Economic Consequences and Positive Accounting Theory

Economic Consequences and Positive Accounting Theory Financial Accounting Theory: Chapter 8 Cathy Phung Jaspreet Sidhu Neil Ganatra YasharDavarpanah

Economic Consequences

Conflict Resolution • Accountants need to understand and appreciate management’s interest in financial reporting • Management’s role if financial reporting is “outside” the conceptual framework • Interests of management need to be incorporated into accounting standards through “conflict resolution”

What is Economic Consequences “A concept that asserts, that despite the implications of efficient securities market theory, accounting policy choice can affect firm value.”  Accounting policies and changes in policies MATTER

Importance of Economic Consequences • Many of the most interesting events in accounting practices if from economic consequences • To suggest that accounting policies do not matter is at odds with accountant’s experience

The Rise of Economic Consequences – Stephen Zeff “ The impact of accounting reports on the decision-making behaviour of business, government and creditors.”

The Rise of Economic Consequences • Increasing influence of third-parties in the standard setting process: • Groups that had rarely shown any interest in the setting of accounting standards began to intervene actively and powerfully • These third-parties invoked arguments other than those traditionally been employed in accounting – these arguments are “economic consequences”

Example: • U.S. corporations wanted to implement replacement cost accounting – management intervention • Lower taxes, low wage increases and increase earnings What would the efficient market argument be?

Delicate Balancing Act • Retain creditability – set up accounting policies in accordance with financial accounting models • No clear theory prescribing what policies to be used – allowing for third-parties to intervene and argue for their preferred accounting policies

Delicate Balance Act

Response to challenges • Bring in different constituencies onto the standard-setting boards themselves • Use exposure drafts of proposed new standards giving them an opportunity to comment on proposed accounting policy changes

Employee Stock Options (ESO)

Employee Stock Options (ESOs) • ESOs stock options issued to management/employees, giving them the right to buy company stock over some time period • Grant date  day the option is granted to employee • Exercise price  price at which employee can purchase stock as granted on grant date • Intrinsic value = market value grant date – exercise price

History of Accounting for ESOs • 1972  Opinion 25 of the Accounting Principles Board (APB 25) • June 1993  FASB issues exposure draft of a proposed new standard • December 1994  FASB drops exposure draft due to lack of support • 2005  SFAS 123R becomes effective

Example • Market value at grant date $10 Exercise price 8 Expense recorded 2

Black/Scholes Assumptions That Don’t Reflect ESOs... • Assume options can be freely traded • Assume option cannot be exercised prior to expiry (a European option)

New Standard Proposal = Economic Consequence! • This change in accounting policy would have an effect on firm value, including lower share prices, higher cost of capital, a shortage of managerial talent, and inadequate manager and employee motivation

Cost to Firm of ESO • Unlike most costs, ESOs don’t require a cash outlay • The cost is borne by the firm’s existing shareholders through dilution of their shares • For ex: if ESO is exercised at $10 when the market value of the share is $30, the ex post cost (or opportunity cost) to the firm is $20. The firm foregoes the opportunity to issue the share at the market price of $30.

Recognizing ESO as an expense increases relevance, since future dividends per share will be reduced since they are now diluted over a larger number of shares

Option Characteristics • The expected return from holding an option exceeds the expected return on the underlying share • The “upside potential” of an American option increases with the time to maturity • If an option is “deep-in-the-money”, the set of possible payoffs from holding the option closely resembles that of holding the underlying share All 3 characteristics lean towards waiting until maturity to exercise the option. So in what circumstances would the employee exercise the option early?  Two circumstances!

Times when employee will exercise option early... • If ESO is only slightly in-the-money, time to maturity is short (no upside potential), and employee required to hold the shares acquired, risk aversion can trigger early exercise • If ESO is deep-in-the-money, time to expiry is short, and employee can either hold acquired shares or sell and invest in riskless asset

Therefore, The Black/Scholes model has a tendency to overstate ESO cost. Fair value estimates, including the Black/Scholes model, are unreliable

SFAS 123 IN 1995 • After dropping the proposed change, the FASB turned to supplementary disclosure • The ruling stressed fair value accounting, but allowed firms to use the APB 25 intrinsic value approach as long as the firm gave supplementary disclosure of ESO expense

Tactics to increase the value of ESOs • Pump and dump  managers would take action to increase share value before exercising options; then sell the shares before share price fell back • Late timing  backdating of ESO awards to a date when share price was lower than at the actual ESO grant date The common theme of these tactics is to increase the likelihood that ESOs will be deep-in-the-money  early exercise more likely

Implications of Expensing ESOs • Their usage as a compensation device would decrease • The fair value of options granted by the top 500 US firms fell from $104 B in 2000 to $30 B in 2005

The Positive Accounting Theory

Positive Accounting Theory • Positive Accounting Theory is concerned with predicting such actions as the choices of accounting policies by firm managers and how managers will respond to proposed new accounting standards. • Positive Accounting Theory may not capture the actual thought process of individuals, it does help us understand the important factors that underlie their actions

Positive Accounting Theory • A firm can be viewed as a nexus of contracts, that is, its organization can be largely described by the set of contracts it enters into. • Contracts with employees • Contracts with suppliers • Contracts with capital providers

Positive Accounting Theory • A firm will want to minimize the various contracting costs • Costs of negotiations • Costs arising from moral hazard & monitoring of contract performance • Costs of possible renegotiation or contact violation

Positive Accounting Theory • Contracts with the lowest contracting costs are called efficient contracts • An efficient contract minimizes costs of moral hazard, by motivating the manager to act in shareholders’ best interests Many contracts involve accounting variables: • Employee promotion and remuneration may be based on accounting based performance measures such as net income, or cost control targets • Contracts with suppliers may depend on liquidity and financing variables

Positive Accounting Theory • - Positive Accounting Theory argues that firms’ accounting policies will be chosen as part of the broader problem of attaining efficient corporate governance • Ex: The greater the interdependence between parent and subsidiary, the more efficient it is (that is, lower contracting costs) to prepare consolidated financial statements • It is more efficient to monitor manager performance by use of consolidated financial statement-based performance measures than by performance measures based on separate parent and subsidiary financial statements when interdependence is high.

Positive Accounting Theory • It is desirable to give managers some flexibility to choose from a set of available accounting policies so that they can adapt to new or unforeseen circumstances. • Ex: a new accounting standard that lowers reported net income, such as the expensing of ESO’s, may reduce a firm’s interest earned ratio to the point where violation of debt covenants is of concern. It would probably be less costly for management to, say, switch from the LIFO to the FIFO inventory method, or issue preferred stock in place of debt than to renegotiate the debt contract or suffer the expected costs of technical violation.

Positive Accounting Theory • Giving management flexibility to choose from a set of accounting policies can lead to opportunistic behaviour. • Tendency of managers to choose from accounting policies from the set for their own purpose, and thus reducing contract efficiency • PAT assumes managers are rational and will choose accounting policies in their own best interest. • PAT does not assume that managers will act so as to maximize firm profits.

Positive Accounting Theory • Optimal set of accounting policies for the firm represents a compromise. • On the one hand, tightly prescribing accounting policies beforehand will minimize opportunistic accounting policy choice by managers but incur costs of lack of accounting flexibility to meet changing circumstances such as new accounting standards that affect net income. • On the other hand, allowing managers to choose from a broad array of accounting policies will reduce costs of accounting inflexibility but expose the firm to the costs of opportunistic manager behaviour.

The Three Hypothesis of Positive Accounting Theory The Bonus Plan Hypothesis: • All other things being equal, managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to current periods. • Ex: If bonus is dependent on net income, then management may choose accounting policies that increase current reported earnings • Ex 2: Risk Averse managers will prefer accounting policies that smooth reported earnings, since a less variable bonus stream is more favourable than a volatile one.

The Three Hypothesis of Positive Accounting Theory • The debt covenant hypothesis: -All other things being equal, the closer a firm is to violation of accounting based debt covenants, the higher the chance of managers to choose accounting procedures that shift reported earnings from future to current period. -This will reduce the probability of technical default.

The Three Hypothesis of Positive Accounting Theory • The political cost hypothesis: -The greater the political costs faced by a firm, the more likely the manager is to choose accounting procedures that defer reported earnings from current to future. - Ex: High profitability of a firm may attract media & consumer attention. New taxes or other regulations may occur if certain firms have very high profits (oil companies)

Efficient Contracting and Conservative Accounting • Conservative accounting may contribute to efficient contracting and stewardship. • Debtholders are concerned about decreases in firm value, and conservative accounting through timely recognition of losses, reduces this concern.

Efficient Contracting and Conservative Accounting • Firms with income escalator clauses in the debt covenants are more likely to choose conservative accounting policies. • Income escalator clause increases the covenant level of net worth that the firm is required to maintain by a percentage of income

Efficient Contracting and Conservative Accounting • Some theorist believe that Conservative accounting can also increase the likelihood of covenant violation when not warranted by the economic state of the firm • Thus far, the extent to which conservatism increases debt contracting efficiency is unclear

Empirical PAT Research • Positive Accounting Theory has generated a large amount of empirical research • Much of the research devoted to testing the implications of the three hypotheses earlier described • Dichev and Skinner (2002) • Calculated the covenant slack for each quarter during which the loan was outstanding

Empirical PAT Research • Political Cost Hypothesis • Relief Investigations • Techniques to reduce earnings • Calculations for Total Accruals • Method 1 = Difference between operating cash flow and net income • Method 2 = Regression Equation

Empirical PAT Research • Regression Equation (Total Accruals in Year) over a period prior to the year of ITC investigation. = α +βΔREV + β(2)PPE + ε • ΔREV = revenues from year t less t-1 • PPE = gross property, plant and equipment • ε = a residual term that captures all impacts on TA other than those from ΔREV and PPE

Empirical PAT Research • Regression Equation (Total Accruals in Year) used to predict non-discretionary accruals during the ITC Investigation years. = TA – (α + βΔREV + βPPE) • TA = firms total accruals for the year • Quantity in brackets is the predicted non discretionary accruals for the year from the regression model

Opportunistic and Efficient Contracting Versions of PAT • The three hypotheses of PAT are stated: • Opportunistic • Managers choose accounting policies to maximize their own expected utility relative to their remuneration and debt contracts political.

Economic Consequences and Positive Accounting Theory