Discussion: “An Empirical Examination

of Factors Affecting the Timing of

Environmental Accounting Standard
Adoption and the Impact on Corporate
Valuation”
JAMES C.MCKEOWN”

This paper studies accounting choice and accounting information concerning

cleanup costs within the natural resources sector. The authors position their work
by referencing previous studies on implementation of the Canadian Institute of
Chartered Accountants (CICA) requirement on accruing liabilities for site restora-
tion costs as well as previous studies concerning Superfund disclosures. They cite
three contributions of the paper: measurement of the impact of the CICA require-
ment on corporate disclosure, determination of factors affecting timing of the adop-
tion of the new standard, and estimation of the valuation relevance of the
disclosures.
While the previous studies appear to have adequately reported the impact of
the requirement on corporate disclosure, the authors do clearly differentiate their
situation from the Superfund situations, thereby creating some distance between
this study and the previous studies of Superfund situations. They make the case
that their situation is cleaner than the Superfund situations because the latter have
substantial allocation uncertainty concerning responsibility. On the other hand, both
situations can have considerable uncertainty regarding amounts of future costs, at
least partly because of government involvement in both cases.
However, they d o not make clear their reasons for examining adoption timing.
In Section 3.1 they cite Amir and Ziv (1997) as showing that “managers have
incentives to strategically choose the adoption timing and reporting method to sig-
nal to the market their private information about the new standard’s financial im-
pact.” They seem to imply that this assertion will be tested, but the hypotheses
and analyses do not have any connection that I can see with this assertion. In fact,
the hypotheses seem to be generated based on expectations unrelated to the Amir
and Ziv model.
When formulating Hypothesis 1, the authors make the case that healthier firms
are better able to absorb the financial statement consequences of adopting the new
standard. However, they do not follow through and discuss any benefit such firms

*Pennsylvania State University

314
DISCUSSION 315

would gain from early adoption. I believe it would be possible to fill this gap by
using signalling or similar reasoning. As it stands now, though, this hypothesis is
almost the opposite of the Amir and Ziv reasoning. Amir and Ziv reason that early
adopters are showing that the effect is less negative, while this hypothesis tends
more to suggest that early adopters do so because they are healthy enough to
withstand the news.
Hypothesis 2 represents more of a control than an experimental variable. Since
one of the issues concerning adoption timing is ability to estimate the future costs,
greater uncertainty in that estimate affecting adoption timing would simply mean
that managers reacted to their own situation. It should be included in the model to
reduce error in the model, but I do not see what it tells us about managers’ ac-
counting decisions.
The justification for Hypothesis 4 seems a bit ambiguous. The authors state
that managers will be concerned that adoption during the year would make financial
results appear less favorable, which “could make future financing more costly.”
This directly implies that managers would not want to raise capital in the year
following that reduction in investor expectations. Consistent with this reasoning, I
would have expected to see an effect (if any) if capital was raised in the year
following the adoption timing decision. This ambiguity does not constitute a major
problem, however, because the authors do check for this possibility in a supple-
mentary analysis and find no support for a relationship between the adoption timing
decision and capital raised in the following year.
Overall, after seeing the explanations of the hypotheses concerning adoption
timing, I am not sure what we should expect to learn from these tests.

1. Variables and Model

The study includes several control variables. Leverage (debt to equity) is used
to control for default risk. However, the reasoning given seems to fit the financial
health consideration contained in Hypothesis 1, probably even better than the prof-
itability variable actually used to test Hypothesis 1. (I am also concerned about the
use of a variable whose values can become quite large as the denominator becomes
small.) The auditor-type variable discussion cites one study which found higher
quality auditors provide more assurance. This is interpreted to imply that Big Six
auditors are more likely to require compliance. There are other studies that tend to
imply the opposite-that large audit firms may be less strict. For example, Messier
(1983) found that non-Big Eight partners in a behavioral study have a lower ma-
teriality threshold than Big Eight partners: they were more willing to disclose a
problem. Chewning, Pany, and Wheeler (1989), using 1980-1983 data, found that
non-Big Six auditors were more likely to issue a consistency modification than
were Big Six auditors. Thus the direction of the effect of this variable is difficult
to predict. This does not affect the current study, since auditor type is a control
variable, but it seems appropriate to disclose both sides of the situation to inform
future researchers.
316 J O U R N A L OF ACCOUNTING, AUDITING & FINANCE

The proxy for uncertainty, LIFE, has some important other properties. Among
them are relative amount of current provision required and present value of the
total required. This means that any effect observed for LIFE might be due to the
hypothesized effect of uncertainty, or it might be due to the relative magnitude of
the amounts involved in adoption.
Lastly, is there a basis for assuming that a single intercept dummy allows
sufficient control for industry differences? I would have expected that several of
the variables might well have different coefficients for mining versus oil and gas
companies. I would include ROA, LIFE, and D E , at least.
The sample selection, entirely from two industries in the natural resources
sector in Canada, provides a fairly homogenous set of firms that would be most
likely to be affected by the new requirement. However, I would have liked more
information on the number of firms that were eliminated because either they had
negative shareholders’ equity or their annual reports were not available in the Met-
ropolitan Toronto Reference Library.

2. Results on Accounting Choice

I compliment the authors on their de-emphasis of the univariate results. Since
these results have no meaning in a multivariate situation, they are descriptive only
and should not be discussed. Use of the Wilcoxon rank-sum test in the univariate
tables is questionable since comparisons of means versus medians of the underlying
data indicate those data certainly violate the symmetry condition required for that
test.
In the discussion, given the number of degrees of freedom, a seven percent
alpha level on ROA in the early adoption model does not seem worthy of discussion
as a significant effect. This variable is not a strong proxy for financial health and
appears to have little, if any, effect on adoption timing.
The discussion of the environmental commitment variable (ENPO) in the early
adoption setting reverses the hypothesized causal effect by comparing the propor-
tion of early adopters with ENPO = 1 versus the proportion of mandatory and late
adopters with ENPO = 1. The effect should really be reported as the percentage
of environmentally committed firms which adopted early (46%) versus the per-
centage of ENPO = 0 firms that adopted early (20%). The same problem occurs
in discussion of the audit-type effect on the mandatory adoption decision.
Also, in their discussion of the mandatory adoption model, the authors con-
clude that “ROA did not have a positive association with the mandatory adoption
decision,” when they simply should have said the null hypothesis of non-positive
association could not be rejected.
The reported prediction tests show a modest increase over the naive prediction
of all firms adopting at the associated date. If those tests were done in sample, that
would be expected and would not mean much. The paper does not specify whether
the predictions were tested out of sample or at least quasi out of sample such as a
Lachenbruch or similar analysis.
DISCUSSION 317

3. Valuation Tests
I believe this section of the paper is potentially the most interesting. The au-
thors examine whether the equity market uses the reported information in com-
puting the values of the firms. While it is quite likely that the answer is yes, it is
still worthwhile to test that presumption. I discuss the two sets of models the
authors use to test the market’s use of the information. However, one important
methodological issue applies to all models. As stated, the models relate total market
capitalization to total equity plus other variables measured on the firms as a whole.
The authors state “All variables are scaled by total assets.” They do not specifically
include the intercept in that statement, so it is not clear whether the intercept is
included. In this type of analysis, where the stated model is at the total firm level,
the scaling should apply to the intercept as well as the independent variables.
The first set of models relates market capitalization of equity to book equity.
They each begin with y, the reported equity plus the accumulated provision for
future costs (AP). This is the amount which would have been reported (by most
companies) if they had not been required to make the provision for future costs.
The obvious test of relevance is in model (4), whose right-hand side is y + AP,
which is also the reported equity of the company. The coefficient on AP thus
nominally tests whether the market included AP or something correlated with AP
in its valuation computations. In an ideal world where y was measured at market
value and AP was the present value of appropriately allocated future costs, the
coefficient on AP would equal - 1. Of course neither of those conditions is true,
so interpretation of the coefficients is somewhat problematic. One additional con-
cern is that AP will be proportional to the number of years the mineral deposits
have been operated. The market could easily be making valuation adjustments
which are correlated with the number of years of operation. Any such adjustments
will likely load on AP.
I find it more difficult to understand the other two models in this set. If the
basic accounting for future restoration costs is to be relevant, it would seem that
the accumulated provision (AP) should be included in any balance sheet model,
but AP is not included in either of these models. The current provision (CP) in
model (3) would seem to have no direct valuation relevance by itself. The annual
provision would need to be multiplied by some factor that is different for different
companies to obtain a valuation relevant number. Multiplying CP by the remaining
operating life of the deposits in model (5) seems to be working the wrong way.
This is the (undiscounted) amount that will be allocated to future years. This model
implies that a larger provision is appropriate for companies that are early in use of
their deposits than for companies which have almost exhausted their deposits.
The results for this set of models are not surprising. The best fit is obtained
for model (4), which includes book equity and accumulated provision for removal
costs. The removal cost component of model (5) is not significant. None of the
models fit well.
Moving to the second set of valuation models, I believe the authors missed an
318 JOURNAL OF ACCOUNTING, AUDITING & FINANCE

opportunity to test the valuation relevance of the income effect in these models.
The basic model includes both book equity and abnormal earnings. They could,
and probably should, include in the model terms for equity and earnings measured
without considering removal costs plus terms estimating effects of removal costs
on both equity and earnings. Taking E(RC) as accumulated provision (AP) plus
estimated future provision (CP * LIFE), this would give the following instead of
equation (6):
,LlFE+l
I

W w
P, = + -
R, - wc p,
)J,

- L(2)
R, - w Rl
LIFE+ I

CP, + (k)
LIFE

(AP + CP, * LIFE) + E,

This equation could then be estimated to test the valuation relevance of CP on
abnormal income and AP + C P * LIFE on the terminal book value.
Instead of doing this, the authors use the same removal cost variables they
used in the first set of models and adapt them to this set of models. These variables
suffer from the same problems as i n the earlier set of models.
The results for these models are similar to the previous valuation models with
fairly poor fits. Another interesting feature is that several of the industry slope
coefficients essentially reverse the effect of the basic variable. For example, the
coefficient of AP in model (8) is -2.47, which is the AP coefficient for mining,
but the coefficient of AP * IN is 7.94. This means that the coefficient of AP for
oil and gas is actually +5.47. Six of the seven industry slope coefficients move
the coefficient of oil and gas toward zero with three of the seven actually showing
the coefficient estimated for oil and gas to be positive. This is a strange result that
might have been explored.
Overall, I do believe that the reported removal costs are valuation relevant,
but this is still based on my initial presumption. The evidence presented here is
not very clear.

4. Conclusions
In their conclusion, the authors imply that removal costs were not adequately
covered by GAAP and the new standard was needed. They base this on their finding
that most companies changed their accounting for removal costs after the standard
was adopted. They fail to consider the possibility, which I believe to be the case,
that GAAP clearly requires that the liability for removal costs should have been
recognized with appropriate charges to operations each year, but that GAAP was
not being enforced properly before an explicit standard was adopted. After all,
removal costs are simply part of salvage value, which should be included in the
depletion computation. Thus, the change in reporting behavior could indicate there
was a need for a change in standards or a need for improvement in enforcement,
possibly through regulatory review of the statements filed by these companies.
DISCUSSION 319

In summary, I believe the authors chose an interesting topic and relevant sam-
ple. Their results on accounting choice are essentially what would be expected. I
would have liked more convincing valuation tests, possibly along the lines I outline
in this discussion. One final caveat is whether the findings are really important,
given that the disclosed provisions were material for only eight of the subject firms.
This may well account for some of the puzzling results in the valuation tests.

REFERENCES

Amir, E.,and A. Ziv. ‘‘Economic Consequences of Alternative Adoption Rules for New Accounting
Standards.” Confeirtporqy Accoiirifirtg Reseurch (Fall 1997): 543-568.
Chewning, G., K . Pany, and S. Wheeler. “Auditor Reporting Decisions Involving Accounting Principle
Changes: Some Evidence on Materiality Thresholds.” Joitrtiul of Accnitrifirig Resenrch (Spring
1989): 78-96.
Messier, W. “The Effect of Experience and Firm Type on Materiality/Disclosure Judgments.” Joiirriol
of Accorrntirtg Research (Autumn 1983): 61 1-618.