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Despite the significance of DB pension plans for risk and investment decisions (Campbell et al., 2012; Cardinale, 2007; Jin et al., 2006; Rauh; 2006), before the adoption of IFRS in 2005 some EU countries, including France, did not require pension plan transparency under domestic accounting standards. In a recent study, published in the European Accounting Review (EAR), Vicky Kiosse, Peter Pope and I study the changes in financial policies following a regulatory shock to the accounting transparency of defined benefit pension plans in 2005 in France. The pension-related debt of French companies at the time of IFRS adoption was on average 21% of the value of financial debt. Hence, increased transparency of pension deficits could have a material impact on companies’ financial policies.
We exploit a feature of French domestic accounting standards before 2005. At that time early adoption of the relevant IFRS pension accounting standard, IAS 19, was allowed (or even encouraged) but it was not required. At the same time, the early adoption of other IFRS’s was prohibited. As a result, a substantial number of French companies adopted IAS 19 early, before the other IFRSs were required in 2005.
We argue that pension deficit information reported by early IAS 19 adopters is relevant to estimating pension deficits for other less transparent companies. We define early adopters as companies that recognize pension deficits or surpluses in accordance with IAS 19 prior to 2005 and we use those early adopters’ disclosures to estimate the pension deficit “surprise” for the first-time mandatory IFRS adopters in 2005. We then examine the impact of expected and unexpected pension deficits on the level, cost, and maturity of debt of mandatory adopters (i.e., companies reporting pension deficits or surpluses under IAS 19 from 2005 onwards).
In the absence of transparency, a rational credit market anticipates off-balance sheet pension deficits by considering available information from all sources, including peer companies. However, the introduction of the more transparent IFRS regime allows the credit market to correct estimation errors. Further despite the theoretically and empirically documented capital market benefits of increased transparency (Botosan, 1997; Florou and Kosi, 2015; Hail, 2002; Lambert et al., 2007; Sengupta, 1998; Yu, 2005), other theoretical work suggests that mandatory increased transparency can have negative effects for some companies in markets with rational expectations (Johnstone, 2015, 2016; Gao, 2010). We explicitly consider this possibility and predict that the cost of debt will increase and leverage will subsequently be reduced for some companies where increased transparency reveals higher than expected pension deficits.
We define pension deficit news (i.e., the unexpected pension deficit) as the difference between actual pension deficit revealed after mandatory IAS 19 adoption and expected pension deficits conditional on information disclosed by voluntary early adopters and company characteristics observable in 2004. Using entropy balancing methodology to mitigate endogenous selection effects of early IAS 19 adoption, we find that increased pension deficit transparency is important for the financial policy of high financial risk companies (identified using excess leverage, default probability and credit ratings). In particular:
· Financially risky companies with unexpectedly high pension deficits reduce leverage, but low financial risk companies do not. A one standard deviation increase in the unexpected pension deficit increases the cost of debt of financially risky companies by between 189 and 237 basis points.
· Debt maturity does not change in the short-term, although we find some evidence of change in the mid- to long-term.
· Importantly, we find that changes in leverage and the cost of debt are associated with the unexpected pension deficit component, but not the expected pension deficit component.
Our findings are robust to endogeneity and various other sensitivity tests. In additional analysis, we examine whether companies whose borrowing capacity declines following the adoption of IAS 19 react by reducing shareholders’ payout. Our results suggest that financially risky companies do not reduce dividend payout or look to equity investors for additional capital when access to the debt market is restricted. In contrast, low financial risk companies increase net payout to shareholders. These findings are consistent with a transfer of wealth from creditors to shareholders.
We contribute to the literature in a number of ways. First, we extend the accounting literature studying the average positive capital market effects of accounting transparency (e.g., Hail, 2002; Florou and Kosi, 2015; Yu, 2005) by showing that some companies are losing from greater transparency. Second, in doing so, we also contribute to the finance literature examining the relation between pension-related leverage and financial leverage (Bartram, 2016; Campbell et al., 2012; Shivdasani and Stefanescu, 2010). Using mandatory IFRS adoption as an exogenous shock, we show that corporate transparency of pension deficits is an important determinant of corporate financial policy, particularly when companies are financially risky. Third, by showing that pension deficits reported under IAS 19 are relevant for creditors and affect companies’ access to debt markets, our paper also adds to the literatures examining the value and credit relevance of pension disclosures (Barth et al., 1992; Hann et al., 2007; Landsman, 1986) and the economic consequences of recognizing pension plan deficits in financial statements (Anantharaman and Chuk, 2018; Barthelme et al., 2019). Finally, our evidence that information provided by early adopters of IAS 19 may be useful to the debt market in estimating the pension deficits of less transparent companies sheds light on the potential importance of information transfers and spillovers (Alves et al., 2009; Kim et al., 2008; Shroff et al., 2017). Our findings may have implications for other settings where disclosure has been traditionally opaque.
Discover more about our study at https://doi.org/10.1080/09638180.2020.1792321
To cite this article: Fani Kalogirou, Paraskevi Vicky Kiosse & Peter F. Pope (2020) Pension Deficits and Corporate Financial Policy: Does Accounting Transparency Matter?, European Accounting Review