Hiding profit and loss

It has long been suspected that fear of competition spurs managers to hide better-than-average business unit profit performance. However, a new study instead finds evidence that fear of increased oversight leads managers to hide less-than-average business unit performance.

by Capital Ideas
Last Updated: 23 Jul 2013

On the basis of readily available data, it is clear many managers do choose to hide some profit information. Managers may not want to fully disclose abnormally high profits in a segment out of concern that such a move would invite competitors interested in capturing some of those profits. This motive is palatable to shareholders, who may appreciate a manager's disinclination to share the good news with rivals even if it also is withheld from owners.

On the other hand, abnormally low profits may not be fully disclosed because doing so would stir unwanted scrutiny from shareholders. This motive would likely alienate shareholders, who would be inclined to demand answers from managers overseeing poorly performing business segments.

In their recent study "Segment Profitability and the Proprietary and Agency Costs of Disclosure," University of Chicago Graduate School of Business professor Philip G. Berger and Rebecca N. Hann of the University of Southern California's Leventhal School of Accounting set out to determine what motivates managers to aggregate (and thus, to effectively hide) line-of-business profit data.

When the FASB proposed changing the Statement of Financial Accounting Standards from SFAS 14 to SFAS 131 in the late 1990s to mandate more disaggregated segment disclosure, 86 percent of firms commenting on the recommended change opposed this move based on the contention that it would put them at a disadvantage vis-a-vis competitors.

Accordingly, most studies of disclosure have focused on the proprietary cost of disclosing abnormal profitability, risking the loss of enviable profits to rivals. Berger and Hann argue that the self-interested agency cost motive of hiding abnormal profits to avoid external scrutiny also merits examination.

According to earlier studies, when the adoption of SFAS 131 made it more difficult for managers to lump segments together to hide abnormal profits, a greater "diversification discount" was created. The diversification discount is the comparison of a firm's stock price relative to the value of a number of accounting variables, such as its sales or total assets.

This would seem to suggest that a motive for managers to combine segments under SFAS 14 is to hide poorly performing segments. When greater disclosure more fully reveals what the authors call "the extent of value destruction at an underperforming firm", there is a greater threat that the underperforming manager will face discipline in the form of heightened corporate governance and control mechanisms.

Berger and Hann identified firms where inefficient transfers occurred as firms with the agency cost motive to conceal segments. All other firms were classified as having the proprietary cost motive for segment aggregation. In the agency cost motive sample, new segments earned substantially lower average abnormal profits than the old segments, ranging from 10 percent to 18 percent lower. This suggested that managers were indeed hiding poorly performing segments when they had the opportunity to do so combined with the agency cost motive.

Berger and Hann's findings suggest that if managers had been left with the amount of discretion afforded them under SFAS 14, they would be inclined to use that discretion in a way that would not be optimal for shareholders. Another implication of the findings is that the change in segment disclosure under SFAS 131 may be beneficial to shareholders. The new standard reduces agency costs by forcing managers to give shareholders more information about segments, even if they are underperforming. However, shareholders also may be hurt by the greater disclosure forced upon managers by SFAS 131, because the additional information may benefit competitors.

"Overall, SFAS 131 segment reporting may be better for shareholders than SFAS 14 reporting," Berger says. "Even though the firm may be giving more proprietary information to competitors when forced to use the new standard, it's also true that the firm receives more information from its publicly traded competitors. The net increase in the proprietary cost of disclosure under the new standard is thus unlikely to be high."

What has been shown to be a better standard in the United States may be embraced internationally as well. The International Accounting Standards Board (IASB) has proposed changing its segment-reporting standard from the current approach (which is similar to that of SFAS 14) to a new approach similar to SFAS 131. Such a change would permit additional research on the ways in which widely varying disclosure practices in a number of other countries reflect proprietary and agency cost concerns.

Segment profitability and the proprietary and agency costs of disclosure.
Philip G. Berger and Rebecca N. Hann.
The Accounting Review, 2007

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