Chapter Economic Consequences and Positive Accounting Theory Copyright © 2009 by Pearson Education Canada 8-1 Chapter Economic Consequences and Positive Accounting Theory Copyright © 2009 by Pearson Education Canada 8-2 What are Economic Consequences? • Answer: Accounting policies matter – Especially to managers – Even if no effect on cash flows Copyright © 2009 by Pearson 8-3 Efficient Securities Market Theory • Accounting policies not matter – Beaver (1973): text, Section 4.3.1 • If no effect on cash flows ã If fully disclosed Copyright â 2009 by Pearson 8-4 Another Efficient Securities Market Anomaly? • Answer: Not necessarily • Economic consequences can be reconciled with efficient securities market theory Copyright © 2009 by Pearson 8-5 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 Copyright © 2009 by Pearson 8-6 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 ã SFAS 123, 1995 ằ Copyright â 2009 by Pearson Continued 8-7 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 Copyright © 2009 by Pearson 8-8 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? » Copyright © 2009 by Pearson Continued 8-9 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 ã Leads to positive accounting theory Copyright â 2009 by Pearson 8- 8.5 Positive Accounting Theory (PAT) A Theory to Predict Managers’ Accounting Policy Choices Copyright © 2009 by Pearson Education Canada - 11 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 Copyright © 2009 by Pearson 8- 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’ » Copyright © 2009 by Pearson Continued 8- 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 Copyright © 2009 by Pearson 8- 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 Copyright © 2009 by Pearson 8- 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 Copyright © 2009 by Pearson 8- 8.5.3 Estimating Discretionary Accruals • Debt covenant slack – Dichev & Skinner (2002) – Supports debt covenant hypothesis » Continued Copyright © 2009 by Pearson 8- 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 Copyright © 2009 by Pearson 8- 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 Copyright © 2009 by Pearson 8- 8.5.4 Distinguishing Opportunistic v Efficiency Versions of PAT • Hard to – 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 Copyright © 2009 by Pearson 8- 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 » Copyright © 2009 by Pearson Continued 8- 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 Copyright © 2009 by Pearson 8- 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 Copyright © 2009 by Pearson 8- 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 Copyright © 2009 by Pearson 8- ... markets theory predicts markets will see through • Leads to positive accounting theory Copyright © 2009 by Pearson 8- 8.5 Positive Accounting Theory (PAT) A Theory to Predict Managers’ Accounting. ..Chapter Economic Consequences and Positive Accounting Theory Copyright © 2009 by Pearson Education Canada 8-2 What are Economic Consequences? • Answer: Accounting policies matter – Especially to... Even if no effect on cash flows Copyright © 2009 by Pearson 8-3 Efficient Securities Market Theory • Accounting policies not matter – Beaver (1973): text, Section 4.3.1 • If no effect on cash