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Chapter 8Economic Consequences and Positive Accounting Theory

8-1 Copyright 2009 by Pearson Education Canada

Chapter 8 Economic Consequences and Positive Accounting Theory

8-2 Copyright 2009 by Pearson Education Canada

What are Economic Consequences? Answer: Accounting policies matter Especially to managers Even if no effect on cash flows

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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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Another Efficient Securities Market Anomaly? Answer: Not necessarily Economic consequences can be reconciled with efficient securities market theory

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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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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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8.3 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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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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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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8.5 Positive Accounting Theory (PAT)A Theory to Predict Managers Accounting Policy Choices

8 - 11 Copyright 2009 by Pearson Education Canada

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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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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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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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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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 investorsCopyright 2009 by Pearson Education Canada 8 - 16

8.5.3 Estimating Discretionary Accruals Debt covenant slack Dichev & Skinner (2002) Supports debt covenant hypothesis

Continued

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8.5.3 Estimating Discretionary Accruals (continued) The Jones model (1991) TAjt = j + 1jREVjt + 2jPPEjt + jt 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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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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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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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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8.5.4 Distinguishing Opportunistic v. Efficiency Versions of PAT (continued) Some research consistent with contracting efficiency, contd. 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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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 valueCopyright 2009 by Pearson Education Canada 8 - 23

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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