8 - 1

Chapter 8

Economic Consequences and Positive Accounting

Theory

8 - 2

Chapter 8 Economic Consequences and Positive Accounting Theory

8 - 3

What are Economic Consequences?

• Answer: Accounting policies matter– Especially to managers– Even if no effect on cash flows

8 - 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

8 - 5

Another Efficient Securities Market Anomaly?

• Answer: Not necessarily• Economic consequences can be

reconciled with efficient securities market theory

8 - 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

8 - 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

8 - 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

8 - 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?

8 - 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

8 - 11

8.5 Positive Accounting Theory (PAT)

A Theory to Predict Managers’ Accounting

Policy Choices

8 - 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 labor markets

– But manager effort & ability not directly observable (moral hazard problem)

– Reporting on manager performance (stewardship) is a second major role for financial reporting

8 - 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’

8 - 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

8 - 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

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– Warranty provisions– Provisions for reorganization, layoffs, restructuring– Contract completion costs

• Note that discretionary accruals not directly observable by investors

8 - 17

8.5.3 Estimating Discretionary Accruals

• Debt covenant slack– Dichev & Skinner (2002)– Supports debt covenant hypothesis

8 - 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

8 - 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

8 - 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

8 - 21

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

8 - 22

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

8 - 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

8 - 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

The End

Thank you