Earnings quality, off-balance sheet risk, and accounting for transferring of financial assets: a capital market investigation

This study examines the reliability of the financial-components approach under SFAS125 for transferring financial assets. The FASB issued the SFAS125 in 1996 as a response to the explosive growth in the securitization market, and to accommodate the fundamental nature of the sophisticated capital market created by securitization. Prior to the adoption of the SFAS125, accounting standards governing the transfer of financial assets were inconsistent about the circumstances that distinguish sales from secured borrowings.

Based on two samples of U.S. public firms, I conducted three empirical analyses to explore how the capital market assesses the financial statement information produced under SFAS125. I examined whether the researcher-constructed proxy of off-balance-sheet (OBS) risk is associated with the information set used by investors to assess systematic equity risk, incremental to accounting-measured risk based on balance sheet information. The empirical results suggest that the OBS risk estimate is incrementally associated with the market measures of risk over other on-balance sheet risk measures, after controlling for other risk relevant factors. Thus, the financial-components approach does not appear to fully reflect the risk of implicit recourse obligations arising from the transfers.

Further tests show that the recognized gains from securitization have a lower stock return association as OBS risk increases. This is consistent with the interpretation that, given the perceived OBS risk involvement, investors view securitization related gains to be less reliable. However, additional analyses assessing financial statement information across the pre and post-SFAS125 regimes suggest that the financial-components approach under SFAS125 is more capable of reflecting the market's perception of the effects of securitization on equity risk; also, the recognized gains from securitization have a higher valuation multiplier in the post-SFAS125 period, relative to the pre-SFAS125 period.

Taken together, the results in this thesis cast doubt on the reliability of the information produced under SFAS125, although the SFAS125 appears to represent an improvement compared to prior standards.

Various regulatory bodies have been continuing their effort to develop standards to resolve accounting issues involving the transfer of financial assets. By assessing the effects of the SFAS125, this dissertation provides much-needed empirical evidence regarding the reliability of financial-components accounting within the context of derecognizing financial assets. More importantly, the financial-components concept underlying the SFAS125 has profound implications for the future development of accounting transactions and instruments (Ryan 2002). Therefore, the evidence in this study also has implications for regulators as they implement or revise future accounting standards.