1. Chapter 8 Economic Consequences & Positive Accounting Theory Financial Accounting Theory

2. Agenda 8.1 Introduction/Overview 8.2 The Rise of Economic Consequences 8.3 Employee Stock Options 8.4 Relationship Between Efficient Securities Market Theory and Economic Consequences 8.5 The Positive Theory of Accounting 8.6 Conclusion

3. 8.1 Overview Managerial Stewardship Economic Consequences

4. Managerial Stewardship Providing information to evaluate manager stewardship is an equally important role of financial accounting as the provision of useful information to investors, but is not a main objective

5. Economic Consequences A concept that asserts that, despite the implications of efficient securities market theory, accounting policy choice can affect firm value Firms’ accounting policies, and changes in policies matter

6. 8.2 The Rise of Economic Consequences 1978 -Stephen Zeff introduces the concept on his article “The Rise of Economic Consequences” “The impact of accounting reports on the decision- making behaviour of business, government, and creditors” Third party intervention and economic consequences greatly complicates the setting of accounting standards.

7. Example: Several US corporations tried to reduce earnings by implementing replacement cost accounting during 1947 to 1948, a period of high inflation. “A delicate Balance”: Standard Setting bodies must operate not only in the accounting theory domain, but also in the political domain. (management vs investors) 8.2 The Rise of Economic Consequences

8. 8.3 Employee Stock Options (ESO) Option Terminology American Stock Option (Timeline) European Stock Option (Timeline) History of ESOs Senior Executive Tactics to Increase the values of ESOs

9. Option Terminology Employee Stock Options (ESO): Accounting for stock options issued to management or other employees, giving them the right to buy company stock over some time period.

10. Option Terminology Slightly in-the-Money Stock Price - Exercise Price > 0 Difference is small Substantial risk of zero payoff Time to maturity short Risk aversion can trigger early exercise

11. Option Terminology Deep in-the-Money Stock Price - Exercise Price > 0 Difference is large Payoffs similar for the share and ESOTime to expiry is shortEmployee can hold acquired share or sell and invest proceeds in risk-less asset

12. American Stock Option (Timeline) GrantDate VestingDateExpiryDateExerciseDate

13. European Stock Option (Timeline) GrantDate Exercise Date / Expiry Date / ExpiryDate

14. History of ESOs 1972- (APB 25) Opinion 25 of the Accounting Principles Board. –Firms issuing ESOs should record an expense equal to the difference between the market value of the shares on grant date and the exercise price.

15. Intrinsic Value Formula: Intrinsic Value = Market Value of Shares at Grant Date - Exercise Price Example: Intrinsic Value = $10 - $10 = 0 Intrinsic Value = $10 - $8 = $2 to be expensed per each ESO granted.

16. History of ESOs 1992 – A bill was introduced into the US Congress requiring ESOs to be valued at Fair Value and expensed. Problem: Difficulty of establishing the fair value of the ESOs. Solution: Black/Scholes option pricing formula.

17. History of ESOs Several aspects of ESOs not captured by this formula: Model assumes that options can be freely traded, whereas ESOs cannot be exercised until the vesting date, or there may be other restrictions on the employee’s ability to sell the acquired shares. Option cannot be exercised until expiry (European option), whereas American ESOs can be exercised prior to expiry.

18. History of ESOs 1993 - FASB issued an exposure draft of a proposed new standard. “To record compensation expense based on the fair value at grant date of ESOs issued during the period.” Fair value could be determine by the Black/Scholes formula or other option pricing formula, with adjustment for the possibility of employee retirement prior to vesting and for the possibility of early exercise. Fair value could be determine by the Black/Scholes formula or other option pricing formula, with adjustment for the possibility of employee retirement prior to vesting and for the possibility of early exercise.

19. History of ESOs 1994 – Huddart – In order to know the fair value of the ESO it is necessary to know the employee’s optimal exercise strategy. Option is slightly in-the-money Option is deep-in-the-money Black/Scholes formula, assuming ESOs held to expiry date, does indeed overstate the fair value of an ESO at the grant date. The exposure draft was dropped in 1994 because it was hard to determine the FMV of ESO

20. History of ESOs 1995- SFAS 123 –It urges firms to set the fair value approach suggested in the exposure draft, but allowes the APB 25 intrinsic value approach provided the firm gave supplementary disclosure of ESO expense, determined by amortizing over their vesting periods the fair value of awarded ESOs based on expected time to exersice. 2005- SFAS 123R/IASB IFRS 2 –Requires ESOs expensing. Usage of ESOs greatly reduced

21. Senior Executive Tactics to Increase the values of ESOs Pump and Dump Spring Loading Late Timing

22. Senior Executive Tactics to Increase the values of ESOs Pump and Dump: Managers take actions to increase share value shortly before exercising options, then sell the shares before share price fell back, and presumably, invest the proceeds in less risky securities.

23. Senior Executive Tactics to Increase the values of ESOs Aboody and Kasznik (2000) (AK) Research on Information release practices of CEOs around ESO grant dates. Sample of 4,426 ESO awards to CEOs of 1,264 different US firms during 1992-1996. “On average, CEOs manipulate share price downwards just prior to the grant date, and manipulate price up shortly after.”

24. Senior Executive Tactics to Increase the values of ESOs How? Making announcements of impending BN or GN earnings report on specific dates. Influencing analyst’ earnings forecasts and selective timing of release of their own forecasts.

25. Senior Executive Tactics to Increase the values of ESOs Spring Loading: Managers pressure compensation committees to grant unscheduled ESOs shortly before good earnings news. This gives the CEO a low exercise price and subsequent benefit as share price rises in response to the GN.

26. Senior Executive Tactics to Increase the values of ESOs Late Timing: Is the backdating of ESO awards to a date when share price was lower than at the actual ESO grant date. Late timing violates GAAP since it disguises the expense recognition.

27. 8.4 The Relationship between Efficient Securities Market Theory and Economic Consequences Efficient Securities Market theory No price reaction to accounting policy changes if they do not impact profitability and cash flows Importance of full disclosure (including accounting policies) Market will evaluate value of securities in light of the policies

28. 8.4 The Relationship between Efficient Securities Market Theory and Economic Consequences Management and regulators should not be particularly concerned about the accounting policies that firm use, if their is no security price reaction BUT Management do care about any accounting policies and its economic consequences

29. 8.4 The Relationship between Efficient Securities Market Theory and Economic Consequences Existence of economic consequences reinforce that security markets are not fully efficient Inconsistent observations lead to Positive Accounting Theory (PAT)

30. 8.5 The Positive Accounting Theory 8.5.1 Outline of Positive Accounting Theory 8.5.2 The Three Hypotheses of Positive Accounting Theory

31. What is the difference between positive and normative theory? 8.5.1 Outline of Positive Accounting Theory

32. Positive theory: A good prediction of real world events. Normative theory: How people ought to react in real-world situations.

33. Predicting choices of accounting policies by managers How will managers respond to proposed new accounting standards? Firms accounting policies chosen as to maintain efficient corporate governance Why positive? 8.5.1 Outline of Positive Accounting Theory

34. Firms are organized in most efficient manner, to maximize ability to survive Managers exhibit opportunistic behaviour Key Assumptions 8.5.1 Outline of Positive Accounting Theory

35. Nexus of Contracts Contracting Costs Efficient Contracts 8.5.1 Outline of Positive Accounting Theory Terminology

36. PAT does not specify accounting policies GAAP (Flexibility and Adaptation) Compromise and Tradeoff Of Opportunistic Manager Behaviour 8.5.1 Outline of Positive Accounting Theory

37. 8.5.2 The Three Hypotheses of PAT 1. Bonus Plan Hypothesis 2. Debt Covenant Hypothesis 3. Political Cost Hypothesis

38. Firms with bonus plans choose accounting policies that shift future earnings to current periods Present value of manager’s utility from future bonuses increases 8.5.2 The Three Hypotheses of PAT Bonus Plan Hypothesis

39. Example: If employee pay depends on bonus related to reported net income, they may increase current bonus by increasing net income as much possible 8.5.2 The Three Hypotheses of PAT Bonus Plan Hypothesis

40. Firm who is close to violation of accounting-based debt covenants Firm likely to select accounting policy, which shifts future earnings to current period 8.5.2 The Three Hypotheses of PAT Debt Covenant Hypothesis

41. Example: If firm has covenant to have certain level of ratio (i.e. interest coverage, etc.), it will want to adopt accounting policies that raise earnings as much as possible in fear of violation of covenant 8.5.2 The Three Hypotheses of PAT Debt Convenant Hypothesis

42. Greater the political cost, more likely firm will choose accounting policies that defer current earnings to future periods 8.5.2 The Three Hypotheses of PAT Political Cost Hypothesis

43. Example: Large firms may want to decrease earnings in current periods to reduce political costs of environmental responsibility 8.5.2 The Three Hypotheses of PAT Political Cost Hypothesis

44. 8.5.3 Empirical PAT Research Healy (1985), who found evidence that managers adopt accrual policies so as to maximize their expected bonuses (the Bonus plan Hypothesis). Dichev and Skinner (2002) (DS) examined the debt covenant hypothesis.

45. 8.5.3 Empirical PAT Research Jones used this formula to examine whether firms used discretionary accruals to reduce NI (the political cost hypothesis)

46. 8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT Opportunistic Form Mangers choose accounting policies to maximize their utility relative to their remuneration Efficiency Form Compensation contracts, internal control systems, corporate governance limit opportunism and motivate managers to choose accounting policies to control contracting costs

47. 8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT Often the two forms of PAT make similar decisions From the bonus plan hypothesis choosing straight- line amortization over declining-balance can benefit management by increasing their bonus Benefits the firm and shareholders if straight-line amortization depicts the opportunity cost to the firm of using capital assets Example

48. 8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT Difficult to distinguish whether firms’ observed policy choices driven by opportunism or efficiency Without knowing difference it cannot be said that we understand the process of accounting policy choice

49. 8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT PAT Research addresses the problem: Mian and Smith (1990) Christie and Zimmerman (1994) Dechow (1994) Study of Dichev and Skinner (2002) Guay (1999) - Study of Derivative Activities Ahmed, Billings, Harris and Morton (2002) (ABHM)

50. 8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT Study of Mian and Smith reports evidence that firms make efficient decisions with respect to preparation of consolidated financial statements Dechow (1994) - Accruals can be a result opportunistic and efficient contracting

51. 8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT The researches conclude that managers use efficient contracting which implies that the firms are able to align the management to those of its shareholders

52. Conclusion Important to understand management’s interests in financial reporting Positive Accounting Theory (PAT) Role Predicting firms’ accounting policy choices The 3 Hypotheses of PAT

53. Conclusion Efficiency perspective: the set of available policies affects the firm’s flexibility Opportunistic perspective: management’s ability to select accounting policies for own advantage affected Management reacts to changes New standards interfering with existing contracts or reducing accounting policy choices, the stronger the reaction

54. Conclusion Managers’ concerns about accounting policies and standards may be driven by opportunism or by efficient contracting, there is significant evidence in favour of the efficient contracting version of PAT Firms are able to eliminate the conflict of interest