A demotion in disguise? The real effects of relocating pension smoothing from operating income to non-operating income

Although operating income is a pervasively used performance metric, the FASB has never defined operating income. ASU 2017-07 moves toward defining operating income for the first time in the FASB’s history by specifying the inclusion and exclusion of certain income components in operating income. We examine the real effects of a mandated relocation of the income-smoothing mechanisms for defined benefit pensions from “above the line” to “below the line” of operating income. For over 30 years, the income-smoothing mechanisms from SFAS 87 (1985) have created financial reporting incentives for employers to invest in higher-risk pension assets. Consistent with ASU 2017-07 reducing the financial reporting incentives for risk-taking, we predict and find that a sample of US firms subject to this mandate reduces investment in riskier pension assets following the change, relative to a control sample of Canadian firms not subject to the change. In cross-sectional tests, we find that the reduction in risk-taking is more pronounced in (1) firms where the financial reporting benefits to risk-taking were stronger in the pre-period, and (2) firms where the regulatory change particularly reduced those financial reporting benefits. Our findings provide the first direct evidence that smoothing induces US pension sponsors to tilt toward riskier pension investments; they also indicate that financial statement presentation has real economic consequences.