JOURNAL OF BEHAVIORAL FINANCE, 12: 6877, 2011 Copyright C The Institute of Behavioral Finance ISSN: 1542-7560 / 1542-7579 online

DOI: 10.1080/15427560.2011.575969

Fair Value (U.S. GAAP) and Entity-Specic (IFRS) Measurements for Performance Obligations: The Potential Mitigating Effect of Benchmarks on Earnings Management
Cheri R. Mazza
John F. Welch School of Business, Sacred Heart University

James E. Hunton
Bentley University

Ruth Ann McEwen

Florida International University

A total of 86 nancial managers participated in an experiment designed to assess the reliability of Level 3 fair value (U.S. GAAP) and entity-specic (IFRS) measurements of performance obligations. The study focuses on asset retirement obligations because, to date, under U.S. GAAP they are the sole performance obligation measured at fair value. The ndings indicate that with a benchmark, managers tend to manage earnings less with fair value measurements than entity-specic measurements. In contrast, without a benchmark, managers tend to manage earnings irrespective of whether the obligation is measured using fair value or entity-specic value. Findings suggest that to the extent IFRS entity-specic measurements are associated with internally derived benchmarks, they may be more reliable than Level 3 fair value U.S. GAAP measurements that will not have benchmarks.

Keywords: Fair value, Entity-specic, Asset retirement obligation, Earnings management,

Benchmark

INTRODUCTION Archival research related to nancial items indicates that fair value measurements are most relevant and reliable when the items are associated with active exchange markets (e.g., Carroll et al. [2003], Barth [1994], Petroni and Wahlen [1995], Barth et al. [1996], Eccher et al. [1996], Nelson [1996]). Due to unease about the reliability of fair value measurements for nancial items traded in thin markets, the Financial Accounting Standards Board (FASB) in 2008 issued interpretive guidance in the form of FASB Staff Position, No. 157-3, Determining the Fair Value of a

Address correspondence to Ruth Ann McEwen, Director, School of Accounting, Florida International University, 11200 SW 8th Street, RB 210, Miami, FL 33199. E-mail: rmcewen@u.edu

Financial Asset When the Market for That Asset is Not Active. In the context of fair value for nonnancial items, concerns arise because by their nature they lack active markets; hence, their valuations are based solely on unobservable cash ow inputs. The current study focuses on the reliability of Level 3 fair value measurements for performance obligations. We use liabilities for asset retirement obligations (AROs) resulting from FASB Statement No. 143, Accounting for Asset Retirement Obligations, because, to date, they are the only performance obligation measured at fair value (FASB [2001]). We assess reliability in the context of earnings management because opportunities exist for manipulation when the ultimate cash settlement is different from the carrying amount of the liability resulting from the application of Statement of Financial Accounting Standards (SFAS) No. 143. Among other things, the ultimate cash settlement could be lower due

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to the requirement to include prot margin and market risk in the fair value measurement. We also investigate the potential impact of International Financial Reporting Standards (IFRS) on the tendency of managers to manipulate earnings via ARO liability measurements. Under IFRS guidance provided by IAS 37 [1998], Provisions, Contingent Liabilities and Contingent Assets, initial measurement of an ARO is provided by managements best estimates. Paragraph 37 states that the best estimate is the amount than an entity would rationally pay to settle the obligation at the end of the reporting period or transfer it to a third party at that time. We use an experiment to address our study hypothesis and research questions. The experiment includes a total of 86 nancial executives. It assesses whether a benchmark in the form of a comparable market price for a fair value measurement tempers earnings management potential (H1). In addition, it relaxes the requirements of SFAS No. 143 to assess two research questions (RQs) related to fair value versus entity-specic measurements. RQ1 examines whether fair value and entity-specic measurements are equally prone to earnings management in the absence of benchmarks, and RQ2 studies whether both measurements are equally subject to earnings management in the presence of benchmarks. Research results indicate that a comparable benchmark signicantly dampens earnings management for fair value measurements. Furthermore, with a benchmark, fair value is less prone to earnings management than entity-specic, presumably because of the external nature of the benchmark for fair value. In contrast, without a benchmark fair value and entity-specic measurements are equally prone to earnings management. Thus, to the extent IFRS entity-specic measurements are associated with internally derived benchmarks they may be more reliable than Level 3 fair value U.S. General Accepted Accounting Principles (GAAP) measurements that will not have benchmarks. BACKGROUND, HYPOTHESES AND RESEARCH QUESTIONS SFAS No. 143 requires entities to recognize and measure ARO liabilities at fair value dened by SFAS No. 157 as the price that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date (FASB [2006], paragraph 5).1 Ideally, fair value would be obtained from a market price. However, because markets for AROs generally do no exist, an expected present value technique would usually be the only appropriate technique to estimate fair value (FASB [2001]). In the hierarchy established by SFAS No. 157, fair value measurements of ARO liabilities reect Level 3 measurements because they are based on unobservable inputs. Level 3 measurements are given less priority and therefore are considered less reliable than Level 1 measurements, which are based on quoted prices in active markets.

SFAS No. 143s requirement for a fair value measurement stems from the decision in Statement of Financial Accounting Concepts (SFAC) No. 7 to require fair value as the sole attribute for any measurement using present value techniques (FASB [2000]). However, in one of two Exposure Drafts leading to SFAS No. 143, the Board considered requiring an entity-specic measurement dened as the present value of the estimated future cash outows that will be required to satisfy the asset retirement obligation (FASB [1996], paragraph 11). At that time, an entity-specic measurement was supported by the rst of two Exposure Drafts leading to SFAC No. 7, in which the FASB indicated that an entity-specic measurement may be appropriate in some situations, and that it will evaluate whether to require fair value or entity-specic measurement on a project-by-project basis (FASB [1997], paragraph 42). However, in the second (revised) present value Exposure Draft (FASB [1999]) and ultimately in SFAC No. 7 (FASB [2000]), the FASB concluded that it could not identify any situation in which an entity-specic measurement objective provided more relevant information than fair value and concluded that fair value provides the most complete and representationally faithful measurement of the economic characteristics of an asset or a liability.2 Relevance and Reliability of Fair Value Relevance and reliability are the two primary criteria the FASB uses for choosing among accounting alternatives. In archival studies, academics usually operationalize the relevance/reliability criteria by investigating whether an accounting amount has a predicted signicant relation with share prices. An accounting amount will have a predicted signicant relation with share prices only if the amount reects information relevant to investors in valuing the rm and is measured reliably enough to be reected in share prices (Barth et al. [2001]). Value relevance research relating to fair value includes studies related to investments in debt and equity securities, bank loans, off-balance sheet items, and certain nonnancial assets. To our knowledge, there is no research relating to the relevance/reliability of fair value for nonnancial liabilities, such as performance obligations. Studies examining the relevance of fair value for various types of nancial instruments include Barth [1994], Petroni and Wahlen [1995], Carroll et al. [2003], Eccher et al. [1996], Nelson [1996], and Barth et al. [1996]. With the exception of Nelson [1996], these studies generally nd the fair value of nancial instruments to be value relevant. On whole, the studies indicate a stronger association with share prices for securities traded in active markets versus those traded in thin markets, presumably because of the reliability of the measurements for the former versus the latter. Evidence with regard to the relevance of fair value for nonnancial assets is scant and most recently related to U.S. rms. Compared to nancial instruments, the reliability of estimates for nonnancial assets is of concern because, for

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the most part, no market exists for these assets. Non-U.S. studies on the relevance of fair value for nonnancial assets are related to rms in Australia and the United Kingdom, where GAAP permits companies to revalue assets such as intangibles and property plant and equipment (Barth and Clinch [1998], Aboody et al. [1999], Dietrich et al. [2000]). In general, the studies nd a signicantly positive relation with share prices, indicating that the estimates of the fair values are reliable. Barth and Landsman [1995] suggest that entity-specic value may be more relevant than fair value for assets and liabilities without active exchange markets.3 They assert that unless estimation error4 is severe, value-in-use (an entityspecic value) is more appropriate for rm valuation for going concerns than exit value (fair value) because value-inuse captures total rm value associated with an asset or a liability, including intangibles relating to management skill. Earnings Management and Fair Value Measurements Schipper [1989] denes earnings management as nonneutral nancial reporting in which mangers intervene intentionally in the nancial reporting process to produce some private gain. Earnings management includes situations in which managers use judgment in nancial reporting to alter nancial reports so as to inuence contractual outcomes that depend on reported accounting numbers (Healy and Whalen [1999]). Watts and Zimmerman [1978] suggest that management compensation contracts create incentives for earnings management because it is likely to be costly for compensation committees and creditors to undo earnings management. Several studies nd that compensation contracts induce some rms to manage earnings to increase bonus awards (Guidry et al. [1999], Healy [1985], Holthausen and Leftwich [1983]). Fields et al. [2001] indicate that rational managers would not be likely to engage in earnings management in the absence of expected benets, and such benets require that at least some users of accounting information be unable or unwilling to disentangle its effects. With respect to earnings management and fair value, we contend that the measurement guidance for Level 3 measurements in SFAS No. 157 (FASB [2006]) combined with SFAS No. 143 (FASB [2001]) falls into the category of the unstructured and imprecise category of standards analyzed by Nelson et al. [2002], who nd that managers are more likely to attempt (and auditors are less likely to question) earnings management under such standards compared to more precise standards. Thus, under some circumstances, performancebased incentives might motivate managers to use the exibility afforded by Level 3 fair value measurements to produce biased and unreliable estimates. In a study related to Level 3 fair value measurements of impairment losses, McEwen et al. [2008] nd that nancial analysts expect rm managers to take advantage of discretionary valuation judgments when

assessing the fair value of nonnancial assets and liabilities, particularly when the lack of an active exchange market obfuscates some of the key valuation assumptions. Nonetheless, even though analysts express concern about management biases in making such estimates, they tend to ignore the biases in the measurement of impairment losses when it furthers their own self-interests related to stock price valuation assessments about the company. In their comment letter to the FASB, the Financial Accounting Standards Committee of the American Accounting Association expressed concern about the reliability and earnings management implications of fair value measurements when there are no active exchange markets (AAA [2005]). The committee indicates that research evidence generally suggests that disclosed fair value estimates for nancial instruments include differing levels of reliability, and that the variation in reliability is related to the extent to which fair value estimates include publicly observed market-based information versus management-produced fair value estimates. Likewise, in its response to the FASB on fair value measurements, the Committee on Corporate Reporting (CCR) of Financial Executives International (FEI)5 voice concern about fair value measurements for nonnancial assets and nonnancial liabilities, indicating that such measurements do not faithfully represent the economic reality of the underlying transactions to which they relate (CCR [2005]). Effect of Benchmarks on Earnings Management Academic research indicates that fair value amounts are more relevant and reliable when there are active exchange markets from which to verify the measurements. Furthermore, the presence of a benchmark makes it more likely that users could disentangle the effects of earnings management attempts. Thus, for nonperformance obligations measured at fair value, we assert that the presence of a comparable market price will serve as a benchmark that will dampen the tendency for managers to choose liability amounts that would result in earnings amounts that serve their self-interest. Therefore, we hypothesize the following with regard to earnings management and fair value measurements for ARO liabilities:
Hypothesis One (H1): When deciding on the fair value amount for an ARO liability and faced with a dilemma of choosing between self-interest and company-interest, nancial executives with a performance-based bonus plan will (will not) choose an amount that serves their self-interest in the absence (presence) of a comparable market price, which serves as an externally veriable benchmark.

Barth and Landsman [1995] and FASB constituent groups including the American Accounting Association (AAA) [2005] and CCR [2005] indicate that an entity-specic measurement may be more relevant than fair value for nonperformance obligations. To the extent relevance is related to the reliability of the measurement, we question whether an

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entity-specic measurement will discourage earnings management attempts relative to a fair value measurement. If so, we also question whether an externally veriable benchmark for the fair value measurement and an internally veriable benchmark for the entity-specic measurement will be equally effective at tempering earnings management attempts. That leads us to the following research questions:
Research Question One (RQ1): In the absence of a comparable benchmark for an ARO liability, are entity-specic and fair value measurements equally prone to earnings management? Research Question Two (RQ2): In the presence of a comparable benchmark for an ARO liability, are entity-specic and fair value measurements equally prone to earnings management?

researchers provided each manager with a $50 contribution to the charity of his/her choice.

The Case
Participants rst read background material about a company called MMH Corporation, a manufacturer and distributor of a variety of products across a broad range of industries. The case described a situation where MMH had built a special-purpose manufacturing support facility. Upon expiration of the land lease, MMH needed to tear down the facility, remove waste and hazardous materials, and restore the land to reusable condition. The participants learned that MMH must recognize an ARO liability under the provisions of SFAS No. 143 (FASB [2001]), the basics of which were described in the case materials.

EXPERIMENT H1 examines whether a comparable benchmark tempers earnings management attempts for fair value measurements. In addition, we compare entity-specic and fair value measurements in the following manner: RQ1 addresses entityspecic and fair value measurements when there are no comparable benchmarks, and RQ2 addresses entity-specic and fair value measurements when there are comparable benchmarks. Method The experiment involved a randomized, two-factor, betweenparticipants design, where the treatments were measurement type (fair value or entity-specic) and benchmark (absent or present). The participants were experienced nancial managers representing medium, large and very large companies, all listed on U.S. stock exchanges, who were attending an international nancing seminar held by a major nancial institution. At the beginning of the seminar, they were asked to volunteer to participate in a research study about accounting for asset retirement obligations. There were a total of three one-half day seminars held in three different cities across the United States. The seminar leader, who was qualied by the researchers in how to administer the experimental materials, was unaware of the experimental treatments. At the beginning of each training session, the seminar leader handed two sealed envelopes to each participant.6 Participants opened the rst envelope and removed the materials. After the participants read the cover sheet and consent form, they read the case materials, responded to a case question, and placed all materials into and sealed the rst envelope. The second envelope included a series of manipulation check, debrieng questions, and demographic information. The trainer did not allow participants to reopen the rst envelope once the second envelope was open. As an incentive to participate, the

The Treatments
Participants in the entity-specic condition were asked to assume that SFAS No. 143 requires companies to measure the liability for an ARO using an entity-specic measurement, the details of which were fully explained. They were provided with the choice of two entity-specic liability amounts ($8.2 million and $9.0 million). Participants in the fair value condition were asked to assume that SFAS No. 143 requires companies to measure the liability for an ARO at fair value, the details of which were fully explained. They were provided with the choice of two fair value liability amounts ($10.4 million and $11.5 million). In all conditions, participants were informed that the staff, which was experienced with SFAS No. 143 liability measurements, had calculated and recommended the respective lower liability amounts ($8.2 million for entity-specic and $10.4 million for fair value). In the entity-specic treatment, participants with no internal benchmark further read: The cost management department has not prepared its projections for this liability. Therefore, there is no projection to aid in your decision about the amount of the ARO liability. On the other hand, participants with an internal benchmark read: The cost management department has prepared its projections for this liability. The $8.2 million liability is more comparable to the projection than the $9.0 million liability. In the fair value with no comparable market price treatment, participants read the following: There are no active exchange markets for the assumption of ARO liabilities. Therefore, there are no comparable market prices on which to base your decision about the amount of the ARO liability. In the fair value with comparable market price treatment, participants further read the following: There are active exchange markets for the assumption of ARO liabilities. In those markets $10.4 million is more comparable to MMHs ARO liability than $11.5 million.

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MAZZA, HUNTON AND MCEWEN TABLE 1 Entity-Specic Financial Information

Assume that you are the controller of MMH Corporation and that MMH will use its own internal resources (labor, materials, overhead) to tear down the support facility. It is December 31, 2007 and for external reporting purposes you must decide on the initial amount of the ARO liability for the support facility described above. You are deciding between two amounts: $8.2 million (staff recommendation) and $9.0 million. Your staff, which is experienced in calculating measurements of this type, provided the following details related to its recommendation for an $8.2 million entity-specic liability: Cash Flow Scenario ($000) Component MMHs estimated cash ows for labor, materials, and overhead. Probability of scenario Probability-weighted estimated cash ows Adjustment for risk (9%) Total expected cash ows Entity-specic ARO liability The $8.2 million liability would result in the following nancial statement results: (Amounts in $millions) Estimated earnings before ARO-related items Effect of ARO on earnings (interest and depreciation) Estimated gain at settlement Earnings net of ARO items Earnings trend over previous year after ARO items Debt-equity multiplier ARO liability $8.2 million 12/31/07 $55.0 N/A $55.0 105% 1.8 12/31/08 $63.0 (4.9) $58.1 106% 1.9 12/31/09 $67.0 (5.0) .8 $62.8 108% 1.8 A $7,909 .333 $2,610 B $9,006 .333 $2,972 C $10,661 .333 $3,518 Total

$9,100 819 9,919 $8,235

You are considering whether you could increase the $8.2 million liability to $9.0 million, which would result in a signicantly higher gain at settlement and the following nancial statement results: ARO liability $9.0 million Amounts in $millions) 12/31/07 12/31/08 12/31/09 Estimated earnings before ARO-related items $55.0 $63.0 $67.0 Effect of ARO on earnings (interest and depreciation) N/A (5.4) (5.5) Estimated gain at settlement 1.8 Earnings net of ARO items $55.0 $57.6 $63.3 Earnings trend over previous year after ARO items 105% 105% 110% Debt-equity multiplier 2.0 2.1 1.8

Tables 1 and 2 include details about the nancial information provided to the entity-specic and fair value participants, respectively. As shown in Tables 1 and 2, the entity-specic liability amounts ($8.2 million and $9.0 million) are lower than the fair value liability amounts ($10.4 million and $11.5 million) due to the absence of two cash ow components required to measure fair value: (a) adjustment for market amounts that are different from entity-specic amounts; and (b) prot margin. However, the amounts and probability assessments associated with the cash ow component for labor, materials and overhead area identical in the entity-specic and fair value conditions. In addition, both conditions include a 9% risk adjustment factor. Although the liability amounts are different for the entityspecic and fair value conditions, they result in the same percentage earnings increases from 2007 through 2009. That is, if the lower amount is chosen (entity-specic $8.2 million; fair value $10.4 million), the resulting earnings increases

from 2007 through 2009 are 105%, 106%, and 108%, respectively. Alternatively, if the higher amount is chosen (entityspecic $9.0 million; fair value $11.5 million), the resulting earnings increases from 2007 through 2009 are 105%, 105%, and 110%, respectively. As discussed in the next section, in 2009, an earnings increase of 10% over 2008 results in a performance-based cash bonus, which can only be achieved by choosing the higher of the two liability amounts (entityspecic $9.0 million; fair value $11.5 million). Therefore, because the bonus is based on the percentage increase in earnings rather than the dollar amount of earnings resulting from the liability, the differing liability amounts in the two conditions do not affect the direction or magnitude of the results.

Additional Assumptions
Participants are asked to assume that they are the controller of MMH Corporation. It is December 31, 2007, and

POTENTIAL MITIGATING EFFECT OF BENCHMARKS TABLE 2 Fair Value Financial Information Assume that you are the controller of MMH Corporation and that MMH will use its own internal resources (labor, materials, overhead) to tear down the support facility. It is December 31, 2007, and for external reporting purposes you must decide on the initial amount of the ARO liability for the support facility described above. You are deciding between two amounts: $10.4 million (staff recommendation) and $11.5 million.

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Your staff, which is experienced in calculating measurements of this type, provided the following details related to its recommendation for a $10.4 million fair value measurement of the liability: Cash Flow Scenario ($000) Component MMHs estimated cash ows for labor, materials, and overhead. Probability of scenario Probability-weighted estimated cash ows Adjustment for market amounts different from entity-specic amounts. Subtotal Prot margin Subtotal Adjustment for risk (9%) Total expected cash ows Fair value of ARO liability A $7,909 .333 $2,610 365 $2,975 327 $3,303 B $9,006 .333 $2,972 416 $3,388 373 $3,761 C $10,661 .333 $3,518 493 $4,011 441 $4,452 Total

$9,100 1,274 $10,374 1,141 $11,515 $1,036 $12,552 $10,420

The $10.4 million liability would result in the following nancial statement results: (Amounts in $millions) Estimated earnings before ARO-related items Effect of ARO on earnings (interest and depreciation) Estimated gain at settlement Earnings net of ARO items Earnings trend over previous year after ARO items Debt-equity multiplier ARO liability $10.4 million 12/31/07 60.0 N/A $60.0 105% 1.8 12/31/08 $70.0 (6.2) $63.8 106% 1.9 12/31/09 $72.0 (6.3) 3.4 $69.1 108% 1.8

You are considering whether you can increase the $10.4 million liability to $11.5 million, which would result in a signicantly higher gain at settlement and the following nancial statement results: (Amounts in $millions) Estimated earnings before ARO-related items Effect of ARO on earnings (interest and depreciation) Estimated gain at settlement Earnings net of ARO items Earnings trend over previous year after ARO items Debt-equity multiplier ARO liability $11.5 million 12/31/07 $60.0 N/A $60.0 105% 2.0 12/31/08 $70.0 (6.8) $63.2 105% 2.1 12/31/09 $72.0 (7.0) 4.7 $69.7 110% 1.8

for external reporting purposes they must decide on the initial amount of the ARO liability for the support facility described above. In all conditions, it would be personally advantageous for participants to choose the higher of the two liability amounts. In 2009, the higher amount produces a larger gain on settlement resulting in a 10% increase in earnings over 2008, which triggers a performance-based bonus that would comprise a signicant part of their overall compensation. However, selecting the higher amount would simultaneously place MMH in default on its line of credit at the bank, as the debt-equity multiplier would meet or exceed its limit of 2.0. Participants were further informed that the selection of either ARO amount would not affect cash ows or income taxes, and that the liability would be material to MMHs nancial statements taken as a whole.

Dependent Measures
Participants are deciding between two amounts for the ARO liability in the entity-specic condition ($8.2 million and $9.0 million) and in the fair value conditions ($10.4 million and $11.5 million). Participants were asked to indicate the likelihood that they would recommend the lower amount and higher amount. Both likelihoods needed to sum to 100. Results

Participants
A total of 86 managers, each representing a different company and possessing considerable nance and accounting

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experience, participated in the study. There were 15 female and 71 male managers in the sample. The mean (standard deviation) age was 47.58 (8.46). The analysts mean (standard deviation) years experience in business was 21.06 (7.62), and years experience in nance and accounting was 19.91 (7.63). There were 56 chief nancial ofcers and 30 chief accounting ofcers in the sample. Of the 86 managers, 57 were certied public accountants. Each participant self-described the size of his/her company relative to other companies in his/her industry (the options were: very small, small, medium, large or very large); there were 17 (19.8%) medium, 43 (50.0%) large and 26 (30.2%) very large companies. The distribution of gender, age, years business experience, years nance and accounting experience, job position, public accountant certication, rm size and the three seminars were not significant (all p-values > .50) across treatment conditions; hence, the randomization of treatments to participants was deemed successful.

Preliminary Testing
We ran an initial ANCOVA model, where the dependent variable reected the likelihood of recommending the higher ARO liability, the independent variables represented measurement type (entity-specic or fair value), benchmarks (absent or present), and the interaction term. The possible covariates were gender, age, years of business experience, years of nance and accounting experience, job position, public accountant certication, rm size and the ve seminars. None of the covariates was signicant (largest F-value amongst all covariates [rm size] = 0.59, p > .44); hence, they were not included in hypothesis testing. Descriptive statistics, ANOVA model results, and multiple pairwise test results are shown on Table 3, panels A, B and C, respectively.

Hypothesis One
H1 indicates that participants in the fair value condition without a comparable benchmark will be more likely to recommend the higher ARO liability amount (i.e., displaying a propensity to manage earnings) than participants in the fair value condition with a comparable benchmark. As indicated by the ANOVA on Table 3, panel B, benchmark presence is signicant (F = 214.81, p <.01), but this main effect includes both fair value and entity-specic measurements. Hence, to test H1, we compare the following two means: fair value with a benchmark (15.23) and fair value without a benchmark (72.09). The results from a t-test (t = 16.45, p <.01) and Scheffes multiple pairwise testing indicate that the two means are signicantly different, thereby supporting H1.

Manipulation Check Items

All participants correctly indicated whether the measurement of the ARO was based on fair value or entity-specic. Participants in the entity-specic (fair value) treatments also accurately noted whether there was an internal cost projection (active exchange market) for the ARO liability. All participants properly recognized the following constant assumptions: choosing the higher of the two ARO liability amounts would result in a 10% increase from 2008 to 2009 earnings, which would trigger a 2009 cash bonus; the cash bonus would constitute a signicant part of the managers 2009 compensation; choosing the higher ARO liability would result in a debt-equity multiplier of 2.1 in 2008, which would place MMH in technical default on its bank line of credit; and the difference between the higher and lower ARO liability amounts is considered material to the nancial statements taken as a whole. Accordingly, the manipulation checks were deemed successful. In addition, in the entity-specic (fair value) conditions we asked participants the extent of discretion they believed they had over changing the staffs recommendation, regardless of whether the cost management department had prepared its projections for this liability (there were exchange markets for the assumption of ARO liabilities). We asked this question because we wanted to determine whether participants felt they could, if desired, select a different liability than that recommended by the experienced staff. On a scale of 1 (no discretion) to 9 (total discretion), the mean (standard deviation) response across all participants was 8.28 (1.02), and the means were not signicantly different across treatment conditions (F = 0.24, p = 0.84). Hence, all participants believed they were afforded considerable discretion to change the staffs estimate.

Research Question One

The rst research question (RQ1) asks, in the absence of a benchmark, whether an entity-specic measurement and a fair value measurement are equally prone to earnings management. A multiple pairwise comparison of the four treatment means is presented on Table 3 (panel C). As indicated, the fair value without a comparable market price mean (72.09) and the entity-specic without an internal cost management projection mean (61.40) are not signicantly different. This result suggests that, in the absence of a benchmark, both measurement approaches are equally prone to earnings management.

Research Question Two

The second research question (RQ2) asks whether benchmarks are equally effective at tempering earnings management for entity-specic and fair value measurements. As indicated on Table 3 (panel C), the entity-specic with an internal cost management projection mean (29.76) is significantly greater than the fair value with a comparable market price mean (15.23), which suggests that an externally veriable benchmark (market price) appears to constrain

POTENTIAL MITIGATING EFFECT OF BENCHMARKS TABLE 3 Likelihood of Recommending the Higher ARO Liability Fair value without a benchmark Fair value with a benchmark Entity-specic without a benchmark Entity-specic with a benchmark 70.24 (17.06) [21] 29.76 (17.06) [21]

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Likelihood of recommending the lower ARO liability

Panel A: Descriptive Statistics: Mean (Standard Deviation) [Sample Size] 27.91 84.77 38.60 (11.97) (11.18) (15.26) [22] 72.09 (11.97) [22] [23] 15.23 (11.18) [23] [20] 61.40 (15.26) [20]

Likelihood of recommending the higher ARO liability

Panel B: ANOVA Results Likelihood of Recommending the Higher ARO Liability d.f. Measurement type Benchmark presence Measurement x benchmark Error 1 1 1 82 MS 79.36 41, 982.20 3, 409.93 16, 026.08 SS 79.36 41, 982.20 3, 409.93 195.44 F 0.41 214.81 17.44 p = 0.53 < 0.01 < 0.01

Panel C: Multiple Pairwise Comparison (Scheffes Test at = .01) Fair value without a benchmark 72.09 = Entity-specic without a benchmark 61.40 > Entity-specic with a benchmark 29.76 > Fair value with a benchmark 15.23

Hypothesis One (H1): 15.23 < 72.09 (p <.01). Research Question One (RQ1): 72.09 = 61.40 (p = .11). Research Question Two (RQ2): 15.23 < 29.76 (p <.01).

earnings management relatively more than an internally veriable benchmark (cost management projection).

DISCUSSION The current study examines the earnings management potential of entity-specic and fair value measurements for ARO liabilities, and studies the effectiveness of comparable benchmarks for both measurement approaches. The experimental results suggest that the presence, relative to absence, of an externally veriable benchmark signicantly tempered potential earnings management for fair value measurement. The ndings also indicate a nonsignicant difference in earnings management between an entity-specic measurement and a fair value measurement, in the absence of a comparable benchmark. In the presence of a benchmark, although earnings management was tempered in both the fair value and entity-specic scenarios, it was tempered relatively more in the fair value scenario. Research ndings suggest that, relative to a fair value measurement with no comparable market benchmark, an entity-specic measurement combined with an internal comparable benchmark appears to be more reliable. Our study contributes to extant literature related to the relative reliability of fair value measurements. For the most

part, previous studies have been limited to nancial items and, because they employ an archival approach, are limited to indirect tests of relevance combined with reliability, based on whether fair value amounts are correlated with stock prices. In general, our study supports prior research that suggests the strength of fair value reliability is correlated with whether the item being measured is associated with a comparable market price. Thus, for ARO liabilities, both relevance and reliability of fair value are at question because of the nonexistence of markets and prices. Our study also contributes to the body of literature related to earnings management by focusing on an accounting measurement that has specically been identied as a potential candidate for earnings management (AAA [2005]). It provides an additional test of the assertion of Nelson et al. [2002] that managers are more likely to attempt earnings management under imprecise standards relative to more precise standards. Finally, our study incorporates various measurements of the same liability and examines the effect of benchmarks in an earnings management context, which simulates differences between U.S. GAAP and IFRS. We acknowledge certain limitations in our study. The participants were provided with limited nancial information about the case company. Providing them with a more complete set of nancial statements could have changed the results of the study. However, in an experimental

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setting, limiting the nancial information in the case materials allows researchers to reduce the time requirements of participants while at the same time providing more control over the variables of interest, thereby strengthening internal validity, admittedly at the potential expense of external validity. With regard to earnings management, participants were provided with one incentive (cash bonus plan) and one way to manipulate earnings to achieve the bonus (choice of ARO liability). In reality, managers likely have more incentives and many options available for achieving earnings targets. In addition, with respect to the internal cost management projection, an underlying assumption is that it was an unbiased albeit internal benchmark. To the extent there is bias in an internal projection, it would not be as effective at tempering earnings management as suggested by the study results. The size of the company, segregation of internal and external accounting functions, and the internal controls associated with internal budgeting functions could also affect the integrity of such projections. Our ndings suggests that an entity-specic measurement (IFRS) that is accompanied by an internally derived comparative benchmark for ARO liabilities is less prone to earnings management and therefore can be considered more reliable than a fair value measurement (U.S. GAAP) that has no externally veriable benchmark. We note that although IFRS is being adopted in Canada, Japan, and China in 2011, the U.S. does not plan to adopt IFRS before 2015. Thus, ARO liabilities are one area where adoption of IFRS may produce more relevant and reliable nancial statement results. Our ndings also support the recommendation of the SECs Pozen Committee [2008] that the FASB be judicious in issuing new standards expanding the use of fair value in areas where it is not already required until a plan is implemented to strengthen the infrastructure that supports fair value reporting. The results of this study are important for auditors and regulators in their assessment of Level 3 fair value measurements, as they should be aware of the earnings management potential inherent in the absence of comparable benchmarks. In addition, the results of our study are important for policy makers, who assert that irrespective of whether there are active exchange markets, fair value is the most relevant and reliable measurement attribute for nonnancial assets and liabilities. We suggest that any discipline gained by a fair value measurement objective, may be lost when there is an absence of market price benchmarks.

2.

3.

4.

5. NOTES 1. In addition, under SFAS 143 entities are required to recognize an offsetting asset retirement cost by increasing the carrying amount of the related long-lived asset. In periods subsequent to initial recognition, FAS 143 requires entities to recognize period-to-period changes

in the asset retirement obligation liability resulting from the passage of time (accretion expense) and revisions in the timing and amount of the underlying expected cash ows. In addition, it requires entities to recognize depreciation expense resulting from the systematic and rational allocation of the asset retirement cost. When using present value to estimate either fair value or entity-specic value, the same techniques are applied to arrive at a single measure that incorporates the following economic components: (a) estimated cash ows; (b) expectations about the variability in timing and amount of cash ows under differing circumstances and the likelihood of those circumstances; (c) the price that marketplace participants demand for bearing the uncertainty inherent in those cash ows; and (d) the time value of money. In determining these components, the difference between fair value and entity-specic value lies in whether the assumptions about estimated cash ows are those that the market would make (general) or those that the entity would make (specic). An entity-specic measurement uses the entitys estimates and assumptions, focusing on cash ows realized or paid over time, to estimate a value unique to the entity. In contrast, a measurement designed to estimate fair value assumes that willing parties exist and can deal in a marketplace that will clear currently at some price. Therefore, an estimate based on fair value would include marketplace assumptions about cash ows, including prot margins and a marketplace risk premium. Barth and Landsman [1995] discuss three alternative fair value constructs: (a) entry value is an assets acquisition price or, if relative prices change, an assets replacement cost; (b) exit value is the price at which an asset could be sold or liquidated; and (c) value-in-use is the incremental rm value attributable to an asset. Using those fair value constructs, the FASBs denition of fair value is analogous to exit value and its denition of entity-specic value is analogous to value-in-use. However, the FASB does not view an entity-specic value as a fair value, as do Barth and Landsman [1995]. Barth and Landsman [1995] describe two, not necessarily mutually exclusive, types of measurement error: (a) unsystematic error arises from general uncertainty; and (b) systematic error arises from management exercising discretion in determining estimates. FEI is a leading international organization of 15,000 members, including chief nancial ofcers, controllers, treasurers, tax executives, and other senior nancial executives. CCR is the nancial reporting technical committee of FEI, which reviews and responds to research studies, statements, pronouncements, pending legislation, proposals, and other documents issued by domestic and international agencies and organizations.

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77

6. The experimental materials were stacked in random order by the researchers and the seminar leader handed out the materials from the top to the bottom of the stack.

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