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

3. What are Economic Consequences?
Answer: Accounting policies matter
Especially to managers
Even if no effect on cash flows
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4. 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
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5. Another Efficient Securities Market Anomaly?
Answer: Not necessarily
Economic consequences can be reconciled with efficient securities market theory
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6. 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
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7. 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
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8. 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
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9. 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
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10. 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
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11. 8.5 Positive Accounting Theory (PAT)
A Theory to Predict Managers’ Accounting Policy Choices
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12. 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
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13. 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
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14. 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
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15. 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
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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
Warranty provisions
Provisions for reorganization, layoffs, restructuring
Contract completion costs
Note that discretionary accruals not directly observable by investors
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17. 8.5.3 Estimating Discretionary Accruals
Debt covenant slack
Dichev & Skinner (2002)
Supports debt covenant hypothesis
Continued
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18. 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
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19. 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
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20. 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
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21. 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
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22. 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
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23. 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
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24. 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
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