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We compare the value and credit relevance of financial statements under fair-value and smoothing (SFAS-87) models of pension accounting. While fair-value improves the credit relevance of the balance sheet, it does not improve its value relevance. Further, fair-value impairs both the value and credit relevance of the income statement and the combined financial statements unless transitory gains and losses (G&L) are separated from more persistent income components. Overall, our results suggest there are no informational benefits to adopting a fair-value pension accounting model.

Current pension accounting recognition and measurement rules (Statement of Financial Accounting Standards 87, hereafter SFAS-87, Financial Accounting Standards Board, 1985) emphasize the attribution of pension costs to periods of employee service. Accordingly, changes in the fair value of pension assets and liabilities are amortized over expected remaining employee service through an elaborate smoothing mechanism. While such a “smoothing” model generates a stable pension expense, the balance sheet recognizes merely an accrued or prepaid pension cost (i.e., the accumulated pension expense net of contributions), rather than the fair value of net pension assets. The smoothing provisions of SFAS-87 have therefore come under unprecedented attack from various quarters. As a result, an alternative fair-value pension accounting model has been adopted or is under active consideration by the world's standard-setting bodies. Under this method, the balance sheet reflects the fair value of net pension assets and all changes in the fair value of net pension assets flow through income. We provide evidence on the properties of financial statement numbers under two alternative approaches to pension accounting—the current smoothing model (largely consistent with SFAS-87) and the proposed fair-value model. Proponents of the fair-value model maintain it will improve the informativeness of the balance sheet by incorporating the most current values of pension assets and liabilities rather than a historical measure of accrued pension cost. However, income under the fair-value model includes transitory changes in net pension assets, which could increase its volatility and reduce its persistence. Thus, whether adopting a fair-value pension accounting model will improve or impair the value and credit relevance of the combined financial statements is essentially an empirical question. We use footnote information to generate income statement and balance sheet numbers under the fair-value pension accounting model. We then compare the time-series properties, value relevance, and credit relevance of financial statement numbers generated under the smoothing and fair-value pension accounting models. We define value (credit) relevance as the association between financial statement measures and equity investors’ (creditors’) future cash flow expectations, which we proxy through stock prices (credit ratings). We conduct our primary analyses on a large sample of firms over the 1991–2002 period. Our evidence is consistent with concerns voiced during the SFAS-87 deliberations: fair-value pension accounting introduces considerable volatility in net income, reducing its persistence and partially obscuring the underlying information in operating (non-pension) income. Because of its lower persistence, fair-value income is less value relevant than smoothing income. However, contrary to expectation, fair-value book values are no more value relevant than those based on smoothing. Consequently, the value relevance of book value and income combined is significantly higher under smoothing than under fair value. The inferior value relevance of income under the fair-value model can be attributed to the fair-value model's aggregation of highly transitory unrealized gains and losses on net pension assets (henceforth G&L) with more persistent income components. After separating G&L from other income components, we find no economically meaningful difference between the value relevance of the fair-value and the smoothing models. Turning to credit relevance, our analyses compare the relative ability of various financial ratios, measured alternatively under the smoothing and the fair-value models, to explain default probability. We proxy for default probability using Standard & Poor's (S&P) long-term issuer credit ratings and model credit ratings following Kaplan and Urwitz (1979). Data requirements restrict our credit-relevance analyses to the 1995–2002 period. We find that the fair-value model improves (impairs) the credit relevance of balance sheet (income statement) numbers vis-à-vis the smoothing model. However, consistent with our value-relevance results, we find that the combined balance sheet and income statement numbers are more credit relevant under the smoothing model. Also consistent with our value-relevance results, there is no statistical difference in the combined credit relevance of the fair-value and smoothing models after G&L is separated from other income components. The primary contribution of our study is that we directly address a current and contentious standard-setting issue. The recent decline in US corporate pension funding has provoked various constituents to severely criticize the smoothing provisions of SFAS-87 and to advocate the fair-value model. However, the fair-value model also has its share of detractors who worry primarily about increased income volatility and susceptibility to manipulation. Nevertheless, the Financial Accounting Standards Board (FASB) and other standard-setting bodies have taken steps to adopt the fair-value pension accounting model, ostensibly with the objective of improving financial reporting quality. Our results have important implications for such standard-setting efforts. For example, we show that fair-value pension accounting does not improve the value or credit relevance of the financial statements, and indeed may impair their relevance unless the transitory G&L is separated from other income components. Our results also have broader implications for fundamental issues under consideration by standard setters. The FASB has recently signaled a fundamental conceptual shift towards the broad-based adoption of fair-value accounting. Our results suggest the existence of important trade-offs in moving toward fair-value accounting: while one could argue that the fair-value accounting model improves the relevance of asset and liability measurements (although our evidence is not entirely consistent with this claim), it significantly impairs the persistence, and in turn the relevance, of income. Therefore, there are unlikely any informational advantages to adopting the fair-value accounting model. Our results also highlight the importance of separating transitory G&L from more persistent income components when adopting the fair-value accounting model. Such a separation is difficult if fair-value measurements are incorporated at the transaction level, as currently contemplated by standard setters.1 Finally, our study is arguably the first to examine credit relevance, i.e., standard-setting implications from the creditors’ perspective. Holthausen and Watts (2001) question the generality of the value relevance literature's findings because of its exclusive focus on equity investors. Consistent with their criticism, we find differences in the information needs of investors versus creditors; that is, an accounting alternative that is preferable from the equity investors’ perspective (value relevant) need not necessarily be preferable from a creditors’ perspective (credit relevant). Our results highlight the importance of studying both equity investors’ and creditors’ information needs when evaluating standard-setting issues. A few caveats are in order. First, our paper examines the likely direct effects of adopting fair-value pension accounting on the usefulness of information recognized in financial statements to equity investors and creditors. We do not examine indirect or unintended consequences of changing pension rules on preparer behavior, e.g., changes in pension funding levels or asset allocation. Second, because all information regarding both smoothing and fair-value pension accounting is currently available in financial statements and their footnotes, our study does not examine which model of pension accounting discloses better information. Rather, our paper seeks to compare two alternative models of recognition and measurement. Third, by using stock prices and credit ratings as proxies for future cash flows, we implicitly assume that investors and credit raters correctly use all available information, including that in the financial statements and footnotes. Although additional analyses suggest otherwise, our inferences could be contaminated if, for example, investors overweight the currently recognized SFAS-87 (smoothing) measures vis-à-vis the disclosed fair-value measures. The rest of the paper is organized as follows. Section 2 motivates the study. Section 3 describes salient design features and Section 4 discusses our results. Section 5 concludes.

We compare the value and credit relevance of financial statements alternatively measured under the smoothing (largely SFAS-87) and fair-value pension accounting models. Our results suggest the following. First, fair-value pension accounting does not improve the value relevance of the balance sheet, although it does improve its credit relevance. Second, fair-value pension accounting can impair both the value and credit relevance of income. This result arises largely because of aggregating the highly transitory unrealized gains and losses on net pension assets (G&L) with more persistent income components. Finally, fair-value pension accounting does not improve either the value or credit relevance of the combined balance sheet and income statement. On the contrary, the fair-value model impairs value and credit relevance unless the G&L component is separated from other income components. Our evidence has direct implications for standard setters who are currently contemplating adopting the fair-value model of pension accounting. For example, we suggest that the FASB's recent proposal to adopt the fair-value pension accounting model is unlikely to improve the value or credit relevance of the financial statements, and may even impair relevance unless transitory G&L is separated from more persistent income components. Phase I of FASB's pension project (which is codified in the recently issued SFAS 158) envisages such a separation by including G&L in other comprehensive income. However, G&L is likely to be included along with net-income components upon completion of Phase II of the project (Moran and Cohen, 2005). Our evidence suggests that while Phase I, at best, will not impair the informativeness of the financial statements, any move to embed G&L into net income—as envisaged under Phase II—would significantly impair the value and credit relevance of the financial statements. Our evidence also has broader implications for the current debate about the merits and demerits of fair-value accounting in general. The world's standard-setting bodies are currently committed to a broad-based adoption of the fair-value model, ostensibly with the objective of improving the informativeness of the financial statements. The move toward broad-based adoption of the fair-value model has come under intense criticism from several quarters. Critics suggest that fair-value accounting involves considerable estimation and judgment, which could introduce intentional or unintentional errors into the fair-value numbers (e.g., Watts, 2003; Ramana and Watts, 2006) and thereby impair the informativeness of the financial statements. While we cannot discriminate between these alternative sources of impairment, our evidence is consistent with fair-value accounting not improving the informativeness of the financial statements and even impairing its informativeness if G&L is not separated from other income components. Overall, our evidence suggests that the rationale for advocating the fair-value model cannot be better communication of firm value or default risk.