The impact of off-balance-sheet pension liability under SFAS No. 87 on earnings quality, cost of capital, and analysts' forecasts

This study examines the impact of off-balance-sheet pension liability under Statement of Financial Accounting Standard (SFAS) No. 87 on earnings quality, cost of capital, and analysts' forecast behavior. Specifically, three questions are investigated: (1) How does reporting of off-balance-sheet pension liability affect earnings quality? (2) How does off-balance-sheet pension liability drive the implied cost of capital? (3) How does off-balance-sheet pension liability influence analysts' forecast behavior measured as forecast coverage, forecast effort, forecast uncertainty, and forecast consensus? This research predicts a negative association between off-balance-sheet pension liability and earnings quality and a positive relationship between off-balance-sheet pension liability and cost of capital. In addition a positive connection is predicted between off-balance-sheet pension liability and analysts' forecast effort and forecast uncertainty, a negative interrelation between off-balance-sheet pension liability and analysts' forecast consensus, and no signed linkage between off-balance-sheet pension liability and analysts' forecast coverage. Based on the sample from 1986 to 2005, the empirical results show that off-balance-sheet pension liability is negatively associated with earnings quality and analysts' forecast coverage, and positively related to the implied cost of capital, analysts' forecast effort and forecast uncertainty. In other words, firms reporting off-balance-sheet pension liability demonstrate poor earnings quality, higher risk premium, less analysts' forecast coverage, and greater analysts' forecast effort and forecast uncertainty. This study extends prior pension research by documenting off-balance-sheet pension liability as an accounting parameter affecting earnings quality, a risk factor driving cost of capital, and an element influencing analysts' forecast behavior. Off-balance-sheet pension liability, however, has an inherent measurement problem. It is calculated from corporate financial information filed under SFAS No. 87, which has been subject to criticisms from both theoretical and practical perspectives. The results of this study support the on-balance-sheet financing approach adopted by SFAS No. 158, issued in September 2006, which provides a unique opportunity for a natural and intertemporal experimental setting to revisit the research questions of this study.