Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 The Impacts of Off-Balance Sheet Types and Investment Positions on Investors’ Judgments Huda Wongyim* This paper examines whether off-balance sheet financing types (operating lease or equity method) and investment preference (short position or long position) effect on investors’ ability to correct financial ratio. MBA students in Thailand as a proxy for nonprofessional investors were used in the experiment. Off-balance sheet finance is hard to define and provide obscure disclosure so that investors cannot see the true nature of the transaction. Even auditors rarely blow the whistle on this accounting manipulation because management uses loopholes in accounting standard to hide debt from the balance sheet. The results show that investors facing with equity method scheme are less able to correct financial ratio than those facing with operating lease schemes because of different level of complexity in structure of the transaction and disclosure related to it. However, additional analysis shows that the effect of off-balance sheet types is conditional on investor preference. Investors who have preference consistence with information (long investors) have less skepticism and thus cannot do better on correction task even when they face with less complex accounting schemes (operating lease) while investors who have preference-inconsistence (short investors) can. The results of the experiment are consistent with motivated reasoning theories that predict when and how directional preference affects information processing of people. Field of Research: Experiment financial accounting Keywords: off-balance sheet financing, investment position, investors’ judgments, preference, experiment, Thailand 1. Introduction Off-balance sheet, hereafter OBS, financing arrangements have long been tools employed by management to conceal financial risks. Through loopholes in the accounting standards, financial managers and financial consultants unscrupulously structure the financial transactions such that liabilities do not appear on the financial statements without in violation of the generally accepted accounting principles. Moreover, although auditors know that firms are concealing debts using these techniques, they hardly mention in their professional opinions as the action taken by the firms is viewed as not in violation of GAAP. The inability to detect hidden financial risk could misdirect investment and thus incur great costs on investors. Thus, this research aims to explore how mechanism of directional preference could induce or reduce investors’ ability to rectify the accounting number when dealing with off-balance sheet accounting. This study is also concerned with the ability of non-professional investors to recognize and deal with OBS accounting in both transparency (less complex structure) and non-transparency cases (more complex structure). * Mrs. Huda Wongyim, Department of Accountancy, Faculty of Commerce and Accountancy, Chulalongkorn University, Bangkok, Thailand 10330. Email: clickdada@hotmail.com, Tel: +66865223438 1 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 Total 30 MBA students in Thailand are used as a proxy for nonprofessional investors. The results show that investors facing with equity method scheme are able to correct financial ratio less than those facing with operating lease schemes because of different levels of complexity in structure of the transaction and disclosure related to it. However, additional analysis shows that the effect of off-balance sheet types is conditional on investor preference. This study provides three contributions to the accounting and psychology literature. First, the results of this research paper would cast some light on the influence of types of offbalance sheet financing, subject to its transparency, on investors’ capability to correct offbalance sheet financing. Second, this research study examines the footnote contents to determine whether the information is adequate to allow investors to comprehend true nature of the transactions and thereby adjust the financial statement numbers to account for the concealed debt items, if any. Third, this research study fills the gap in directional preference literature by looking into how bias from directional preference exerts influence when decision makers have to find irregularities in information and assess information risk. The organization of this study is as follows. Literature review and hypotheses are presented in section 2. Research methodology of this study is discussed in section 3. The research findings are provided in section 4. Section 5 concludes the paper. 2. Literature review and hypotheses OBS is a form of financing in which large capital expenditures are kept off of a company's balance sheet through various accounting methods. Firms are motivated from various economic reasons to engage in OBS as these tools provide them with high debt rating, tax shelter, and impressive financial performance. Besides, OBS sometimes even resolves underinvestment problems arising from agency cost of debt (Mills and Newberry, 2005, Zhang, 2006, John and John, 1991, Shah and Thakor, 1987, Amat and Gowthrope, 2004, Lim et al, 2005). This study focuses on two types of off-balance sheet techniques, i.e., operating lease and equity method that are usually found in the country. Operating lease is regarded as a surrogate for transparent (less complex) off-balance sheet financing while equity method as a surrogate for non-transparent (more complex) OBS. Corporate managers use operating lease as a tool to hide debt off-balance sheet because of its legitimate advantages (Edman, 2011). When a company acquires an asset through debt financing, a liability presenting in its financial statements tells investors of the claims against the company’s future revenue. However, if the asset is leased, no debt is posted on balance sheet even though the company has entered into lease contract and is committed to making lease payments in the future. The equity method is one of accounting tricks that firm use to hide liabilities. When a company controls the operation of another entity, it tends to structure voting power or 2 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 percent of shares holding to be less than significant portion to avoid consolidation and apply equity method instead. Under equity method, firm reports its investment in an affiliates company as a single line item in the balance sheet; net debts of the investee with its assets in the parent’s investment account. Since assets are almost always greater than liabilities, this net amount show balance on left-hand side, thus exclude investee’s debts from analysis. Disclosure levels of different kinds of off-balance sheet accounts are diverse. Operating lease is required by law to provide greater details of its transaction and provide information that easier to understand than is the equity method. As a result, it is anticipated that more complex schemes (equity method) are less likely to be identified and corrected than are less complex schemes (operating lease). Thus, the first hypothesis is provided as follows: H1: Investors facing transparent OBS (operating lease) have greater propensity to correct financial ratio than those facing non-transparent OBS (equity method). Research studies on psychology conclude that decision makers’ preference or directional incentives influence the manner in which they process information (Kunda, 1990). A large body of research suggests that people tend to give higher weight to information that favors their preference outcome, exhibit more skepticism on information that contradicts their desired goal, and do not realize that their process is biased by their goals. Investors are motivated to hold directional preference according to their investment positions (Han and Tan, 2010, Hales, 2007, Thayer, 2011) and directional preference could either reduce or induce situational skepticism in their decision making process (Ditto and Lopez, 1992, Ditto et al, 1998, Ditto et al, 2003). Several studies indicate that skepticism or suspicion affects individuals’ ability to detect fraud and creative accounting (Fathil and Schmidtke, 2010, Popova, 2013, Rose, 2007). Thus, I expect that participants holding short condition will have higher skepticism and will better correct OBS than those holding long position. The second hypothesis is presented below: H2: Investors holding short position have greater propensity to correct financial ratio than those holding long position. The ability to scrutinize information when individuals are faced with preference inconsistent is subject to the amount of information available to them. Limited disclosure related to offbalance sheet transactions might affect investors’ ability to scrutinize information. Consequently, skepticism and suspicion induced by their investment position may produce lower effect in the case of non-transparent OBS in which disclosure are less available than 3 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 in the case of transparent OBS in which disclosure are more available. The third hypothesis is provided below: H3: Investors holding short position have a higher correction rate than those holding long position, with the difference being larger for transparent OBS condition than non-transparent OBS condition. 3. The Methodology 3.1 Procedure This research applies 2 x 2 full factorial between subject design that manipulates (1) the type of OBS (operating lease vs. equity method) and (2) the participant’s investment position (short vs. long). A sample of 30 MBA students were invited and randomly assigned to one of four groups; short position with equity method, long position with equity method, short position with operating lease, and long position with operating lease. The conceptual framework of the study is presented below: Figure 1 The conceptual framework Short /Long Investment position Transparency of OBS Transparent (Operating lease) / Non-transparent (Equity method) Investor judgment s Correction rate The experiment begins with training about investment and compensation criteria in the experiment before directing to the case to make sure that participants are well understand short and long position. Then, all participants will be presented with the same information about the firm, and good financial performance, except for information related to OBS transaction and investment position which would vary. In general, the information includes overview of the company, financial statements (i.e., both balance sheet and income 4 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 statement), key financial ratio, analysts’ report containing analysts’ consensus of EPS forecast and some analysts’ comments. The participants then go over the company’s financial information. Afterward, they will be asked to assess the likelihood that they will gain or lose from this investment, based on the available financial information. The participants then will be asked to correct key financial ratio of the firm and illustrate their calculation in table to determine the participants’ ability to correct OBS. The ratio is debt to equity ratio, which most likely influenced by this accounting scheme. The experiment ends with the participants completing their demographic profile and providing answers to the manipulation check. 3.2 Experimental manipulation The first manipulation is investment position. The lower earnings benchmark is assigned to short position participants and the higher benchmark to long position participants, the approach of which is similar to previous studies on the investment positions (Hale, 2007, Han and Tan, 2009, Thayer, 2011). In this research study, all participants will be presented with good financial performance so that the preference-consistent behavior can be induced in those with long position and the preference-inconsistent behavior in those with short condition as the long position participants would prefer higher performance than their short position counterparts. The second manipulation is made on types of OBS. The participants face two kinds of OBS techniques: equity method and operating lease. The footnote disclosure and accounting policy related to each OBS transaction will be presented following the company overview. 3.3 Compensation The compensation scheme is designed based on the work of Thayer (2011). There are three sources of compensation. First, all participants receive 100 Bath for participation. Second, to motivate attention to the task, participants with the most accuracy ratio will receive Starbucks card with stored value of 700, 500 and 300 Baht for the first, second and third prize, respectively as a special reward. This component of the compensation scheme provides participants with an incentive to make as accurate as possible, and to do so they need to thoroughly study the financial information in the case. Third, to induce the investment position manipulation, participants receive 20 starting points each and they could either earn or lose their points based on the outcome of their investment in relation to the initial investment position. Those holding a long position earn (lose) five points for every baht that actual earnings-per-share (EPS) exceeds (falls below) their EPS benchmark. Similarly, participants holding a short position earn (lose) five points for every baht that actual earnings-per-share falls below (exceeds) their EPS benchmark. This component of the compensation scheme captures investors’ incentive to hold a 5 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 profitable investment. The details of the compensation scheme are given in the instructions at the start of the experiment. At the end of the study, points were converted to Thai baths. Participants earned an average of 300 Baths each and took an average of 23 minutes to complete the experiment. 4. Research results 4.1 Manipulation checks At the end of experiment, participants were asked to assess the likelihood that they will gain or lose from this investment, based on the case, to check whether they understand their pay-off function in the experiment. Results shows that position manipulation is succeed, all 30 participants pass the manipulation checks for investment position. However, one participant did not complete the correction task and was removed from the sample. Therefore, my sample reduces to 29 participants. 4.2 Research findings My main analysis is to investigate the main and interaction effect of types of OBS financing and investment position on investor’s ability to correct financial ratio from manipulated financial statements. I test hypotheses using analysis of variance (ANOVA) and planned comparisons for specific predictions. TABLE 1 – Main result Panel A: Descriptive statistic for correction rate Condition Short Long Average Equity Method Mean St.dev. (N) 11.30 16.54 (8) 17.35 21.29 (7) 14.12 18.46 (15) Operating lease Mean St.dev. (N) 67.89 40.28 (7) 39.39 33.50 (7) 53.64 38.54 (14) Average Mean St.dev. (N) 37.71 41.06 (15) 28.37 29.29 (14) 33.2 35.55 (29) 6 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 Panel B: Overall ANOVA Source of Variance df SS MS F-stat. p-value Model OBS types(OBS) Investment position(IV) OBS x IV Error 3 1 1 14286.02 11167.59 909.84 4762.00 11167.59 909.84 5.63 13.23 1.08 0.004 0.001 0.309 1 25 2156.58 21110.28 2156.82 844.41 2.55 0.123 Table1, Panel A presents descriptive statistic of dependent measure, correction rate. On average, short participants get higher correction rate than long participants who have preference-consistence with information in the case. Participants with non-transparent OBS (i.e. operating lease) get higher correction rate than those with non-transparent one (i.e. equity method). Result of ANOVA test on OBS types and investment position are presented in Table1, Panel B. Hypotheses 1 are supported by main effect of OBS types (p =0.01). However, result does not support H2 and H3. The main effect of investment position is not statistically significant (p=0.30) and no interaction effect found significant for correction ability. To test more specific prediction, I examine whether short participants facing with transparent OBS, operating lease with short position, have higher correction ability than average of other groups. The rationale behind this test is participants belong to this group, short-operating lease, were induced to be more skepticism and faced with less complex scheme OBS, thus, they should perform the best among other groups on correction task. I test this prediction by performing planned comparisons with the following contrast weight: Contrast 1: equity method/ short position [-1], equity method/ long position [-1], operating lease/short position [3], and operating lease/long position [-1]. 7 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 Contrast Contrast 1* Std.Error t-stat. p-value 48.99 2.823 0.023 TABLE 2 - Planned contrast 1 * Ho: μ OS = (μ ES + μ EL + μ OL) / 3 Definition of abbreviation is as follows: ES = Equity method and Short position OS = Operating lease and Short position EL = Equity method and Long position OL = Operating lease and Long position Table 2 reports that this contrast is significant (p= 0.023). The result suggests that although investment position does not exhibit significant influence on correction ability in ANOVA test, however, participants with short position who face with transparent OBS perform better in correction task than the rest of participants I further complement my hypotheses by performing additional more specific test on an interaction effect of investment position and OBS types. I expect that types of OBS will exhibit effect on correction ability only in short participants who have preferenceinconsistence and thus have more skepticism, but not exhibit effect on long participants. I use two following contrast code to test this conjecture. Contrast 2a: equity method/ short position [1], equity method/ long position [0], operating lease/short position [-1], and operating lease/long position [0]. Contrast 2b: equity method/ short position [0], equity method/ long position [1], operating lease/short position [0], and operating lease/long position [-1]. 8 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 TABLE 3 - Planned contrast 2 Contrast Contrast 2b* Std.Error t-stat. p-value 15.00 -1.469 0.172 Panel A: Contrast 2a *Ho: μ ES = μ OS Panel B: Contrast 2b *Ho: μ EL = μ OL Table 3 reports that only contrast 2a is statistically significant (p = 0.009). This result suggests that only short participants can significantly correct operating lease better than equity method. However, long participants cannot correct off-balance sheet financing differently when they face with operating lease or equity method. The ANOVA analysis shows significant result for the main effect of OBS types, transparent and non-transparent, however, its effect on correction ability of investor only exhibits on investor assigned to a short position, but not affects investor assigned to long position. This suggests that longposition investors who have preference consistence with given information have less skepticism and thus cannot do better on correction task even when they face with less complex accounting schemes while short-position investors can. 5. Conclusions This study examines how off-balance sheet financing types and investment preference affect investors’ ability to correct off-balance sheet financing. Employing theories of motivated reasoning, I predict that the complexity and disclosure level of off-balance sheet Contrast Contrast 2a* Std.Error t-stat. p-value 16.31 -3.469 0.009 schemes affect individual ability in correcting manipulated financial statement, but the relation is conditional on investor preference. Overall result supports my prediction regarding to type of OBS, transparent and nontransparent. Consistence with prior research, I find that more complex accounting schemes, equity method, is harder to define and correct by non-professional investors than less complex one, operating lease. For investor preference, although no significant 9 Proceedings of 7th Asia-Pacific Business Research Conference 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 effect is shown in the ANOVA test, I do find support for my additional prediction. In particular, I find that only investors holding short position can correct transparent OBS significantly better than those with non-transparent one, but this result does not hold for investors holding long position. This implies that effect of OBS types on investor’s correction ability is conditional on investor preference. These results will interest standard setter to revisit the effectiveness of current disclosure requirement related to equity method and operating lease, i.e., whether it provides sufficient information for investors to grasp the true nature of the transaction. For investors, the results of this research work would increase an understanding among investors on how they could be biased by their investment positions because their choices of investment positions could produce directional preference that either induces or reduces their skepticism when they assess financial risk and information risk of the company. 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