financial accounting theory5

Financial Accounting Theory

Feb./Mar. 2011 – week 5

Final questions… week 4

2

What do you expect a manager to prefer: pre-tax or after-tax income as performance measure

What are plusses and minuses for motivating on stock price?

Jacco Wielhouwer - financial accounting theory - 2011

Today…


Earnings management What it is… Good/bad earnings management Implications for accounting

Standard setting: Economic Issues (part I) Information ‘production’ Disclosure principle

Earnings management

4

A definition: Choose accounting policies or actions to achieve some

specific earnings objective

Last week: how? Changing accounting policies Timing of adoption of new standards Changing real variables (decisions): R&D, advertising etc Create Special Purpose Vehicles (Enron) Capitalize operating expenses (WorldCom) Discretionary Accruals

Provisions for reorganization, layoffs etc Allowance for doubtful accounts Warranty provisions


Real variables versus Accruals

5

Real variables (R&D e.g.): change cash flows and thus shareholder value

directly Typically: impact on result now and in the long run Conflicting interests between shareholder and

manager Example: bank adjusting savings rate

Accruals Generally a timing issue of income ‘recognition’ IRON LAW: ACCRUALS REVERSE !!


‘Patterns’ of earnings management

6

Taking a bath Reason: accruals reverse!

Income minimization Reasons: political, potential entrants, taxes

Income maximization Reasons: bonuses, covenants

Income smoothing Reasons: risk aversion, covenants, bonus caps,

signalling persistence


Bonus plan hypothesis

7

Typical bonus scheme (Scott fig. 11.2)

Am

ount

of b

onus

Reported net income

bogey cap


Empirical evidence: avoid losses Burgstahler and Dichev (1997)

8

Burgstahler & Dichev, ‘Earnings Management to Avoid Earnings Decreases and Losses’, Journal of Accounting and Economics, 24/1 (1997), 99-126.


Empirical evidence: bonus plan hypothesisHealy (1985)

9

P.M. Healy, Journal of Accounting & Economics, 1985 p.96

Proportion of accruals with given sign

# obs Average accrual

s

Positive

Negative

LOW 0.09 0.91 22 -0.0671

MID 0.46 0.54 281 +0.0021

UPP 0.10 0.90 144 -0.0536

447


Empirical evidence: bonus plan hypothesis Holthausen, Larcker, Sloan (1995)

10

Contrary to Healy, later studies find evidence of income smoothing (not taking a bath), when looking at discr instead of total accruals


Earnings management: good or bad?

11

Do you think earnings management is good or bad?

Good Bad Efficient contracting Opportunistic

behaviourFlexibility (debt cov.) Breaking

GAAP rulesUnblocking ins. information Raising more

capital (IPO)Showing earnings persist. Misleading

investorsSignalling ‘Fooling’ the market


Earnings management and market efficiency…

12

Meet (and beat) expectations: positive abn. return

Fall short on expectations: more negative abn. return

Does this conflict with market efficiency? No for example:

Prospect theory (6.2.2 p.181 5th ed. Scott) Limited attention, so lower degree (longer time to

adjust) Efficient: market is aware of EM possibilities: falling

short implies ‘even when applying EM’ Yes for example:

Managers do not accept market efficiency (there are anomalies)

Expect the market not to fully ‘see through’


Manager interests

13

Option compensation: asymmetric reaction for losses and gains… more EM?

If managers assume some degree of inefficiency… more EM?

Relation of EM with contracts: Some flexibility is good (contracts rigid, efficient

risk sharing) Too much makes contracts worthless (tells

nothing, no motivation to high effort)Jacco Wielhouwer - financial accounting theory -

2011

EM: the role of accounting

14

So what is the role of accounting with respect to EM?

1. Disclose ‘choices made’ to facilitate ‘see through’

2. Maybe increase comparability (limited attention)?

3. Finding out real persistenceIn order to

4. Detect (and prevent) bad earnings management, but

5. Allow good side (signalling)

Objective: assist investors in determining firm value Information perspective (Decision usefulness) (1.) Measurement perspective (2.)


Today…


Earnings management What it is… Good/bad earnings management Implications for accounting

Standard setting: Economic Issues (part I) Information ‘production’ Disclosure principle

Economic view on information production


Crucial economic issue: What is socially optimal role of accounting (amount of

information production) and is regulation necessary to obtain this?

To discuss this: Focus on regulation w.r.t. standard setting

minimum information production (disclosure) with reliability (audits)

So first: Types of information Types of information production Incentives for information production

Proprietary vs. Non-proprietary inform.


Two types of information: Proprietary

Disclosure will affect firm cash flows Examples?

Technical details on valuable patent, Strategic initiatives, Takeover/merger plans, Demand information in duopoly

Non-proprietary Disclosure will not directly affect firm cash flows Examples?

Financing details, earnings forecasts, financial statement, audit

Types of information production


Finer More detail Increase relevance

Additional New information Possibly relevant info

More credible E.g. better audits (switch to big 4?) Increase reliability

Information production Y/N: cost/benefit analysis Note: often made error: no marginal approach

Do market forces lead to the optimal amount of information? Incentives…


Firm incentives to provide information are?

1. To be able to enter contracts Offer an audited statement investors pay more Offer an audited statement base remuneration on

performance Offer an audited ratio less interest required by

banks Note problems:

Too many parties, too many different needs not one contract

Contract must be enforced (otherwise no Nash equilibrium): cancel audit

2. Market forces Managerial labor market (reputation) Capital market: reduce estimation risk higher share

price

Do market forces lead to the optimal amount of information? Desincentives…


Firm desincentives to provide information are?

1. Costs Direct (producing the info) Indirect (e.g. competitor learns valuable info)

Note: manager’s and firm’s interest may not be aligned…

Market forces leading to disclosure

Sales disclosure increased over time

But: slowly

Alternative explanation: ‘deter’ regulation


Sales disclosure by dynamic panel of 75-100 listed Dutch companies, 1945-1983; no mandatory disclosure until 1984; index figure is required minimum disclosure starting 1971; Camfferman (1997)

The disclosure principle


Suppose all firms have information on future profitability Market expectation: on average 10 Alternatives: between -10 and +30

Your firm has information: +15 Will you disclose?

Your firm has information: 0 Will you disclose?

The disclosure principle: All firms with > 10 disclose; new market expectation of non-disclosers: 0, so All firms with > 0 disclose; so … So all firms disclose: otherwise the market assumes the

worst case Nondisclosure implies that the worst case is expected!

Reasons for the disclosure principle not too hold…


When does this reasoning not hold?

If there are costs of disclosure (direct, indirect, proprietary)

If the market is unsure whether the firm has the information The market cannot punish non-disclosers since they may not

have info If the objective of the manager is not optimizing firm

value If disclosure policy has to be committed to before the

information is available If disclosure may not be fully thruthful If contracting purposes and investor needs conflict

E.g. manager may want to delay share price increases Disclosure may decrease discretion and make contract more

risky (inefficient)

Alternative way of disclosure: signalling


It may be desirable to reveal the fact that there is good news, without disclosing details (e.g. because of proprietary costs)

SIGNALLING Taking an action that reveals good news (without

disclosing details), that would be irrational for someone without the favourable info.

Examples? Audit quality (more expensive and higher quality audits) Earnings forecasts (high penalties if not met) Buying own shares (by management) Smooth earnings (lower bonus) to reveal earnings persistence

Note: tighter reporting standards may lower signalling possibilities!

financial accounting theory5

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