Financial accounting theory 5e scot ch08

Chapter 8
Economic Consequences and
Positive Accounting Theory

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Chapter 8
Economic Consequences and Positive Accounting Theory

Copyright © 2009 by Pearson Education Canada

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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

»

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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?

»

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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

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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’
»

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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 investors
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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 = 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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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

»

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Continued

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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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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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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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