306-684 Financial Accounting

1. 306-684 Financial Accounting Seminar 6 – Economic Consequences & Positive Accounting Theory Semester 2, 2009

2. First – some revision Measurement perspective applications - The pressures for a measurement perspective in accounting practice face two main obstacles: 1 the sacrifice of reliability for relevance 2 management’s concern over inclusion in net income of unrealized gains and losses (See chapter 7 for more details) Semester 2, 2009

3. Measurement perspective applications The lower of cost or market rule – A long established example of a measurement perspective Once an asset is written down it forms the new “cost” – it is conservative but is it decision useful? It reduces the chance of overstatement Semester 2, 2009

4. Measurement perspective applications (cont.) Ceiling test for property, plant and equipment – Assets are to be written down when net carrying value exceeds net recoverable value (an estimate of future direct net cash flows from the asset) Then, to determine a fair value (estimate of PV of future direct net cash flows) Note: no write-up if fair value rises Semester 2, 2009

5. Measurement perspective applications (cont.) Valuation of debt and equity securities On acquisition assets are classified as: 1 Held-to-maturity –valued at amortised cost 2 Trading securities – valued at fair value; unrealised gains and losses included in income 3 Available for sale – valued at fair value; unrealised gains and losses included in other comprehensive income Semester 2, 2009

6. Measurement perspective applications (cont.) Hedge accounting – Hedge instruments are used to manage risk. Gains and losses on fair value hedges are included in current earnings. The related gain or loss on the hedged item is also included in current earnings. Thus, net income is affected only by extent that the hedge is not completely effective. Semester 2, 2009

7. Measurement perspective applications Intangibles – Example: Goodwill (two forms) 1 Purchased goodwill – retained on balance sheet unless evidence of impairment 2 Self-developed goodwill – not readily recognised - usually a cost and may be recognised in future income statements as recognition lag. Perhaps recognised as a capitalisation of expense if pass a feasibility test? Semester 2, 2009

8. PART III The Preparer Perspective – Managers and Financial Accounting Information Semester 2, 2009

9. Learning Objectives • To develop the concept of economic consequences; • To understand the nature of the firm in relation to contracting theory; • To introduce the three hypotheses of positive accounting theory [PAT]; • To distinguish the opportunistic and efficient contracting versions of PAT; Semester 2, 2009

10. Important terms/concepts • Positive accounting theory • Agency costs • Bonus hypothesis • Debt hypothesis • Political cost hypothesis Semester 2, 2009

11. The Story So Far…. • In the real world accounting reports have a conservative bias • To the extent that markets operate efficiently • investors are price protected, • users can determine firm value given full disclosure; • accounting policy choices and changes are therefore price irrelevant (no impact on future cash flows) – the information perspective • If markets have some inefficiency, then preparers and standard setters should disclose ‘FV’ for items. Semester 2, 2009

12. The Problem • HOWEVER, managers, investors and regulators all behave as if accounting policy choice does matter • considerable time, effort & cost devoted to accounting choices and lobbying of regulators • adoption of IFRS • mandatory expensing of ESOs • WHY??? Semester 2, 2009

13. The Answer: Economic Consequences • Accounting choices have economic consequences • Can affect firm value • Can affect reported net income (from which dividends are paid) • Therefore affect the distribution of wealth in the economy • So we need a theory to explain manager’s accounting policy choices Semester 2, 2009

14. Positive v. Normative Theories • Theories that prescribe are called normative theories • E.g. single person decision theory and the theory of investment • That is, rational decision makers should use Bayes’ theorem • Theories that explain or predict are called positive theories • They are empirical – i.e. based on real world data/observations Semester 2, 2009

15. Economic consequences – example Employee stock options (ESO) (Regulator response to management accounting policy) Previously, ESOs were not required to be valued or expensed. Management claimed that lower profits would be reported – hence lower share prices, higher cost of capital, reduced management motivation Dilution of shareholder value Semester 2, 2009

16. Economic consequences – example Successful efforts (SE) accounting (investor reaction to accounting policy) Lev’s research indicated that investors responded negatively to SE accounting policy when required to switch from full cost (FC) accounting and hence report lower net income and more difficult to raise capital –even though there were no cash flow effects Semester 2, 2009

17. Positive Accounting Theory • Concerned with explaining and predicting managers’ accounting choices and reactions to accounting standards • Rationale – we need to understand existing practice (positive objective) in order to improve it (normative objective) Semester 2, 2009

18. Theory of the Firm • The firm is the nexus of direct contractual relationships among individuals who are assumed to be rational, evaluative utility maximisers; • A firm exists as efficient means of organizing economic activity; • Assumed corporate objective: maximise firm value Semester 2, 2009

19. Theory of the Firm ECONOMIC, POLITICAL & SOCIAL CONTEXT DEBTHOLDERS THE FIRM - MANAGEMENT SHAREHOLDERS Semester 2, 2009

20. The Agency Problem & Costs • An agency relationship arises where there is a contract under which one party (the principal) engages another party (the agent) to perform some service on the principal’s behalf. • Under the contract, decision-making authority is delegated to the agent Semester 2, 2009

21. The Problem of Agency arises if... • The interests of the principal and agent may not be aligned – agent may make decisions to maximise his/her own utility, not that of the principal • Q: how can the agent be induced to maximise the principal’s welfare? • What are the potential costs of doing this? • What is the role of accounting in doing so?? Semester 2, 2009

22. The Problem of Agency INFORMATION ASYMMETRY ADVERSE SELECTION MORAL HAZARD Contracting Perspective Role of accounting reports to reduce agency costs (opportunism) Capital Markets Perspective Role of accounting reports to improve decision making Semester 2, 2009

23. Manager-Shareholder Contracts • Separation of ownership and control • Partial or non-ownership of firm by managers provides incentives for managers to act contrary to shareholders’ interests because they do not bear the full cost of dysfunctional behaviour Semester 2, 2009

24. The Bonus Plan Hypothesis • All other things being equal, managers of firms with bonus plans are more likely to shift reported earnings from future periods to current periods (More on this in Seminar 8 on Management Compensation) Semester 2, 2009

25. Shareholder-Debtholder Contracts • Assumption that interests of managers and shareholders are aligned • The debtholder is the principal and the manager acting on behalf of shareholders is the agent Semester 2, 2009

26. Debt Covenant Hypothesis All other things being equal, the closer a firm to violation of accounting-based debt covenants, the more likely a firm manager is to choose accounting methods that shift reported earnings from future periods to the current period • Also called the “debt-equity hypothesis” Semester 2, 2009

27. The Political Costs Hypothesis All other things being equal, the greater the political costs faced by a firm, the more likely the manager to choose accounting methods that defer current earnings to future periods Semester 2, 2009

28. The Role of Accounting • Management compensation contracts and debt contracts are based on accounting numbers • Accounting used to align interests and minimize contracting costs – efficiency • But managers choose the accounting – possible opportunism! Semester 2, 2009

29. Opportunism v. Efficiency – choice of accounting policies • Opportunism – change in allocation of resources between competing parties • Choose accounting policies to create a biased measure of manager’s performance • Efficiency – increase in total resources available for allocation • Choose accounting policies to lower contracting costs (e.g. costs of negotiating contracts, costs of monitoring contract performance and possible renegotiation or contract violation should unanticipated events arise during the term of the contract) Semester 2, 2009

30. Conclusions • Contracting theory can explain why accounting policy matters (even in the absence of direct cash flow effects) • Accounting numbers have economic consequences – they affect the distribution of wealth in the economy Semester 2, 2009