1. Semester 2, 20091 306-684 Financial Accounting Seminar 6 – Economic Consequences & Positive Accounting Theory

2. Semester 2, 20092 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)

3. Semester 2, 20093 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

4. Semester 2, 20094 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

5. Semester 2, 20095 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

6. Semester 2, 20096 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.

7. Semester 2, 20097 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?

8. Semester 2, 20098 PART III The Preparer Perspective – Managers and Financial Accounting Information

9. Semester 2, 20099 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;

10. Semester 2, 200910 Important terms/concepts Positive accounting theory Agency costs Bonus hypothesis Debt hypothesis Political cost hypothesis

11. Semester 2, 200911 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.

12. Semester 2, 200912 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???

13. Semester 2, 200913 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

14. Semester 2, 200914 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

15. Semester 2, 200915 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

16. Semester 2, 200916 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

17. Semester 2, 200917 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)

18. Semester 2, 200918 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

19. Semester 2, 200919 Theory of the Firm THE FIRM - MANAGEMENT DEBTHOLDERS SHAREHOLDERS ECONOMIC, POLITICAL & SOCIAL CONTEXT

20. Semester 2, 200920 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

21. Semester 2, 200921 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??

22. Semester 2, 200922 The Problem of Agency INFORMATION ASYMMETRY ADVERSE SELECTION MORAL HAZARD Capital Markets Perspective Role of accounting reports to improve decision making Contracting Perspective Role of accounting reports to reduce agency costs (opportunism)

23. Semester 2, 200923 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

24. Semester 2, 200924 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)

25. Semester 2, 200925 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

26. Semester 2, 200926 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”

27. Semester 2, 200927 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

28. Semester 2, 200928 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!

29. Semester 2, 200929 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)

30. Semester 2, 200930 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