Economic Consequences and Positive Accounting Theory Chapter 8 Economic Consequences and Positive Accounting Theory Copyright © 2009 by Pearson Education Canada

Chapter 8 Economic Consequences and Positive Accounting Theory Copyright © 2009 by Pearson Education Canada

What are Economic Consequences? Answer: Accounting policies matter Especially to managers Even if no effect on cash flows Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

Another Efficient Securities Market Anomaly? Answer: Not necessarily Economic consequences can be reconciled with efficient securities market theory Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

8.5 Positive Accounting Theory (PAT) A Theory to Predict Managers’ Accounting Policy Choices Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

8.5.3 Estimating Discretionary Accruals Debt covenant slack Dichev & Skinner (2002) Supports debt covenant hypothesis Continued Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

8. 5. 4 Distinguishing Opportunistic v 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 Copyright © 2009 by Pearson Education Canada

8. 5. 4 Distinguishing Opportunistic v 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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada

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 Copyright © 2009 by Pearson Education Canada