Accounting Choice and Financial Information

1. Accounting Choice and Financial Information Marc Pontone, Ed Elzinga, Quinn Bateson, Iulia Lacau-Rodean, Landin Miller , Candice Wang

2. Overview • Accounting Choice Definition • Regression Review • Research Papers • Damage Awards in Oil Industry • Role of accounting Conservatism • Troubled Companies • Initial Public Offerings • Jeopardy!

3. Does Accounting Matter? Complete and Perfect World

4. Accounting Policy Choice I paint objects as I think them, not as I see them - Pablo Picasso

5. Change in Accounting Policy An entity is permitted to change an accounting policy only if the change: is required by a standard or interpretation; or results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity's financial position, financial performance, or cash flows. [IAS 8.14] Reference: http://www.iasplus.com/standard/ias08.htm

6. A Broad Definition An accounting choice is any decision whose primary purpose is to influence (either in form or substance) the output of the accounting system in a particular way, including not only financial statements published in accordance with GAAP (IFRS), but also tax returns and regulatory filings. Journal of Accounting and Economics 31 (2001) 255–307 ,Empirical research on accounting choice by Thomas D.Fields, Thomas Z.Lys, Linda Vincentb- Graduate School of Business Administration, Harvard University

7. Variables explaining accounting choice Firm size and leverage are the only two significant variables explaining choices of accounting techniques - Holthausen and Leftwich What do you think?

8. Classification for reasons for accounting choice Influence one or more of the firm’s contractual arrangements Driven by information asymmetries, attempts to influence asset prices To influence external parties other than actual and potential owners of the firm.

9. Regression Analysis as a tool Y = B0+ B1X1+ B2X2 + R Y = response variable X = explanatory variable Bi =regression coefficients R = Residual

10. Regression Analysis Examine relationship between variables Estimates response variable given independent variables Any result with a p-value <0.05 is significant

11. P-value In statistical significance testing, the p-value is the probability of obtaining a test statistic at least as extreme as the one that was actually observed. when the p-value is less than 0.05. the relationship is said to be statistically significant.

12. Coefficient the size of the coefficient for each independent variable gives you the size of the effect that variable is having on your dependent variable, and the sign on the coefficient (positive or negative) gives you the direction of the effect.

13. Damage Awards Damage Awards and Earnings Management in the Oil Industry Study Authors: S. Hall & W. Stammerjohan Source: The Accounting Review, Vol. 72, No. 1 (Jan., 1997), pp. 47-65

14. Question Can anyone think of any examples of litigations in the oil industry? What do you think were the implications?

15. Damage Awards • Looks at relationship between the incidence of litigating events with potentially large damage awards and • Managers’ accounting choices • Defendants’ management has incentive to make firm look unprofitable

16. Hypotheses • Hypothesis 1: “Firms make income decreasing accruals during periods in which they are defendants in litigation with high potential damage awards relative to other periods” Remember from BU 231: what are punitive damages?

17. Damage Awards and Earnings Management Article • Punitive Damages: To punish wrong doing and provide protection against future misconduct • the wealthier the defendant, the larger the award of exemplary damages Can anyone think of income decreasing methods?

18. Manipulating Earnings • Possible ways to manipulate earnings: • Accounting methods and estimates • Share repurchase • Retiring debt • Liquidating LIFO inventories • Selling assets • Asset write down • Manipulating accruals

19. Earnings Management Methods • Difficult to detect: • Reserves • Accruals (revising estimates down; capitalising vs. expensing costs) Hypothesis 2: “Firms under-report new reserves during periods in which they are defendants in litigation with high potential damage awards relative to other periods”

20. Research Design Large firms always have litigation in their contingencies Study chose an industry with potential for substantially higher damage awards (oil & gas) Looking at income decreasing methods for entire term of litigation (i.e. a few years). Do you think working capital accruals are one of those methods used in the study?

21. Data and Method • Sample: all firms in oil industry with data from 1974-1992 meeting the criteria: • Have sufficient data for 20 years on sales and fixed assets • Listed on the Wall St Journal Index • Firm was one of the largest 20 oil firms

22. Sample Firms

23. Litigation Events • …were included in the model if: • Reported possible damages >= 2% of total assets and final judgement was unfavourable to the firm • 6 significant cases • 2 resulted from super tanker accidents: • Amoco Cadiz in France • Exxon Valdez in Alaska • 2 other types of environmental damages • Occidental Petroleum • Shell Oil Case • Product liability: Diamond Shamrock • Illegally interfering with contract: Texaco

24. Oil Reserves • “Oil in Place” • Total estimated amount of oil in an oil reservoir • Producible and non-producible • Reserves divided into two principal classifications: • Proven • have a reasonable certainty of being recoverable • Proven Developed and Proven Undeveloped • Unproven • Probable – 50% confidence level of recovery • Possible – less likely of being recovered (10% or so)

25. Capital Costs • AcG-16 Oil and Gas Accounting • Full cost accounting method • combination of costs incurred and present value of future costs • Equipment costs, development costs, etc. • Future cost estimates based on development method most likely to be taken • Net of salvage values

26. Ceiling Test • Impairment of Long-Lived Assets, Section 3063 • Current book value vs. NPV future cash flows • Specific to Oil Reserves • Fair value of Proved & Probable Reserves vs. Capital Costs • Carrying amount not recoverable when net amount exceeds undiscounted cash flows expected to result from use and salvage value

27. Depreciation, Depletion & Amortization • Unit-of-Production method • Capital costs depreciated • Computed on basis of units of proven reserves • Calculated each time FS are issued • Wide array of estimations • Size of reserve • Future prices • Future costs • Salvage values • Currency exchanges

28. Disclosure • Methods used in calculating DD&A • Gross or net numbers • How gas and oil converted into common unit of measure • Description of adjustments made to prices to arrive at revenue • Prices used for ceiling test • Full disclosure encouraged

29. Effect of Litigation • Ait= total accruals in year t (working capital accrual + non-working capital accrual) • CHSALES = Change in sales • FIXASSETS = fixed assets at end of year t • CHPRICE = Change in gasoline price • CHEARN = Change in annual earnings • INTERACT = Combined effect of change in price and earning • TA = total asset balance at the end of year t • Damage = 1 if firm I is involved in litigation in year t

30. Results of Regression Estimation

31. Summary and Conclusion • Findings are consistent with hypothesis that “defendants in major litigations use non-working capital accruals to decrease earnings during the period of litigation”. • Estimated reserves are under-reported incr. depletion  explain results for non working capital accruals • No evidence of fin. stmts. disclosure manipulation, however undisclosed manipulation is substantial

32. The Role of Accounting Conservatism Mitigating Bondholder-Shareholder Conflicts over Dividend Policy and Reducing Debt Costs Study Authors: Anwer S. Ahmed, Bruce K. Billings, Richard M. Morton, Mary Stanford-Harris Source: The Accounting Review, Vol. 77, No. 4 (Oct., 2002), pp. 867-890

33. Context of Study: Dividend Policy, Earnings, and Debt • Dividend payouts increase the risk of debt default • Dividend policy tied to earnings • Reduced earnings = fewer dividends • Conservatism: Lower risk of default; cheaper debt

34. Hypotheses of Study H1: “Firms that face more severe bondholder-shareholder conflicts over dividend policy adopt more conservative accounting, ceteris paribus” H2: “Firms that adopt conservative accounting incur a lower cost of debt, ceteris paribus”

35. Conservatism CICA Handbook: “…estimates of a conservative nature attempt to ensure that assets, revenues and gains are not overstated and, conversely, that liabilities, expenses and losses are not understated” Study: considers not just conservative methods, but also the effects of conservative estimates and assumptions Study: focuses on the cumulative effects of conservatism

36. Two Proxies For Conservatism • Market-Value-Based • Conservative accounting generally reduces book value of equity relative to market value of equity • Accrual-Based • Conservative accounting leads to persistently negative accruals

37. Three Proxies for Dividend Policy • Operating Uncertainty • Earnings volatility causes excess dividend payments • Level of Dividends (as a percentage of assets) • A high level of dividends increases conflicts with shareholders • Leverage • Ratio of long-term debt to assets

38. Proxy for Cost of Debt Senior Debt Rating assigned by Standard and Poor’s

39. Research Design: H1 CONi= β0+ β1 STDROAi+ β 2DIVi + β 3LEVi+ β 4 ROAi + β5 SIZEi + β6SALESGROj + β7RNDADVi + Ɛi Where CONi = One of the two measure of conservatism STDROAi = St. Dev. Of firm i’s ROA DIVi = firm i’s common dividends divided by total assets LEVi = firm i’s long-term debt divided by total assets ROAi = firm i’s net income before extny items, / total assets SIZEi = natural log of firm i’s total assets SALESGROj = annual % change in firm i’s sales RNDADVi = firm i’s R&D plus adv. expense, / total assets

40. Research Design: H2 RATINGi= γo+ γ1CONi+ γ2ROA, + γ3LEVj+ γ4SIZEj+ γ5BETAi + γ6MSEj+ ui Where RATINGi= a numerical transformation of S&P's senior debt rating for firm i over the interval 2 through 21, where larger values correspond to a less favorable debt rating, averaged over each six-year estimation period; BETAi = the value-weighted market-model beta, obtained from market-model esti-mates over the six-year period for firm i, for firms with a minimum of 24 monthly returns MSEj= the mean squared error of the market-model residuals, obtained from mar-ket-model estimates over the six-year period for firm i, for firms with a minimum of 24 monthly returns

41. Results: H1 There is a strong correlation between both measures of conservatism and two of the three proxies for dividend policy conflicts The evidence on leverage, the third dividend policy proxy, is mixed Overall, the authors conclude that firms facing more severe dividend conflicts choose more conservative accounting

42. Results: H2 The authors conclude that firms using conservative accounting do have more favourable debt ratings and there do incur a lower cost of debt

43. Troubled Companies Determinants of Accounting Choices in Troubled Companies Study Authors: Dominic Peltier-Rivest (2000)

44. Details • Date: 2000 • Firms: 127 • Characteristics • Troubled firms • Three consecutive years of losses, and; • Reduced dividends

45. Methodology & Variables • Methodology • Multivariate Regression Model • d • Variables

46. Non-Current Discretionary Accruals • D • Proportionate effect (% of total assets) • Largest Components • PPE • Intangibles • Question • What could cause these results to be inaccurate?

47. Firm Composition What industry would have the highest levels of NCDA (Non-current Discretionary Accruals)?

48. Hypotheses • Hypothesis 1 • Binding Debt Covenants (COV) • Managers more likely to make income-decreasing accounting choices in the binding year • Question • Why would managers make income-decreasing accounting choices in the binding year?

49. Hypotheses • Hypothesis 2 • Seeks Government assistance (GOV) • managers are more likely to make income-decreasing accounting choices in the year before the petition was filed and in each year prior to the investigations completion • Question • Why would managers make income-decreasing accounting choices if it was seeking government assistance?

50. Hypotheses • Hypothesis 3 • Non-routine change of top executive (CEO) • the incoming executive is more likely to make income-decreasing accounting choices in the year of the change • Question • Why would incoming executives make income decreasing accounting choices in the year of change?