© 2006 Pearson Education Canada Inc.8-1 Chapter 8 Economic Consequences and Positive Accounting Theory

© 2006 Pearson Education Canada Inc.8-2 Economic Consequences, a Simple Definition Accounting Policies Matter (Especially to Managers)

© 2006 Pearson Education Canada Inc.8-3 Recall From Efficient Securities Market Theory Beaver (1973) Argued That Accounting Policy Choices Do Not Affect Firms’ Security Prices, if No Cash Flow Effects and if Chosen Policies are Fully Disclosed This Argument Implies That Accounting Policies Do Not Matter

© 2006 Pearson Education Canada Inc.8-4 Another Efficient Securities Market Anomaly? Answer: No Economic Consequences Can Be Reconciled With Efficient Securities Market Theory But First, We Illustrate Existence of Economic Consequences

© 2006 Pearson Education Canada Inc.8-5 Employee Stock Options APB 25 (1972) –ESOs usually issued with zero intrinsic value, so that no expense recorded FASB Exposure Draft (1993) –Fair value of ESOs to be expensed Fair value based on an option pricing formula, such as Black/Scholes Fair value amortized over vesting period

© 2006 Pearson Education Canada Inc.8-6 Employee Stock Options, Cont’d Management’s Negative Reaction to 1993 FASB Exposure Draft, Despite No Direct Effect on Cashflows –Lower share prices, higher cost of capital? –Inadequate employee motivation? –Reduced innovation? –Low reliability?

© 2006 Pearson Education Canada Inc.8-7 Employee Stock Options, Cont’d More recent developments –Enron, WorldCom financial reporting scandals Concerns over “pump and dump” behaviour –Renewed pressure to expense ESOs –In Canada and internationally, ESOs expensed from 2004 –In U.S., ESOs expensed from June, 2005

© 2006 Pearson Education Canada Inc.8-8 Successful Efforts (SE) Accounting in Oil and Gas Recall Full Cost v. SE Controversy –SE tends to lower reported earnings, especially for actively exploring companies Note no effects on cash flows –SFAS 19 (1977) exposure draft Required SE Strong manager objections Lev (1979) documented negative share price reaction for affected firms. Why? Today, firms can use either method

© 2006 Pearson Education Canada Inc.8-9 Positive Accounting Theory (PAT)

© 2006 Pearson Education Canada Inc.8-10 What is PAT? Studies Managers’ Accounting Policy Choices, As Part of the Overall Process of Corporate Governance That Is, Accounting Policies are Chosen Strategically Positive, Not Normative. Tries to Understand and Predict Managers’ Accounting Policy Choices.

© 2006 Pearson Education Canada Inc.8-11 The 3 Hypotheses of PAT Bonus Plan Hypothesis –Derives from managerial incentive contracts Debt Covenant Hypothesis –Derives from debt contracts Political Cost Hypothesis –Very large firms minimize political “heat”

© 2006 Pearson Education Canada Inc Versions of PAT Opportunistic Version –Managers choose accounting policies for their own benefit Efficient Contracting Version –Managers choose accounting policies to attain corporate governance objectives of the firm

© 2006 Pearson Education Canada Inc.8-13 Distinguishing Opportunistic v. Efficiency Versions of PAT, Concl. Conclude: Significant Evidence in Favour of Efficiency Version of PAT This Implies that the Inherent Conflict Between Investor and Manager Interests is Reasonably Controlled –How this is done is subject of Chapter 9