Chris Agoglia, January 17, 2013

1. Auditing Doctoral Consortium: Panel on Regulation & Research Behavioral/Experimental Research and Audit Regulation:One Person’s 1st (and 2nd) Hand Experiences with Some of the Challenges Chris Agoglia, January 17, 2013

2. My First-Hand Experience: Limited # of papers dealing w/regulatory issues (more of a financial bent): • Agoglia, Doupnik, & Tsakumis (2011 TAR)—principles/rules stds • Fanning, Agoglia, & Piercey (2013 WP)—SFAS 5 disclosure thresholds But, MUCH 1st hand experience with potential “challenges.” Preface: • DON’T let these challenges discourage you—This is important work! • Just go in with eyes open and keep these challenges in mind BEFORE gathering data. PvR study will serve as “backdrop” for my comments

3. Lease Standard: Poster Child for PvR Debate A little background: • ADT used lease setting: Classification as Operating or Capital lease • GAAP vs. IFRS Both GAAP & IFRS std use similar dimensions of lease in order classify— Criteria include: transfer of ownership, bargain purchase options, min lease pymt, LEASE TERM relative to leased asset’s economic life. Key differences: • GAAP std often cited as “poster child” for Rules-based stds (VERY bright lines!—e.g., ≥75% economic life) • IFRS std more Principles-based (“Blurrier” criteria—e.g., “for the major part of the economic life”) Under both stds: If ANY criterion met, lease MUST be capitalized more CONSERVATIVE treatment… Sets the stage for Challenge #1:

4. The Big Kahuna: Challenge #1Comparing a Current to a Proposed Std—Is it a Fair Race? Leveling the playing field isn’t as easy as you may think… Setting up the experiment  What are lease details? 1) If JUST below all R-B Bright Lines (e.g., 72% economic life), R-B = Operating Lease, but P-B = some discretion Conclusion:Ps more conservative under P-B std. 2) If JUST above ANY R-B Bright Line (e.g., 78% economic life), R-B = Capital Lease, but P-B = some discretion Conclusion:Ps more conservative under R-B std.

5. The Big Kahuna: Challenge #1Comparing a Current to a Proposed Std—Is it a Fair Race? Tricky issue…whether exploring a transition to P-B stds or some other regulatory change under consideration. Many different studies…many different ways of trying to deal with it. Before you think about criticizing their approach or questioning their choices: Consider WHY they may have made those choices. Typically, they’re just trying their best to inform an important debate. Here’s what we tried…

6. OurAttempt to Tame the Big Kahuna Manipulation focused on the LEASE TERM/economic life criterion: ≥75% of economic life (GAAP) vs. “for the major part” (IFRS) Plus, provided the following definitions from std: • “Lease term” is defined as the fixed non-cancelable term of the lease plus all periods covered by bargain renewal options. • “Bargain renewal options” allow the lessee to renew the lease for a rental sufficiently lower than the fair rental of the property such that exercise of the option appears, at the inception of the lease, to be reasonably assured. Specifically, we focused on the BRO in our attempt to level the playing field.

7. OurAttempt to Tame the Big Kahuna Lease details provided to participants: 10 yr. economic life of leased asset 5 yr. non-cancellable lease term (i.e., 50% of economic life) option to renew for 3 yrs. at 92%* of fair rental value [* a grey area with respect to its “bargain-ness”] For R-B std, it’s all about the renewal option: • if renewal option deemed NOT a bargain: lease term = 50% of economic life  OPERATING lease • but, if renewal option deemed a BARGAIN: lease term = 5+3 yrsor 80% of economic life  CAPITAL lease

8. OurAttempt to Tame the Big Kahuna Lease details provided to participants: 10 yr. economic life of leased asset 5 yr. non-cancellable lease term (i.e., 50% of economic life) option to renew for 3 yrs. at 92%* of fair rental value [* a grey area with respect to its “bargain-ness”] For P-B stdto place Ps in a similar professional decision context (i.e., similar level of discretion), Ps must interpret “for the major part” as ≥51 and ≤80 % of economic life (i.e., “major part” > 5 yrs, but no more than 8). If so (and it was), then just like for the R-B std, it’s all about the renewal option: NO bargain = OPERATING lease; BARGAIN = CAPITAL lease One thing to notice here is how narrow a facet of the issue we’re focused on.

9. Challenge: Facet-itisThe challenge of addressing only a portion of a multidimensional issue We focused on a single facet (lease term) of two stds that differed on multiple dimensions (and an ancillary band of it at that—BRO) —we were solely looking at the determination of whether an option to renew the lease should be considered a bargain. While this certainly IS a way clients structure transactions to get around capitalization, it’s just ONE way. What to do if this challenge applies to your study: Do your best to think through how your narrow facet relates to other facets and, as a result, informs the BROADER debate. [maybe “early mover’s advantage”and we just got lucky!]

10. Related Challenge: Narrowness Due to SettingThe challenge of limited applicability of solution Peytcheva & Wright (2013 WP) • shared a session couple years ago at KU Audit Symposium • discussed here with permission (and, I hope, with respect) Also looked at GAAP vs. IFRS lease std • Unlike us, they didn’t just focus on a single difference b/w stds (GOOD!) But…details of lease were all below R-B Bright Lines  horse race not fair [but they’re NOT necessarily trying to set up a fair horse race—so how can they sell their narrow setting?]

11. Related Challenge: Narrowness Due to SettingThe challenge of limited applicability of solution Their 2 tacks: • Acknowledged they’re not speaking to whether P-B stds GENERALLY result in more or less conservative decisions (i.e., horse race not fair) —they’re looking only at this band of decisions made when the BLs are not quite met—just barely… BUT point out that this is where all the action is happening— It’s these Bright Lines that drive some clients to structure transactions to come in under thresholds (i.e., due to structuring, there aren’t going to be a lot of transactions that are JUST over the threshold in a R-B setting) So, this is a narrow “decision band,” but an important one!

12. Related Challenge: Narrowness Due to SettingThe challenge of limited applicability of solution Another Good Thing: gathered process measures relating to auditors’ decisions regarding clients’ preferred treatment of lease. This helps tell us WHY auditors are doing what they’re doing. What to do if this challenge applies to your study: If your results are destined to be applicable only to a narrow band of the decision context, do your best to make it an important band and, if possible, delve deeper into what’s going on.

13. . Challenge: Novelty of SettingThe challenge of comparing a familiar world to a less familiar one Clearly an issue for us: • US-based professionals likely more familiar with GAAP lease treatment. • Measured familiarity—no significant influence.

14. Challenge: Novelty of SettingThe challenge of comparing a familiar world to a less familiar one Peytcheva & Wright took a different (more creative) approach —make BOTH less familiar settings. They altered the more familiar R-B Bright Lines (e.g., lease term BL = 80%). Great, right? Well…maybe… At the KU Symposium (and thru the review process), they got hit with Qs about WHY they altered the current std and why they chose the thresholds they did. No good deed goes unpunished! Lesson: Have a PLAN for how to deal with issues of familiarity (at the very least, have some measure that you can include as a covariate). Think through how you might respond to Qs about your approach.

15. Final Challenge: The “What Ifs” The great fears: • “What if std setters change std I’m examining while I’m working on the study?” • “What if the proposed std I’m investigating is altered?” • “What if the proposal is dropped?” Many times, these can be big obstacles to relevance and, in turn, publication. So… • Think up front about how your research can be relevant regardless of the possibility of an unexpected change • AND STAY ON TOP of the CHATTER surround your regulation [but don’t let every shift of the wind drive you crazy!]

16. The Take Away So, what’s the take away from all this? Do your best to think through these (and other) challenges BEFORE gathering data And make what you feel are the BEST CHOICES you can when designing your study, b/c: This work is really important… And of all the work that we tend to do, It’s generally the stuff that regulators, std setters, firms, & investors are MOST INTERESTED in. So…make it count!