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Chapter 8

Chapter 8. Economic Consequences and Positive Accounting Theory. Chapter 8 Economic Consequences and Positive Accounting Theory. What are Economic Consequences?. Answer: Accounting policies matter Especially to managers Even if no effect on cash flows. Efficient Securities Market Theory.

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Chapter 8

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  1. Chapter 8 Economic Consequences and Positive Accounting Theory

  2. Chapter 8Economic Consequences and Positive Accounting Theory

  3. What are Economic Consequences? • Answer: Accounting policies matter • Especially to managers • Even if no effect on cash flows

  4. Efficient Securities Market Theory • Accounting policies do not matter • Beaver (1973): text, Section 4.3.1 • If no effect on cash flows • If fully disclosed

  5. Another Efficient Securities Market Anomaly? • Answer: Not necessarily • Economic consequences can be reconciled with efficient securities market theory

  6. 8.3 Economic Consequences in Action • Employee stock options (ESOs) • APB 25 applied until 2004/2005 • No expense need be recorded if intrinsic value = zero • Are ESOs an expense? • Dilution • Opportunity cost • Continued

  7. 8.3 Economic Consequences in Action (continued) • Measuring ESO expense • Black/Scholes option pricing formula • Assumes option held to expiry date • But ESOs can be exercised early, between vesting and expiry dates • As a result, Black/Scholes overstates ESO expense • Accountants’ answer • Use expected exercise date in Black/Scholes formula • Report ESO expense as supplementary information • SFAS 123, 1995 • Continued

  8. 8.3 Economic Consequences in Action (continued) • Manager abuses of ESOs • Since no effect on net income, firms overdosed on ESO compensation • Pump and dump • Manipulate share price down prior to scheduled ESO grant dates • Spring loading • Late timing • Theory in Practice 8.1 • Continued

  9. 8.3 Economic Consequences in Action (continued) • Increasing evidence of abuses lead to renewed pressures to expense ESOs, despite strong manager resistance • Manager resistance overcome • IFRS 2, SFAS 123R, 2005 • Note no effect of ESO expensing on cash flows • Why such strong manager resistance? • Continued

  10. 8.3 Economic Consequences in Action (continued) • Reasons for managers’ strong resistance to ESO expensing • May lead to reduced use of ESOs as compensation • Resulting reduced scope to abuse ESO value? • Concerns about reliability of Black/Scholes? • Lower reported net income? • Efficient markets theory predicts markets will see through • Leads to positive accounting theory

  11. 8.5 Positive Accounting Theory (PAT) A Theory to Predict Managers’ Accounting Policy Choices

  12. 8.5.1 Assumptions of PAT • Managers are rational (like investors) • Implies conflict between interests of managers and investors • Efficient securities markets • Efficient managerial labour markets • But manager effort & ability not directly observable (moral hazard problem) • Reporting on manager performance (stewardship) is a second major role for financial reporting

  13. 8.5.2 The Three Hypotheses of PAT • Bonus plan hypothesis • Derives from managerial incentive contracts • Bonus often based on accounting variables • Implies a stewardship role for financial reporting • Debt covenant hypothesis • Derives from debt contracts • Debt covenants often based on accounting variables • Political cost hypothesis • High profits may create political ‘heat’ • Continued

  14. 8.5.2 The Three Hypotheses of PAT (continued) • NB: contracts are rigid and incomplete • Otherwise, could simply renegotiate contracts if unforeseen events happen • Creates incentives to manage earnings instead

  15. Managing Reported Earnings • Changing accounting policies • Timing of adoption of new accounting standards • Changing real variables--R&D, advertising, repairs & maintenance • Create special purpose entities (Enron) • Capitalize operating expenses (WorldCom) • Discretionary accruals

  16. Managing Reported Earnings Through Discretionary Accruals • NI = OCF ± net accruals = OCF ± net non-discretionary accruals ± net discretionary accruals • Examples of discretionary accruals • Allowance for doubtful accounts • Warranty provisions • Provisions for reorganization, layoffs, restructuring • Contract completion costs • Note that discretionary accruals not directly observable by investors

  17. 8.5.3 Estimating Discretionary Accruals • Debt covenant slack • Dichev & Skinner (2002) • Supports debt covenant hypothesis • Continued

  18. 8.5.3 Estimating Discretionary Accruals (continued) • The Jones model (1991) • TAjt = αj + β1jΔREVjt + ß2jPPEjt + εjt • Estimate by least-squares regression • Use estimated equation to predict non-discretionary accruals • Discretionary accruals = actual – predicted • Jones’ study supports political cost hypothesis

  19. Two Versions of PAT • Opportunistic version • Managers choose accounting policies for their own benefit • Efficient contracting version • Managers want to choose accounting policies to attain corporate governance objectives of the firm

  20. 8.5.4 Distinguishing Opportunistic v. Efficiency Versions of PAT • Hard to do • E.g., are manager objections to expensing ESOs driven by • Opportunism: preservation of big ESO awards • Efficiency: ESOs an effective compensation device. Reducing ESO use decreases compensation contract efficiency • Continued

  21. 8.5.4 Distinguishing Opportunistic v. Efficiency Versions of PAT (continued) • Some research consistent with contracting efficiency • Mian & Smith (1990) • Consolidated financial statements • Christie & Zimmerman (1994) • Takeover targets • Dichev & Skinner (2002) • Debt covenants • Continued

  22. 8.5.4 Distinguishing Opportunistic v. Efficiency Versions of PAT (continued) • Some research consistent with contracting efficiency, cont’d. • Dechow (1994) • Net income more highly associated than cash flows with share returns • Guay (1999) • Limit firm risk using derivatives • Conclude: significant evidence for efficiency version

  23. PAT Perspective on Conservatism in Financial Reporting • Recall text, Section 6.7, shows an investor demand for conservatism • PAT also supports conservatism, from an efficient contracting perspective • Conservative accounting makes it more difficult for managers to take advantage of debtholders • e.g., more difficult to pay excessive dividends • Investors realize this increased security and will lend at lower interest rate • Arguments for conservatism conflict with standard setters’ moves to current value

  24. Conclusions • PAT helps us understand why accounting policies have economic consequences, without conflicting with efficient securities markets theory • PAT supported by a large body of empirical evidence • PAT supports a corporate governance (stewardship) role for financial reporting • PAT supports an efficient contracting role for conservative financial reporting

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