Proceedings of 7th Asia-Pacific Business Research Conference

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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: [email protected], Tel: +66865223438
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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
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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
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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
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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
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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)
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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].
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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].
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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
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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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Proceedings of 7th Asia-Pacific Business Research Conference
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