of academic dishonesty (Comas and Sureda 2010; Stevenson,

2001). Overall, the literature is not concerned with plagiarism which is caused

by student ignorance of academic referencing requirements; and, it focuses on the

deliberate submission of written or oral assignments that contain the words or

ideas of other people without proper acknowledgment. There is, however,

another form of unintentional plagiarism whereby writers subconsciously use the

ideas of others. This is known as cryptomnesia and is a relatively unexplored

area of plagiarism (Roig, 2001).

Harding et al. (2004) contends that plagiarism skills are first

developed in high school and then further honed when students enter the writing

intensive environment of college. This argument is supported by studies that

show most high school students have at some point plagiarized their writing

assignments (Bushway and Nash, 1977; Decoo, 2002). A study conducted by

Stevenson (2001) found that 40% of college undergraduates admitted to

plagiarizing material from the Internet. Another study pointed out that most

students do not view this form of cut-and-paste plagiarism as a serious violation

of academic honesty (Yeo, 2007).

The literature yields conflicting results about the prevalence of

plagiarism by academic ability. Smith et al. (2007) and Newstead et al. (1996)

found that plagiarism is more prevalent among weaker students as measured by

grade point average. This result was confirmed by a study which measured the

relationship between grade point average and college plagiarism (Tackett et al.

Tackett,,Shaffer, Wolf and Claypool

138

2010). Conversely, studies by Roberts et al. (1997) and Franklin-Stokes and

Newstead (1995) did not find a statistically significant relationship between

plagiarism and grade point average. Similarly, the relationship between gender

and plagiarism is open to question. Studies by Roberts et al. (1997) and Smith et

al. (2007) found that males are more likely to plagiarize than females. On the

other hand, Franklin-Stokes and Newstead (1995) and Granitz and Loewy (2007)

did not find a significant relationship between gender and plagiarism.

Prior research has demonstrated that such electronic

countermeasures can reduce the incidence of blatant plagiarism by as much as

77% (Tackett et al. 2010). Regrettably, students have adapted to these plagiarism

search engines by avoiding verbatim quotations and choosing to paraphrase the

plagiarized material to make detection more difficult. Paraphrasing can be

effective because it masks the exact source of the plagiarized material, thereby

making formal charges of college cheating difficult to prove beyond reasonable

doubt. This form of "gray plagiarism" has now become the norm for students

seeking dishonest shortcuts to completing college writing assignments.

Paraphrasing can be identified by commercial plagiarism detection engines (e.g.,

similarity indices), but formal prosecution via academic dishonesty committees is

rare because intent cannot be adequately established. This is known as the

cryptomnesia defense, and many students are willing to take full advantage of

this loophole.

THE ETHICAL DILEMMA OF PLAGIARISM Extensive ethical preparation is mandated by most college

accrediting agencies (e.g., AACSB for baccalaureate business accreditation). If

students overwhelmingly choose to plagiarize college assignments, then the

effectiveness of the ethics pedagogy administered to those students must be

questioned.

The traditional underlying theme of all business and professional

ethical codes is altruism, which expresses a sincere concern for the welfare of

others (Cheffers and Pakaluk, 2005). Students who engage in college cheating

are obviously placing self-interest above altruism to achieve economy in

preparing college assignments. The philosophy of acting in one's own self-

interest is called ethical egoism or simply egoism (Sanders, 1988). On the

surface, egoism appears to be the exact opposite of altruism; yet, this is not

necessarily correct. The short-term advantages of unethical behavior can be

more than offset by the long-term consequences. Accordingly, a rational person

pursuing egoism would need to balance the short and long-term consequences of

unethical behavior (Rachels, 2008). It is possible that a rational egoist would

view traditional altruistic behavior as something that would be in their own long-

term best interest. There are of course idealistic issues with egoism because it

advocates selfishness. Nevertheless, when viewed from a long-term perspective,

egoism and altruism can be seen as philosophies that could yield the same

behavior from individuals practicing those ideals.


139

The ethics literature provides mixed results on the impact of

ethical codes on behavior. Some studies show that ethical decision-making is not

affected by having a factual knowledge of ethical codes (Laczniak and

Inderrieden, 1987; White and Dooley, 1993; and Cleek and Leonard 1998). On

the other hand, other studies have suggested that knowledge of ethical codes

provides positive benefits to decision-makers (Barnett and Vaicys, 2000; and

Pflugrath et al. 2007). Tackett et al. (2010) examined the impact of teaching

accounting ethics from an altruistic approach versus ethical egoism and found

that student performance on ethics examination questions was unchanged.

However, students who were exposed to the ideas of egoism evaluated the ethical

conduct of accounting professionals in several classic auditing failures more

harshly than students who were exposed to traditional altruistic ethics. This

result provides evidence that egoism is worthy of further exploration in terms of

altering student beliefs about ethical behavior.

HYPOTHESIS DEVELOPMENT As discussed previously, there is a troubling inconsistency

between the behavior of plagiarizing students and the ethical education imparted

to them in the classroom. This raises the question of whether altering ethics

pedagogy would reduce the magnitude of student plagiarism. If the answer is

yes, then which ethics pedagogy is more effective in promoting student honesty.

In the current study, the AICPA Code of Professional Conduct is

used as an ethical benchmark because it is a structured set of ethical rules that is

taught by every accounting program. The AICPA Code can be supplemented

with either altruistic philosophy, ethical egoism, or both. If both altruism and

egoism are taught together, then one must argue that behaving in a manner that

considers the legitimate interests of others is in our own long-term economic

interest. The following hypotheses are developed:

H1: Presenting the AICPA Code of Professional Conduct combined with

ethical altruism does not alter the incidence of student plagiarism

compared to presenting the Code alone.


ethical egoism does not alter the incidence of student plagiarism

compared to presenting the Code alone.


ethical altruism and egoism does not alter the incidence of student

plagiarism compared to presenting the Code alone.

METHODOLOGY The above hypotheses are tested using a 2x2 full factorial,

between subjects design with 136 accounting seniors from a Midwestern,

AACSB accredited college of business. Separate sections of the same upper

division accounting class were selected to participate in the study. Students were

unaware that the lectures and presentation of material would be slightly different

between these sections, and they registered according to their own needs in


140

scheduling. Any students who had previously taken the course were removed

from the study so each participant was viewing the lecture and presentation for

the first time. Demographic information was collected from the students via

academic transcripts and included age, gender, and grade point average. The

dichotomous grouping variable for age was under 25 years old. Random

assignment was used to determine which sections received which set of lectures.

The random assignment of students would have been desirable to create a true

experimental design, but student scheduling needs made this impossible.

Accordingly, a quasi-experimental design by means of the General Linear Model

was used with grade point average as a covariate. The experiment was conducted

as part of the college’s educational assessment program and the results are being

used to evaluate the professional ethics learning goal for accounting majors.

Each student in the study prepared a research assignment

requiring a series of written papers analyzing a major auditing failure. Detailed

instructions for preparing the paper were described in the course syllabus and

discussed in class. These instructions included the need for proper academic

referencing of the sources used; and, specific examples were given of appropriate

referencing procedures. Students were required to submit their papers

electronically as attached files in Microsoft Word, and were warned that they

would be held accountable for proper referencing procedures. The course

syllabus also stipulated that any academic misconduct by students would result in

a failing grade for the course.

All of the student papers were analyzed by a commercial

plagiarism detection service. The output from this service showed a "similarity

index" for each student. This index represented the proportion of the paper that

was taken from the Internet or contained in a publication from their proprietary

database (e.g., published articles, books, manuscripts, etc.). The service also

provided an HTML copy of the student’s paper with highlighted sections and

notes to show exactly where the writing material was taken from. The papers

were reviewed, and any direct quotations or paraphrased statements with proper

references were noted and removed from the calculated similarity index.

Otherwise, the index would be including properly referenced material. This

adjusted similarity index would thus measure quotations and paraphrasing that

was not referenced by the student.

The 136 students in the study were partitioned into four groups.

Each experimental group received the same factual presentation of the AICPA

Code of Professional Conduct as part of the normal course requirement. Three of

the four groups, however, had the following supplemental discussions seamlessly

incorporated into the lecture: Group 2: Ethical Altruism; Group 3: Ethical

Egoism; Group 4: Ethical Altruism and Egoism. There was no discussion of

altruism or egoism in Group 1.

Altruism was discussed as a moral duty to behave in a manner

that benefits the common good of everyone (Cheffers and Pakaluc, 2005).

Specific examples of altruistic thinking included the need for accountants to

protect society from misrepresented financial statements as well as the need for


141

students to exercise academic integrity when preparing college assignments. The

argument was made that abstaining from academic dishonesty benefits all

students because the reputation of the college is enhanced over time. Egoism

was presented along the lines of showing that unethical behavior invariably

results in unfavorable complications and possibly dire results in the long-run, and

that self-interest is best served by behaving in an ethical manner (Chong, 1992).

FACTORS AND DEPENDENT VARIABLES The two factors evaluated in this study are the application of

altruism and egoism as discussed above. The dependent variables are the

adjusted similarity index score from student papers and the number of verifiable

academic references (footnote citations) cited by each student. Age and gender

are included as controlling factors, and student grade point average is used as a

covariate in the General Linear Model. There would be an obvious negative

correlation between the similarity index and footnote citations; therefore, a dual

approach is used for the analysis. First, multivariate analysis of covariance

(MANCOVA) is used to examine the effects of the factors on the joint

relationship between the similarity index and footnote citations. Second, analysis

of covariance (ANCOVA) is used separately for the similarity index and footnote

citations. This dual analysis (MANCOVA then ANCOVA) is used for the sake

of completeness, and it should be noted that a significant MANCOVA does not

necessarily imply a significant ANCOVA and vice versa.

RESULTS: Table 1 shows a Pearson correlation matrix with P-values for the

variables and factors.

Table 1:Correlation Matrix of Factors and Variables

Correlation Matrix

Marked correlations are significant at p < .05

N=136

Variable Altruism Egoism Age Gender GPA Footnotes

Egoism

Age

Gender

GPA

Footnotes

Simila rity

-.0000

p=1.00

.3607 -.0239

p=.000 p=.783

-.0445 -.1375 -.1084

p=.607 p=.110 p=.209

-.0471 -.1527 -.2107 -.0518

p=.586 p=.076 p=.014 p=.549

.1068 .3173 .0425 -.1996 .1808

p=.216 p=.000 p=.623 p=.020 p=.035

-.0560 -.2514 .0091 .1812 -.1085 -.3498

p=.517 p=.003 p=.916 p=.035 p=.209 p=.000


142

The correlation between altruism and age is coincidental, indicating a

disproportionately large group of students who were over age 25 in the altruism

group. This confirms the need for age as a controlling factor. Additionally, older

students had a lower cumulative grade point average. Males provided fewer

footnote citations than females, and had significantly higher similarity index

scores. There is no significant correlation between footnotes or the similarity

index for the altruism group; however, both of these correlations are significant

for egoism. Based on this simple correlation matrix, students in the egoism

group had a lower similarity index and provided more footnotes than the altruism

group.

Table 2: Multivariate Analysis of Covariance

MANCOVA ~ Footnotes and Similarity versus

Altruism, Egoism, Age, Gender, (GPA as Covariate)

Variable W

ilks' F Degrees of Freedom

P

Value

S

tatistic

N

um

Denom

inator

GPA

0

.95351

3

.12 2 128

0

.048

Altruism

0

.99576

0

.272 2 128

0

.762

Egoism

0

.87791

8

.901 2 128

0

.001

Age

0

.99906

0

.06 2 128

0

.941

Gender

0

.96977

1

.995 2 128

0

.141

Altruism*E

goism

0

.99809

0

.122 2 128

0

.885

Table 2 shows the MANCOVA results for how the factors and

GPA covariate influenced the combined effect of similarity and footnote

citations. GPA is significant at the 5% level, suggesting that stronger students

had lower similarity indices and/or higher footnote citations. This result is

consistent with the previously discussed findings of Smith et al. (2007) and

Newstead et al. (1996). Altruism is not significant, but egoism is highly

significant (P-value < 0.001). Gender was the next most significant factor (P-

value 0.141). There was no significant interaction between altruism and egoism.


143

Figure 1: Surface Plot of Similarity and Footnotes

A linear surface plot of the data is shown in Figure 1, and it

provides a visual representation of the MANCOVA results. Each graph shows a

three-dimensional regression model of the similarity (top) and footnote (bottom)

components of the data.

The surface plot of similarity has some significant outliers

(altruism with no egoism), but the overall center mass of the observations seems

to suggest higher levels of plagiarism (similarity index > 12) for the students who

received neither the altruistic or egoistic presentations. The footnote surface plot

is clearly more pronounced and appears to show greater footnote presentation for

students who received both altruistic and egoistic lectures.


144

Figure 2 shows an ANCOVA graph of the four experimental

groups by similarity index (top) and footnotes (bottom) with grade point average

as a covariate.

Figure 2: Analysis of Covariance ANCOVA Graph on Similarity Index

Current effect: F(3, 131)=3.8000, p=.01188

Vertical bars denote 0.95 confidence intervals

AICPA Only Altruism Egoism Altruism+Egoism

Treatment

-2

0

2

4

6

8

10

12

14

16

18

20

Sim

ila

rity

In

de

x

Covariate means:

GPA: 3.282059

ANCOVA Graph on Footnotes

Current effect: F(3, 131)=5.4094, p=.00154

Vertical bars denote 0.95 confidence intervals

AICPA Only Altruism Egoism Altruism+Egoism

Treatment

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Fo

otn

ote

s

Covariate means:

GPA: 3.282059

The ANCOVA on similarity index is significant at the 1% level.

However, an ex-post multiple comparisons procedure demonstrates that only the

altruism plus egoism group is significantly different from the AICPA group at the

5% significance level (note vertical bars for Tukey’s HSD test). Similarly, the

ANCOVA on footnotes is significant (P-value 0.00154), and only the altruism

plus egoism combination produced a significant difference from the AICPA

group based on Tukey’s HSD test. The graphs in Figure 2 seem to indicate that

altruism alone provides little if any benefit beyond the AICPA Code; egoism

alone produces a stronger (but not statistically significant) response; and, the

combination of altruism plus egoism is more effective in reducing plagiarism

than the AICPA Code alone or the Code plus altruism.


145

Table 3

Factorial ACOVA: Altruism x Egoism x Age x Gender Test of SS Whole Model vs. SS Residual

Dependent

Variable

Multiple

R

Multiple

R²

Adjusted

R²

SS

Model

df

Model

MS

Model

SS

Resid

df

Resid

MS

Resid

F p

Simila rity 0.4318840.186524 0.0771494464.33 16 279.02 19470.01 119 163.61 1.71 0.05

Fisher's LSD Test on Similarity Index

Probabil i ties for Post Hoc Tests

Error: Between MSE = 163.61, df = 119.00

Cell

Alt Ego Age Gen 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

0 0 0 0

0 0 0 1 0.18

0 0 1 0 0.65 0.24

0 0 1 1 0.29 0.78 0.25

0 1 0 0 0.36 0.80 0.32 0.68

0 1 0 1 0.55 0.03 0.88 0.14 0.11

0 1 1 0 0.34 0.03 0.88 0.09 0.08 0.61

0 1 1 1 0.81 0.27 0.83 0.29 0.38 0.90 0.65

1 0 0 0 0.67 0.16 0.91 0.21 0.26 0.98 0.73 0.90

1 0 0 1 0.86 0.17 0.74 0.25 0.31 0.74 0.48 0.92 0.79

1 0 1 0 0.87 0.29 0.59 0.36 0.48 0.46 0.29 0.73 0.59 0.75

1 0 1 1 0.06 0.48 0.14 0.90 0.41 0.01 0.01 0.14 0.07 0.06 0.12

1 1 0 0 0.38 0.02 0.94 0.10 0.08 0.69 0.90 0.71 0.80 0.53 0.32 0.01

1 1 0 1 0.82 0.12 0.75 0.23 0.26 0.75 0.47 0.94 0.80 0.98 0.71 0.04 0.52

1 1 1 0 0.21 0.01 0.79 0.06 0.03 0.42 0.85 0.54 0.60 0.34 0.18 0.00 0.74 0.32

1 1 1 1 0.91 0.19 0.71 0.27 0.34 0.69 0.44 0.88 0.75 0.95 0.80 0.07 0.49 0.92 0.31 Test of SS Whole Model vs. SS Residual

Dependent

Variable

Multiple

R

Multiple

R²

Adjusted

R²

SS

Model

df

Model

MS

Model

SS

Resid

df

Resid

MS

Resid

F p

Footnotes 0.4383 0.1921 0.0835 55.8549605 16 3.49 234.90 119 1.97 1.77 0.04

Fisher's LSD Test on Footnotes

Probabil i ties for Post Hoc Tests

Error: Between MSE = 1.9740, df = 119.00

Cell

Alt Ego Age Gen 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

0 0 0 0

0 0 0 1 0.03

0 0 1 0 0.93 0.21

0 0 1 1 0.18 1.00 0.30

0 1 0 0 0.88 0.02 1.00 0.16

0 1 0 1 0.77 0.00 0.95 0.12 0.92

0 1 1 0 0.79 0.10 0.80 0.28 0.69 0.59

0 1 1 1 0.33 0.70 0.44 0.77 0.29 0.23 0.46

1 0 0 0 0.90 0.09 1.00 0.22 1.00 0.94 0.75 0.35

1 0 0 1 0.06 0.88 0.21 0.92 0.05 0.02 0.13 0.66 0.11

1 0 1 0 0.25 0.44 0.43 0.63 0.20 0.13 0.42 0.90 0.31 0.45

1 0 1 1 0.29 0.22 0.50 0.49 0.24 0.13 0.51 0.75 0.37 0.27 0.80

1 1 0 0 0.74 0.01 0.92 0.13 0.87 0.93 0.58 0.24 0.90 0.03 0.15 0.17

1 1 0 1 0.99 0.04 0.92 0.19 0.87 0.77 0.81 0.34 0.90 0.07 0.27 0.32 0.74

1 1 1 0 0.43 0.00 0.71 0.06 0.54 0.55 0.32 0.13 0.63 0.01 0.06 0.06 0.66 0.43

1 1 1 1 0.73 0.02 0.90 0.13 0.84 0.90 0.57 0.24 0.87 0.04 0.16 0.19 0.96 0.72 0.71

Table 3 shows the results of full factorial ANCOVA on the

similarity index (top) and footnote (bottom) factors with Fisher's LSD multiple

comparisons test. The overall significance of the ANCOVA is 5% for the

similarity index and 4% for footnotes. Yet, as discussed above in the surface

plots, the similarity index contained skewed data that was not normally

distributed. A Box-Cox logarithmic transformation was performed on the

similarity index, and this reduced the ANCOVA significance level from 5% to

1%. Accordingly, a multiple comparisons procedure can be used to search for

significant differences between the factors. Fisher's LSD test is shown because


146

there were no statistically significant differences between any of the factors using

Tukey’s HSD test. Tukey’s HSD uses a pooled variance to establish confidence

intervals; therefore, each confidence interval will be the same length. Fisher's

LSD calculates individual variances and thereby provides confidence intervals of

different sizes for each variable. Fisher's test is considered more precise, but it is

less conservative than Tukey’s if one is searching for large differences between

the independent variables.

Fisher's LSD multiple comparisons procedure shows that gender

(male = 1, female = 0) is an issue for both the similarity index and footnote

dependent variables. For the similarity index, males in the egoism group

plagiarized less than males in the other groups (column 2, P = 3%). The sharpest

similarity index gender difference occurs between males from the AICPA group

versus females over age 25 from the altruism plus egoism group (P = 1%). This

same gender effect is noted for footnotes and is even stronger (P < 1%). In fact,

males from the AICPA group footnoted significantly less than males or females

from the altruism plus egoism group. This result is consistent with the findings

of Roberts et al. (1997) and Smith et al. (2007) which observed higher plagiarism

rates by males. It also implies that egoism may have its greatest behavioral

impact on males.

Another interesting result from Table 3 concerns the fact that the

altruism group is not significantly different from any combination of egoism,

age, and gender (column 9). Moreover, most of the results for altruism are not

even close to being significant for both the similarity index and footnotes. On

the other hand, the altruism plus egoism group has a significantly lower

similarity index when compared to the altruism group (column 12 of similarity

index). This implies that altruism combined with egoism may be the most

effective pedagogical combination.

DISCUSSION AND CONCLUSIONS Seven of the 136 students received failing grades in the course

for plagiarism (outliers in the similarity index of Figure 1). Another 16 students

had significant grade reductions for negligence in failing to provide acceptable

citations. At least 31 additional students fell into the "gray plagiarism" area of

successful paraphrasing without crossing the line into academic misconduct. All

the reprimanded students alleged human error or fatigue for "forgetting" to add

proper references for their research.

The results from the MANCOVA and ANCOVA analysis

suggest that ethical egoism seems to be more effective than traditional altruism in

reducing the incidence of plagiarism in the selected sample. The most effective

combination appears to be combining altruistic philosophy with egoism by

explaining that ethical behavior is, in the long run, in our own best economic

interest. Egoism appears to have a greater impact on males than females.

The counterargument to this study would advocate the position

that greater discussions with students about the negative consequences of

plagiarism results in less plagiarism. This is, however, overly simplistic. The


147

contribution of this study rests in comparing traditional ethical arguments based

on altruism with those of ethical egoism, and then measuring the impact of these

different philosophies on the ethical behavior of students. Further research on

the advantages and disadvantages of incorporating ethical egoism into traditional

ethics courses seems warranted.

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