Chapter 8 Economic Consequences and Positive Accounting Theory

Chapter 8 Economic Consequences and Positive Accounting Theory Group A Stephanie Cenedese Nicholas Ferguson Elisa Martone John severin Marcus Traynor

AGENDA Economic Consequences Employee Stock Options Positive Accounting Theory Empirical Research Opportunistic Version of PAT Efficient Contracting Version of PAT Article

BINGO WORDS

Concept of Economic Consequences • Conflict resolution managers and accountants need to understand each other’s roles in order to abide by accounting standards and the conceptual framework • Stewardship role how conflict works out in financial reporting that differs from the investor decision-based and efficient market oriented theories • Economic consequences a concept that asserts that, despite the implications of the efficient securities market theory, accounting policy choice can affect firm value

Concept of Economic Consequences Accounting Policies • Matter primarily to management • Also matter to investors who own firms • Do not only affect a firm’s cash flows • matter under the “economic consequences” theory • Do not have an effect on the “market efficiency” theory

Concept of Economic Consequences Economic Consequences of Accounting Policy Derives many of the most interesting events in accounting practice A suggestion that accounting policies do not matter is at odds with accountants’ experience

Concept of Economic Consequences Positive Accounting Theory Answers the question as to why certain accounting policies exist Attempts to predict what accounting policies managers will choose to maximize the firm’s or manager’s interests

Concept of Economic Consequences Article: “The Rise of ‘Economic Consequences’” by: Stephen Zeff (1978) Economic consequence: the impact of accounting reports on the decision-making behaviour of business, government and creditors ‘delicate balancing act’: standard-setting bodies must operate not only in the accounting-theory domain, but also in the political domain

Employee Stock Options APB Opinion 25 (1972) Firms would issue shares with a zero intrinsic value in order to avoid expenses Intrinsic value: difference between the market value of the shares on the date the option was granted and the exercise, or strike price of the option Vesting date: one or more yeas after stocks are granted when ESOs can be exercised

Employee Stock Options Black/Scholesformula overstates the fair value of an ESO at the grant date Assumption: ESOs held to expiry date Expected return from holding an option>expected return on the underlying share “Upside Potential” of an American option increases with the time to maturity “deep in the money”: value of the underlying share > exercise price, the probability of share price falling below exercise price is low

Employee Stock Options SFAS 123R: the usage of ESOs as a compensation device would decrease if ESOs had to be expensed This reduces management’s incentive to manipulate ESO values for their own benefit Accounting for ESOs illustrates Zeff’s argument that third-party intervention complicates the setting of accounting standards

Efficient Securities Market Theory and Economic Consequences Efficient Securities Market Theory No price reaction to accounting policy changes that do not impact underlying cash flows Importance of full disclosure Accounting policies matter even in the absence of cash flow effects Potential to affect real management decisions

Efficient Securities Market Theory and Economic Consequences Does the existence of economic consequence reinforce the theory and evidence that securities markets are not fully efficient?  Positive Accounting Theory

PAT: Positive Theory of Accounting • Main Concerns • Predicting accounting policies chosen by management • Management response to proposed new accounting standards • Organization of a Firm • Organize in most efficient manner to maximize prospects for survival • Factors that help determine this organization • Legal environment, technology, degree of competition, etc.

PAT: View on Firms • Nexus of Contracts • Described as the set of contracts that it enters into • Ex: employee contracts Firm will want to minimize various contracting costs associated with these contracts. • Efficient contracts have the lowest contracting costs Many contracts are determined based on the accounting policies used by a company. What is an example of such a contract?

PAT: Firm Accounting Policies • Accounting policies will be chosen as part of achieving the goal of corporate governance • Example: Mian and Smith (1990) • Examined the choice of whether to consolidate a subsidiary • More interdependence, greater efficiency of preparation of financial statements • Joint results become more desirable • High interdependence: management performance monitored through joint rather than separate

PAT: Firm Accounting Policies Managers should have a set of accounting policies to choose from when dealing with new circumstances. • Usually considered to be those allowed under GAAP • Opens up the possibility of opportunistic behavior • Managers may choose policies for their best interests, thereby reducing contract efficiency

PAT: Rational Managers • PAT assumes that managers are rational and will choose policies that are in their best interests if possible • Managers will maximize profits if perceived to be in own best interests Managers will be willing to work for a lower compensation from a company if they can augment their utility through opportunistic behavior

PAT: The Need for Balance Firms must seriously consider the potential for opportunistic behavior when determining contracts concerning accounting policy. How would you draw the line between allowing flexibility to deal with new situations and limiting opportunistic behavior?

The Three Hypotheses of PAT The predictions made by PAT are largely organized around three hypotheses • Walts and Zimmerman (1990) Commonly viewed in their opportunistic form • Managers choose accounting policies in their own best interests

Hypothesis 1: The Bonus Plan “Managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from the future to current period” • If remuneration depends on bonuses related to net income, will likely report as high as possible

Hypothesis 2: The Debt Covenant “All other things being equal, the closer a firm is to violation of accounting-based debt covenants, the more likely the firm manager is to select procedures that shift earnings from the future to current period” • Increasing reported net income will reduce the probability of technical default

Hypothesis 3: The Political Cost “All other things being equal, the greater the political costs faced by a firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future periods” What is an example of a political situation that would lead to a manager desiring to defer earnings to future periods?

The Three Hypotheses of PAT • These three hypotheses can also be interpreted from a efficient contracting perspective • Hypothesis 1: exclude policies that lower reported net income or produce volatile earnings • Hypothesis 2: exclude policies that lower earnings or increase volatility • Hypothesis 3: policies that lower earnings help avoid political costs

Efficient Contracting and Conservative Accounting • Watts argues that conservatism will lead to efficient contracting • Protects debtholders • Lowers contracting costs • Aligns with investor-oriented rationale

Efficient Contracting and Conservative Accounting Firms will choose conservative accounting depending on debt covenants Potential for more covenant violations

Efficient Contracting and Conservative Accounting Why do you think conservative accounting will lead to more covenant violations?

Empirical PAT Research • Dichev and Skinner (2002) • Investigate debt covenant hypothesis • Managers try to manage debt covenants • Covenant slack

Empirical PAT Research Why is the cost of the first covenant violation higher than subsequent violations?

Empirical PAT Research • Healy (1985) • Investigates bonus plan hypothesis • Managers adopt accrual plans to increase net income

Empirical PAT Research • Jones (1991) • Investigates political cost hypothesis • Firms attempt to lower net income • Increase discretionary accruals • Why is there little incentive for investigators to adjust manipulated earnings?

Empirical PAT Research • Jones (1991) TAjt= αj+ β1j∆REVjt + β2jPPEjt + εjt • TAjt = total accruals for firm j in year t • positive TA increases net income • αj, β1j, β2jare estimates of the relation between the explanatory variates and total accruals • εjt = captures all other impacts on total accruals

Empirical PAT Research • Jones (1991) Ujp = TAjt – (αj + β1j∆REVjt + β2jPPEjt) • Ujpis an estimate of the discretionary accruals

Accounting Method ChoiceOpportunistic Behaviour, Efficient Contracting, and Information Perspectives • Robert W. Holthausen (1990) • Three methods for selecting accounting policies • Opportunistic Behaviour • Efficient Contracting • Information Perspective

Opportunistic vs. Efficient Contracting Versions of Positive Accounting Theory • 3 hypotheses of PAT have been stated in the opportunistic form • Opportunistic Form: • Assumes that managers choose accounting policies to maximize theirown expected utility • Efficiency Form: • Managers are motivated to choose accounting policies to control contracting costs - to act in the best interest of shareholders

Discussion Question: Can you give an example of an accounting policy change that would motivate managers to act in their own interests?

How do manager’s choose accounting policies? Mian and Smith (1990) Firms make decisions based on consolidated financial statements since they are less costly to prepare (more efficient) Christie and Zimmerman (1994) Investigated the extent of income-increasing accounting policy choices in a sample of “takeover target” firms Found that the effects of these choices were small and the extent of opportunism in firms is even less.

How do manager’s choose accounting policies? Dechow (1994) If accruals reflect opportunistic manipulation of earnings, the market will reject them in favour of cash flows, associating them with share returns as opposed to net income. If accruals reflect efficient contracting, net income should be more highly associated with share returns, rather than cash flows. Dichev and Skinner (2002) Calculated the variability over time of firm’s covenant ratios Probability of incurring covenant violation costs increases with covenant ratio variability – therefore more slack at inception

How do manager’s choose accounting policies? Guay (1999) Efficient compensation contracts will encourage managers to reduce firm-specific risk Some managers use derivatives to speculate – this is often regarded as opportunistic behaviour Hope and Thomas (2008) Firms that did not disclose earnings by geographic area post SFAS 131 = foreign sales , but total foreign earnings Once full disclosure of geographic earnings is relaxed (SFAS 131), managers start to behave opportunistically

How do manager’s choose accounting policies? Armstrong, Jagolinzer, and Larcker (2010) Estimated the CEO’s temptation to behave opportunistically or efficiently given their “portfolio delta” Results found that it CEO’s with higher portfolio delta’s did not engage in more opportunistic behaviour than CEO’s of similar firms with lower portfolio delta’s. Efficient Contracting version of PAT is supported

Discussion Question Can you give an example of an accounting policy change that would motivate managers to act in the interests of shareholders?

Summary Economic consequences: Accounting policies matter PAT: Attempts to understand and predict managers’ accounting policy choices • management compensation contracts • capital structure • exposure to political costs

Summary Given some flexibility in accounting choice: From an efficient contracting perspective: A large set of available policies enables a firm to respond efficiently to unforeseen evens that affect existing contracts From an opportunistic perspective: A large set of available policies gives management the ability to select accounting policies for its own advantage Security Markets Efficiency Theory still holds with PAT

eToys Inc. Similar business strategy as Amazon (focus on toys) Founded in 1997 Initial day trading as an IPO, had a higher net worth than Toys R Us Within 5 months had a CAPM of 2.5 times that of Toys R Us Bankruptcy in 2001

Discussion Question How could positive accounting theory be applied to eToys’ situation?

“Positive Accounting theory, political costs and social disclosure analyses” Suggest that the political cost hypothesis explains why firms make voluntary social (ie. environmental) disclosures Any thoughts why this is??

Voluntary Social Disclosures (VSD) Mainly companies that are: large, industry classification, continued profitability Advocacy advertising Going green/energy efficient movement Image building/public interest concern VSD can be considered social taxation

Why? • Under PAT managers are assumed to want to maximize personal wealth • In government and public eye seen as giving back to the community • Lower growth in earnings deters: • Government from additional taxations • Unions from gaining bargaining power • Long run economic gains, share value growth and favourable personal taxation

Discussion Question Can positive accounting theory have negative implications? If so, how?

WorldCom Telecommunications giant (focus on phone and internet) Experiencing massive growth during the internet bubble FCC denied a proposed merger with Sprint in 1999 Fraudulent activities began in 1999-2002 Chapter 11 bankruptcy from 2002-2004 Company is now o/a Verizon Business

Chapter 8 Economic Consequences and Positive Accounting Theory