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Chapter 8 Economic Consequences and Positive Accounting Theory

Chapter 8Economic Consequences and Positive Accounting Theory

What are Economic Consequences?Answer: Accounting policies matterEspecially to managersEven if no effect on cash flows

Efficient Securities Market TheoryAccounting policies do not matter Beaver (1973): text, Section 4.3.1If no effect on cash flowsIf fully disclosed

Another Efficient Securities Market Anomaly?Answer: Not necessarilyEconomic consequences can be reconciled with efficient securities market theory

8.3 Economic Consequences in ActionEmployee stock options (ESOs)APB 25 applied until 2004/2005No expense need be recorded if intrinsic value = zeroAre ESOs an expense?Dilution Opportunity cost

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8.3 Economic Consequences in Action (continued)Measuring ESO expenseBlack/Scholes option pricing formulaAssumes option held to expiry dateBut ESOs can be exercised early, between vesting and expiry datesAs a result, Black/Scholes overstates ESO expenseAccountants answerUse expected exercise date in Black/Scholes formulaReport ESO expense as supplementary informationSFAS 123, 1995

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8.3 Economic Consequences in Action (continued)Manager abuses of ESOsSince no effect on net income, firms overdosed on ESO compensationPump and dumpManipulate share price down prior to scheduled ESO grant datesSpring loadingLate timingTheory in Practice 8.1

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8.3 Economic Consequences in Action (continued)Increasing evidence of abuses lead to renewed pressures to expense ESOs, despite strong manager resistanceManager resistance overcomeIFRS 2, SFAS 123R, 2005Note no effect of ESO expensing on cash flowsWhy such strong manager resistance?

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8.3 Economic Consequences in Action (continued)Reasons for managers strong resistance to ESO expensingMay lead to reduced use of ESOs as compensationResulting reduced scope to abuse ESO value?Concerns about reliability of Black/Scholes?Lower reported net income?Efficient markets theory predicts markets will see throughLeads to positive accounting theory

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

8.5.1 Assumptions of PATManagers are rational (like investors) Implies conflict between interests of managers and investorsEfficient securities marketsEfficient managerial labour marketsBut manager effort & ability not directly observable (moral hazard problem)Reporting on manager performance (stewardship) is a second major role for financial reporting

8.5.2 The Three Hypotheses of PATBonus plan hypothesisDerives from managerial incentive contractsBonus often based on accounting variablesImplies a stewardship role for financial reportingDebt covenant hypothesisDerives from debt contractsDebt covenants often based on accounting variablesPolitical cost hypothesisHigh profits may create political heat

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8.5.2 The Three Hypotheses of PAT (continued)NB: contracts are rigid and incompleteOtherwise, could simply renegotiate contracts if unforeseen events happenCreates incentives to manage earnings instead

Managing Reported EarningsChanging accounting policiesTiming of adoption of new accounting standardsChanging real variables--R&D, advertising, repairs & maintenance Create special purpose entities (Enron)Capitalize operating expenses (WorldCom)Discretionary accruals

Managing Reported Earnings Through Discretionary AccrualsNI = OCF net accruals= OCF net non-discretionary accruals net discretionary accrualsExamples of discretionary accrualsAllowance for doubtful accountsWarranty provisionsProvisions for reorganization, layoffs, restructuringContract completion costsNote that discretionary accruals not directly observable by investors

8.5.3 Estimating Discretionary Accruals

Debt covenant slackDichev & Skinner (2002)Supports debt covenant hypothesis

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8.5.3 Estimating Discretionary Accruals (continued)The Jones model (1991) TAjt = j + 1jREVjt + 2jPPEjt + jt

Estimate by least-squares regressionUse estimated equation to predict non-discretionary accrualsDiscretionary accruals = actual predictedJones study supports political cost hypothesis

Two Versions of PATOpportunistic versionManagers choose accounting policies for their own benefitEfficient contracting versionManagers want to choose accounting policies to attain corporate governance objectives of the firm

8.5.4 Distinguishing Opportunistic v. Efficiency Versions of PATHard to doE.g., are manager objections to expensing ESOs driven byOpportunism: preservation of big ESO awardsEfficiency: ESOs an effective compensation device. Reducing ESO use decreases compensation contract efficiency

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8.5.4 Distinguishing Opportunistic v. Efficiency Versions of PAT (continued)Some research consistent with contracting efficiencyMian & Smith (1990)Consolidated financial statementsChristie & Zimmerman (1994)Takeover targetsDichev & Skinner (2002)Debt covenants

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

PAT Perspective on Conservatism in Financial ReportingRecall text, Section 6.7, shows an investor demand for conservatismPAT also supports conservatism, from an efficient contracting perspectiveConservative accounting makes it more difficult for managers to take advantage of debtholderse.g., more difficult to pay excessive dividendsInvestors realize this increased security and will lend at lower interest rateArguments for conservatism conflict with standard setters moves to current value

ConclusionsPAT helps us understand why accounting policies have economic consequences, without conflicting with efficient securities markets theoryPAT supported by a large body of empirical evidencePAT supports a corporate governance (stewardship) role for financial reportingPAT supports an efficient contracting role for conservative financial reporting