© 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. Problems Of Black/Scholes Applied To ESOs –Black/Scholes assumes freely traded American options –ESOs cannot be exercised until they vest Exposure draft proposed using expected time to exercise in Black/Scholes Time to exercise is highly variable (early exercise) Leads to low reliability –May overstate fair value (Huddart (1994), Marquardt (2002))

© 2006 Pearson Education Canada Inc.8-8 Employee Stock Options, Cont’d FASB Backs Down –SFAS 123: Disclosure in notes allowed Use Black/Scholes formula with expected time to exercise

© 2006 Pearson Education Canada Inc.8-9 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.8-10 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.8-11 Positive Accounting Theory (PAT)

© 2006 Pearson Education Canada Inc.8-12 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.8-13 ASSUMPTIONS OF PAT Managers are Rational (Like Investors)  Conflict (Between Interests of Managers and Investors) Efficient Securities Market Efficient Managerial Labour Market –But may be inside information about manager effort and ability (moral hazard problem) –A second major role for financial reporting-- to report on manager effort and ability

© 2006 Pearson Education Canada Inc.8-14 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” NB: Contacts are Rigid

© 2006 Pearson Education Canada Inc.8-15 Managing Reported Earnings Ways to Do It –Changing accounting policies –Managing discretionary accruals –Timing of adoption of new accounting standards –Changing real variables--R&D, advertising, repairs & maintenance –SPEs (Enron), capitalize operating expenses (WorldCom) –

© 2006 Pearson Education Canada Inc.8-16 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 –Provision for reorganization

© 2006 Pearson Education Canada Inc.8-17 Estimating Discretionary Accruals Use Total Accruals as Proxy –Healy (1985) Examine Specific Accounts –Accounts receivable & allowance McNichols & Wilson (1988)

© 2006 Pearson Education Canada Inc.8-18 Estimating Discretionary Accruals, Cont’d The Jones Model –TA jt = α j + β 1j ΔREV jt + ß 2j PPE jt + ε jt –Estimate by least-squares regression –Discretionary accruals = actual - predicted –The  s and ßs are coefficients to be estimated. No relation to a share’s beta

© 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.8-20 Distinguishing Opportunistic v. Efficiency Versions of PAT Hard to Do –Mian & Smith (1990) Consolidated financial statements –Christie & Zimmerman (1994) Takeover targets –Dichev & Skinner (2002) Debt covenants

© 2006 Pearson Education Canada Inc.8-21 Distinguishing Opportunistic v. Efficiency Versions of PAT, Cont’d Hard to Do, Cont’d –Dechow (1994) Net income more highly associated with share returns than cash flows –Guay (1999) Limit firm risk using derivatives

© 2006 Pearson Education Canada Inc.8-22 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