Scotty Chapter 4 Market Effigheney. Eiticiency iy based on the Information content of disclosure not the form of disclosure that is valued by the market Primary reason for the existence of accounting ~ information asymmetry Accounting can be Viewed as a mechanism to enable communteation of usef information from inside the firm to outside (o better enable investor's decisions and have social benefits through improvement of operation of securities market Market fully uses all available information © Efficient Securities market: Is one where prices of sec market at all times fully reflect all information that is publicly knows about these securities ‘* Sources of information — financial press, tips from friends. changes in | economic conditions, advice from analysts and financial statements (most important) ‘* Market prices are efficient with respect to publicly known information © Insiders are able to eam excess profits at the expense of outsiders © Managers may credibly communicate inside information to market, to increase firm’s share price/teputation Market is efficient relative to a stock of publicly available information The efficiency of securities market pene = Model of how a securities market operates = Semi-strong form assumed | - Market efficiency is a relative concept which may not necessary reflect real firm value = Suggest that prices are unbiased relative to publicly available information and will react quickly to new or revised information = Investing is a fair game if market is efficient — investors cannot expect to earn excess returns on a security/portfolio, = Security’s market price should fluctuate randomly over time = Prices change only when unexpected events arise - Different investors interpret information different, but these | differences will average out and reflected in the market | 1) Choice of specific accounting policy does not matter © As longas there are no differential cash flows & full disclosure is made © Accounting policies chosen will only affect reported net income but not Implications of future cash flow (e.g. full-cost vs. successtul etYorts approach for oil and market for gas company financial © Market is not “fooled” by differing accounting policies when comparing. reporting firm securities 2) Efficient securities market go hand in hand with full disclosure © Management should develop and report information about the firm on a _timely basis_ i _ { | i | 4Sous Chapter 4: Efficient Secure, M lary As long as benefits 10 investors exceeds the cos 7 © As "rage all available information to improve their pr, Investors wil ae Soformation the firm discloses, the greater is the inyg, ‘he more in! ° cendenee in the securities market story? estor when choosing disclosy, concerned about the naive inv« 3) Need not be concern : ies a ts i ket policies and format ted by the efficient mart = ney > a securities market will always reflect all that ig ey trust tthe firms ; : : publicly iene understand the disclosed information, the market © Ife price will be the same as though all investors understand © They can hire their own experts 4) Accountants are in competition with other providers of information 8 the jent market is interested in useful information from any source © A need to provide useful, cost effective information. If not, our function will decline overtime Market Prices (page 116) ‘Should fluctuate randomily overtime and is only partially informative because: * _ Presence of liquidity or noise traders . ic These people have other reasons to why buy/sell securities (decisions come at random, not based on rational evaluation of information). Security prices are Partially informative in presence of noise traders but still efficient (expected value sense) Security prices respond less to financial statement informa than for small firms, since they are more “in the news” incorporate considerable information. tion for large firms => market price will When people are not independent in their views, n The price is biased when they collectively have the same views on a security ¢__ Information asymmetry — presence of inside ; rm ¢ of inside informati ‘note that market prices are still efficient of in the presence of noise trading, but in the SsPected value Sens, since noise has an expectaton cree se taing, but in Xpectation of zero, \ =|) \] | Extent which iG imyestors gather | information \° | How to improve | financial | reporting |? | Capital asset | * | pricing model/ | market model | | le | | Information Asymmetry = ous Chapter 4. Efficient Securities Market Depends on how ta price ts (Y of Financial statement into ation | the aw The costs of analysts and interpreta > Loads to predictions about how security market prices respond to statement information, D Sccurity prives of lar information than for small nancial m will respond less to financial statement ‘mis large firm release more information the minimum requirements of GAAP (imitation formation that gives away their compeunve Voluntary disclosure, beyon management may not disclose advantage) : Management can signal inside information by its choice of accounting policies Increase the quality through Management discussion and analysis jovernment to impose penalties on the market Current Price = ('xpected future price + Dividends) / (I+ F(R) risk free return, market return & beta determine expected returns ofa ECR) = Ret B[E(RW) = Rd 3 main us © Show how st price and dividends © Provides us with a way to separate the realized return on a share into expected and unexpected components/ ex post separation) © Convenient way to estimate the stock's beta | Does not consider information asymmetry © Investors face the risk of insider trading and demand higher returns | re prices depend on investors’ expectation of future share nt in the market may not be Known by Information known by one part another buyer vs. seller Major information advantage over the other participant © Adverse selection problem-> people whose health is adverse self-select themselves to buy insurance OR using insider information to trade, which is adverse to the interest of investors © Moral Hazard problem > Cheat the company by failing mmetry problents such as Securities market is subjected to information as’ insider trading/insider information © Take advantage of their information to carn ercess profits by biasing, delaying, or withholding its public release while they buy ot sell shares on the basis of this information, Ideal conditions > price reflect fundamental value (Value of the share with no inside information present) Non ideal > market value fully reflects all publicly available information in an |Scotts Chapter 4: Efficient Securiy ies y hey ‘efficient market : ~ information and may lead to adverse seg. ideality i by inside i ‘* Non ideality is caused by he true state of the firm) attracting outsiders that threaten ' Reduce this problem with full and timely disclosure cies of full disclosure, to expand the set of T blicly available and reduce biases, tig ° ° Improving poll information that is pul © Investors realize that it is not a level playing field and either withdray W fro market or lower the amount they are willing to pay for any security ™ the . | Social welfare will be enhanced if scarce capital goes to most productive : alternatives To prevent lemons phenomenon that come into play because of adverse sel, i and moral hazard lection Social © People withdraw from the market> a thin market significance of © Willing to pay less for any security ' securities © Signaling to credibly communicate information to the market market that with high quality investment for firms work well © Engage in full disclosure to remove own company from the “lemons” cat hence investors are more willing to invest in them as Impose penalties on the market > Regulations such as SEC in the US Provide incentives for the release of inside information > through signalingInformation Perspect von Decision Use ne Information Perspective on decision usefulness Reasons for market response to financial statement informa Finding the Market Response fulagss [Ctuuter § Scotts! | Am approach to financial reporting that recognizes individual responsibility for Predicting future firm performance and that concenttates on providing uveful information for this purpose. + Unvestor > Wants to predict future tiem performance and make decisions themselves * Accountant > supply usetul financial statement information, to assist investors. © lnvestors and accountants may benefit from useful information but it does not follow that the society will be better off > cost of producing financial statements may be more than the increased usetiulness is worth westment + Usefulness judged by stock market response to accounting information, © Market responds only to unexpected portion of earnings announcement Assumption : Securities market efficiene; | 1 Tnvestors have prior beliefs about the expected return and risk ofa lirm’s shares, Prior belief’ based on all available information attained by investors and their ability in interpretation | 2. Upon retease of current year’s net income, investors will analyze the income number > net income higher than expected; revise their beliefs about firm's future performance upwards. Vice versa. 3. Investors who have revised their beliefs about future firm performance upwards Will buy the firm’s shares at the current price 4. Increased volume of shares traded when a firm releases its net income. The greater the differences in investors’ prior belief’ and their interpretations of the Current financial information, the greater the volume, “eEfficient markets theory implies that the market will react quickly to new information, EtTicient market react in a narrow window of a few days surrounding this date © Investors evaluated reported net income as good or bad news based on their prior expectations * Efficient market will only react to the portion of earnings that it did not expect ‘¢ Many events taking place (market-wide factors) may affect firm’s share price and volume hard to infer response to reported net income > neced to separate market-wide and firm-specitic factorsudy to document statistically shows that firm's share price response to the statement (1968). ion content of finan ach Sampk . ‘* Estimate expected earnings (expected = last year’s actual) © Classity as Good News - GN (reported earnings > expected earnings) or Bad News - BN(reported earnings < expected earnings) ‘© Evaluate market return on the shares of firms near the time of each earnings announcement according to the abnormal return procedures \ ‘© Abnormal share return = actual share return — expected share return, * Calculate Average Abnormal Share Return for BN and GN firms \ — \ \ Evidence that firms’ share returns respond to the information content of its | current net income The Ball & Brown Study Results: ‘© Wide window-> 11 month period prior to earnings announcement and 6 month following earnings release. GN firms strongly outperformed the market BN firms strongly underperformed the market > Market began to anticipate and respond to GN and BN firms as much as a year earlier Association between share returns and earnings increases as the window widens * The greater the change in unexpected earnings, the greater the security market response due to investor's revision of estimatesEee: Earnings Response Coefficient t PEEEuRSEG | ERO: Meas | unex pe | vures the extent of a security abnormal market return in response to the ‘cted component of reported earnings of the firtn issuing the security Unexpected EB | Abnormal! market | earnings: GN/BN = || return | Reasons for Differential Market Response © Beta © Higher 6 + Lower ERC © Migher 6 Higher risk © Capital Structure © Higher D/F. > Lower ERC © Highly levered firms-> More of the earnings goes to debt holders instead of shareholders © Persistence © Higher Persistence > Higher ERC © IFGN is due to long term strategies instead of short term gains (disposal of a plant) > GN expected to persist ‘© Also dependant on the firm's accounting policies (fair value accounting vs. cost base) + Earnings Quality © Higher Quality > Higher ERC © Earnings quality depends on quality of working capital accruals © Growth Opportunities © Higher Growth Opportunities > Higher ERC milarity of Investors Expectations More Precise Analysts’ Forecasts > More Si Expectations — Higher ERC lar Investor © The Informativeness of Price ‘© Price more informative > info content of current accounting earnings less informative Lower ERC All the above just proves that better disclosure of financial accounting information improves the decision usefulness for investorssch vto base future expectations on past Feported net income les Approw % current year’s earnings sting i veg persistence: unexpected earnings Jnange in earnings ee = fast year's earnings a expected curnings Ateasti a verags expectaious |g Analysts’ Foreens i mace | 1. Evidence that they are more ‘eliness of a forecast domi the average forecast eae 3. Bat some suggest analysts" forecasts may be optimistically biased accurate than time series. mates the canceling-out-of-errors effect of ns or events that frequently over several years ness activities of the entity I decisions by management or owners jing unusual items above or below S whieh result from transactio 1. Are not expected to occur 2) Do not typify the normal bu 3. Do not depend primarily on Management can smooth earnings by classify ae end the operating earnings line Sane ais | Seputate classification: Help prevent investors from overestimating the persistence of operating income + Amount and timing of disclosure are subject to strategic manipulation by ‘management © Higher number of large special items reported over time > lower ERC + Assen may be bter off the extent that hey provide useful information to investors, but it does not follow that society will nc il r : ecessarily 1. Information is a public good a What is the best 2. DitYerent people interpret information differently accounting policy 3. Production of annual reports and costly to firm losure of valuable information is | ¢ Sono one knows how much information is enoughScotts Chapter 6: The M eusurement Persp Why financial statements is moving towards fair value accounting Measurement perspective on dee' under which accountants undertake a responsibil financial statements proper, providing that thiy cat be elo thereby recognizing an increased obligation to aysist in Inconsistency with securities market efficiency Scotty Chapter 6. The measurement perspective ame decishine uanttess echive on Desivlon Usesulaems ion usethlnoss iv An AppronEh Co Aumnelal report, ry to I on into the Scowritios market are not Hilly eMieient Investors may not be dlept at processiagt information > fair value accounting inereasey uveliuhiess (0 inventors Low proportion of share prige variability A financially distre countants exposed to Iegal liability when firm becomes ed Investors may not respond with rational decisions theory, and investment models due (0 © Having limited attention and do not have tine and ability to process all available information > fous on readily available information © Be overconfident in the precision of information they collected © Self attribution/velf-serving bias > individuals (eel that good decision outcomes are due (0 thelr abilities while bad outcomes are due to unfortunate realization of states of nature * Develop share price momentum whereby share prive ine will reinforce contidenee > more purchase af shares share price will inerease further > further ine tn confidence Behavioural finance ~ study of behayioural-based securities market inetlivigncios‘Seous Chapter 6: The measurement perspective on decision usefulness Prospect theory by Kahneman and Tversky A behavioural based altcmative to the rational decision theory Investor considering a risky investment separately evaluate prospective gains and losses, and weigh the probabilities due to narrow framing (individuals isolate problems)> narrow framing—where individuals analyse problems in isolated manner Loss Aversion ~ Individuals dislike even very small losses (Rate of utility loss is greater than rate of utility increase for again) Leads to Disposition effect-- Investors will hold on to losers and sell winners, or even buy more losers (not wanting to realize a loss — irrational behaviour) Weighing probabilities-> lowers probabilities on states that are likely to happen and increases probabilities on states that are less likely to happen Investors are risk adverse to gains and risk taking to losses Combination of separate evaluation of gains and losses, and weighting of probabilities leads to: © Fear of losses may cause investors to stay out of market even when prospects are good © Investors may underreact to bad news by holding on © Rate of utility decreases more for small losses than the rate of increase for small gains->Firms manage earnings upwards to avoid reporting small loss Arguments for and against Usefulness of Beta Against: using beta Market acts as if firm risk increases Over a longer period of time, results showed. with book-to-market (B/M) and decreases with firm size instead of For: that beta was a better predictor of retum © Recognize that itis affected by changes in interest rates, firms’ capital structures, improvements in firms’ abilities to manage risk, development of global markets‘Scotts Chapter 6: The measurement perspective on decision usefulness Reasons why volatility exist: © Consistent with efficiency, derives from non-stationarity © Driven by behavioural factors such as positive feedback-> prices to overreact and fall back when the revealed overreact Extreme case of market volatility Derive from a combination of biased self-attribution and resulting momentum, positive feedback trading and to ‘herd’ behaviour reinforced by optimistic media predictions of markets ‘experts? Efficient Securities Market Anomalies > cases that appear inconsistent with securities market efficiency Post announcement drift — abnormal security returns last for at least 60 days after announcements of results ‘© Driven by unsophisticated investors who do not comprehend the full information in current quarterly earnings Market response to accruals — market respond more positively to increase in operating cash flow compared to increase in accruals since accruals are reversible and non-persistent Risk could be the driving force of the increased profits ‘Transaction costs may limit the ability of investors to exploit, the GN Thus, efficient securities market efficiencies continue to raise challenging questions about the extent of securities market efficiency Implications of securities market inefficiency for financial reporting ‘©. Increase importance of financial reporting © Securities market inefficiency supports measurement perspective‘Scots Chapter 6. The measurement perspective om dectsion usefulness Securities market 4» efficient as believed * Investors need more help in assessing probabilities of future pertormane: | Hescesliproric, |° canes a nceme explana only a small part of varia Measurement } Perspective | es * More practical considerations due to major lawsuits auditors are | involved in recent years | * Such accounting standards reduces auditor liability when mark- to-market techniques overstates assets low relationship * Security market response to earnings ‘* Net income lag in recognizing much economically significant Value relevance of information (eg. intangibles) financial statement information * Low value-relevance of earnings suggest that there is still room for accountants to improve the usefulness of financial statement information | | | * Shows how the market value of the firm can be expressed in | terms of fundamental balance sheet and income statements | components | Ohlson’s Clean Surplus | Assumes ideal conditions in capital markets including dividend Theory ~ Residual irrelevaney Income Model | * 3 formulae to estimate firm value | * Supports measurement perspective-> the more fair values are | reported, the less the potential for investor mistakes in | estimating firm value | | * Auditors often under considerable pressure from management to bend or stretch GAAP, so that legal capital requirements, earnings targets and/or analyst forecasts will be met Auditors’ legal liability | ¢ Yielding to such pressure can result in substantial legal liability * Auditors’ response is ethical behavior, but this will lead to conservative accounting + Ceiling tests — represent a partial application of the measurement perspective, requiring the auditor to estimate the fair value of assets (apply lower of market)a Beotts Chapter &: Feonomi: Cansoquiencas anal Povlive Accounting Heory (PAT Economie consequ attect tir value) “In essence ‘Changes in accounting, polictes Positive Accounting Theory Definition of economic consequences [accounting potcies do” not matter (3" party intervention) Stock options Iss Traditionally “But over the years inadequate Jed to management / employees giving them right to buy company stock over some time period \o8 (asserts that deypite the bnplicatton of afffclent securities market theory, accounting policy can 1. Hime accounting policles and changes do matter 3. Puhinatly they matter Co management (Investors too because managers may change the actual opevation of thet fins due to changes in accounting polices) 1. It negative and investors are affected will bear pressure on elected representatives. 2. Auwl managers will lobby these same representatives 1 Gaved on contacts that fms enter Into (executive compensation contracts and debt contracts) 2. Goutracty baved on varlables ike ROE => affected by accounting polices. Since management Is responsible for the contracts, concern of accounting policies. 4. May choose accounting polices to maximize frm’s interests. $+ Positive accounting theory attempts to predict what accounting policies managers will ehoose tn order to do ths, The Rise of Ceonomie Consequences 1. Inypact of accounting reports on the decision-making behavior of business, government and creditors. 2. Accounting reports can affect the real decisions made by managers and others rather than simply reflecting these decisions ‘Choices of such policies strictly between standard-setting bodies and accountants/auditors. 24 Then traditional accounting model (matching of costs and revenues, conservatism) could be applied ane! no one would care what policies were used. Employee stock options 1. Record expense ference between market vaiue of shares onthe date the option was | granted to the employee (grant date) and the exercise price 2, Difference called the intrinsic valve ofthe option 3. Most firms set the grant date = exercise price => 0 intrinsic value => no expense 44, Tractlonaly Leif exercise price ls $8, and market value s $10 => $2 expense Even If no Intinsle value, an option has far value on grant date, since price of underying share may rise over the term to expiry (the explry date). 2. Failure to recard expenses understate firm's compensation cost and overstates its net Income. 1 ‘ack of earnings comparability across fmm 2. Since ferent fms have different proportions of options in their total compensation packages. b, Executive compensation came under political scrutiny, due to high amounts of compensation that top executives received. 1. Excessive compensation since such compensation was free. 1. So charging the fair value of ESOs to expense would help investors see the real cost to the firm. Proposed firms record compensation expanse based on fai value at grant date of €50s Issued. 2. Fair value could be determined by Black/Scholes or other option pricing formula with the possibility of employee retirement prior to vesting and for possibilty of early exercise. Enrly exercise => by using expected time to exercise. £505 do not require cash outlay. Cost borne by firm’s existing shareholders through dilution of their proportionate interest in firms _2 ESO ex price = $10, market value Of share = #30, @x post cost to firm fs 520, Cause 8 REW shareholder with $10, opp cost forgone to issue share at market price of $30. 3- Fair value of £50 at grant date, hence cost to firm, is then the expected present value of this opp cost. 1 £50 cost is very difficult to measure relably- 2 Cause employee may exercise the option any time after vesting up to expiry. Ex post cost depends on the difference between market value of share and the exercise price at that However time. 3. So to know the fair value of ESO, necessary to know the employee's optimal exercise { strategy. ‘So determining 1. Requires knowledge of the process ‘employee's strategy generating firm’s future stock price, b. the employee's wealth and utility function, whether the employee holds or sells the acquired shares d._and if sold what investment alternatives are available. Expected return from holding option > expected return on underlying share. (option cannot ‘be worth less than o, but share price can fall below option’s exercise price) @. Would not normally exercise ESO before maturity Propensity to increase in value increases with time to maturity. | Foption characteristics | (to hold to maturity) 2 ‘2 Longer the time, greater likelihood that during this interval underlying share price Will take off, making option more valuable. 3: “ deep-in-the-money”is value of underlying share greatly exceeds the exercise price, set of, possible payofts from holding the option and ther probabiltes closely resembles the set of payoffs and probablities from holding the underlying share, 2 Cause the probability of share price fling below exercise price is low. => every realization of share price Induces similar realization in option value. b._Therefore mightas well hold the option to maturity. £50'5 only slightyin-he-money (substantial risk of eo pay) a. Time to maturity is short (little sacrifice of upside potential) b. Employee's required 1 hold the shares acquired Risk aversion can trigger early exercise 4. So since with substantial risk of o return, risk-averse employee feel that reduction Inrisk from exercising the option now rather than continuing to hold outweighs the lower expected return from holding the share. £S0 is deep-inmoney, the time to expiry is short, and employee can either hold the acquired share or sell it and invest the proceeds in a riskless asset. To exercise option early Employee stock options ‘+ Stock options issued to management giving them the right to buy company stock over some time period ‘+ Traditional method for the US: © _ Intrinsic value > Firm to record an expense equal to the difference between the market value of the shares on the date the option was granted to the employee (grant date) and the exercise or strike price of the option, © Hence most firms set the grant date price to be the exercise price such the intrinsic value or expense recorded is zero. © Flaw: Did not truly consider the intrinsic value of the stock issued Failure to record an expense understates the firm’s compensation cost + Lack of earnings comparability across firms as different firms have different proportions of share options© Resuited in excessive compensation made by firm through ESOs (© Usage of Black/Scholes model may not capture option value * ftassumes that options can be freely traded but it cannot be exercised until vesting ats * teassumes that options cannot be exercised tll expiry date (European option), where ns af Avrieri at ‘option can be * New standard under FASB: ‘© Companies to record compensation expense based on the fair value of the option at grant late © Amortize this expense over vesting period © Fair value could be determined from the Black/Scholes formula + Early exercise was dealt with the expected time to exercise © Flaw: + Congress concerned about the lower reported profits which would result ‘+ Lower share price, management and employee motivation * Black/Scholes model may overstate option value * Hard to value > unclear when employee will exercise option ‘+ Important to know employee's optimal exercise strategy ‘+ Length of period help affected by © Expected return from holding an option ‘© ‘Upside potential’ longer holding, greater the likelihood that the share yrica vl) take off ‘© ‘Deep in the money’- high intrinsic value of the share © Early exercise due to Risk aversion of the employee ‘© Furthermore, if option is ‘deep in the money’ one can buy and sellitin a shirt tun a0 use the money to invest in a riskless asset ‘* Manipulation techniques (© CEO manipulate earnings downwards just prior to grant date and manipulate price up shortly after (theavgn early announcement of quarterly report, influencing analysts earnings forecasts, selective timing of releave of their own forecasts) ‘© Low share price during grant date increases the possibility that option will be ‘deep in the money” ede eel eh ca AiR ADs Relationship between Efficient Securities Market Theory and Economic Consequences ‘© Efficient securities market predicts no price reaction to accounting policy changes that do not affect underiying profitability and cash flows. This highlights the Importance of full disclosure.Positive Theory of Accounting PAT is concerned with predicting such actions as The chol Fespond to proposed new accounting standards, fort The need for empirical investigation to determine © Trade ofbetween cost of capital and contracting costs ee5 of accounting poles by Thin mangers aed Neo maags © Costs of Contracting > Costs of negotiation, monitoring of contract performance, renegutinton, viaon * Gost of capital can be reduced by accounting policies that fully inform the market, thereby tering, wrest concerns about adverse selection. However, this may reduce the correl manager effort (increasing costs of contracting) © Flexibility for managers to choose policies ° a @__Understand and predict managers’ accounting policy | | ® Firms organize themselves inthe most efitent manner, 5035 to MaNIMInG TH prospects Trivial 5 The Tank Pier and institutional environment, its technology and the cegree of ‘orporate governance itself ™ of organization depends on factors such as its legal competition in the industry Mar snagers are rational performance measures Firms viewed as a nexus of contracts > aims to minimi bankruptcy), and the contracts with the lowe eff Effi ‘Maximize their own expected utility ‘Maximize firm profits if t's in their ow terests icient Securities Market icient Managerial Labor Market lation between fire pertormanca and ‘choosing investing polices in their own best interests) as these contracts may affect ize contracting costs (Le. cost of negotiation, expected cost of est Contracting costs are called efficient contracts, Flexibility * Difficult to ‘Opportunistic Behavior Flext to chose rom ast of acon pls so that they an adapt to new or unforeseen ceumstancen ee | | UFO vs. FIFO Civen the avalable set, managers may choose accounting policies from the set for their own purposes thereby reducing contract efficiency circumstances Efficient Contracting © Managers choose accounting polices to attain corporate governance objectives of the firm © Minimize costs of moral hazard, by motivating the manger to actin shareholders’ best interests inguishing the two ‘Bonus plan hypothesis may induce a manager to choose strai srease remuneration. Opportunisti balance so as t ight ine amortization over declining Efficient Contracting: Argue that straight line amortization best measures the opportunity cost tothe fim of ks fixed | assets. Thereby result ig in a reported income that better measures managers performances Boni ius Plan Hypothesis. Managers with bonus plans are more likey to choose accounting procedures that shift reported earnings from future Period to the current period » reduces future reported earnings ang bonuses but increases the PV of manages cece © manager is risk-averse, he will prefer accounting polcy that smooth reported earnings and thus alese verses bonus scheme *Healy(1985), found evidence that managers systematically adopted accrual polices so as to maximize their expected bonuses ( when income expected to be between the cap and bogey) ‘Amortization expenses: Non-discretionary accrual, manipulated through changing estimated useful ite Increase in net accounts receivable: a) Discretionary, derives from decre: 2S¢ in the allowance for doubtful accounts; b) Dscrevonary, ever revenue recognition, amore gererus ce Poy, ke he book open 5 i rease the volume of business nd the year-end; c) Non-discretionary, increase t increase Inventory) Deetoary, manta ste rng he parad of exces manufacturing coped (higher overhead costs) ifthe intention s using real variable to manage earrings;b) Nondscresionary, anticipation of a strike or simply increased demand Decrease in accounts payable and accrual iablitie optimistic about warranty claims‘ See Debt Covenant Hypothesis ‘2 The closer a firm isto violation of accounting-based debt covenants, the more likely the firm manager Is to select accounting procedures that shift earnings to the present period > reduce probability of technical default 2 Most debt agreements contain covenants that the borrower must meet during the term of agreement e.g. maintaining specific levels of debt-to-equity, interest coverage. Violation leads to penalties e.g. constraints on dividends or additional borrowing Efficient Contracting and Conservative Accounting, 2 Conservative accounting requires timely recognition of losses, it also lowers company’s net worth > company has to retain more net assets to avold covenant violation > increases debtholders’ security Beatty, Weber, and Yu (2008), firms with income escalator clauses in their debt covenants are more likely to choose conservative accounting policies 2 Gigler, Kanodia, Sapra, and Venugopalan (2009), conservative accounting may lower interest rate on debt > conservatism increase the likelihood of covenant violation when economic state if bad * extent to which conservatism increases debt contracting efficiencyisunclear | Polltical Cost Hypothesis, ee 2 The greater the politcal costs faced by a firm, the more likely the manager is to choose accounting procedures that deter reported earnings from current to future periods + High profitability may attract media attention and politicians may respond with new taxes or other regulations. + During periods of restricted crude oil supply and rising gasoline oil prices. Resulting public anger led to special taxes on oil companies to take back the excess profits + May be more evident in large companies due to higher performance standards © Large firms will tend to choose more conservative accounting policies and less likely to oppose new standards that may lower reported net income 2 _ Bonus plan + debt covenant hypothesis work in opposite direction to firm size in the accounting predictions + Some managers use derivatives to speculate Increases total firms risk ‘+ However, this may also be efficient contracting use derivatives to hedge to reduce risk Opportunistic Contracting ‘Sweeney (1994) found that managers are mindful of the costs vs. benefits of accounting policy changes. Appeared to change accounting policies in the face of debt covenant problems only when itis cost effective to.doso, ‘© Firms limit risk by the use of derivatives to hedge. E.g. a majority of test firms with high interest rate risks Effictent used hedging instruments that reduced interest rate risk, such as interest rate swaps. Consecting Efficient compensation contracts will encourage managers to reduce firm-specific risks -> encourages risk-averse managers to take on other firm-specific risks, ‘© Conservative accounting promotes efficient contracting ~ Firms are able to allgn managers’ Interests with those of shareholders pat vs. | © PAT judged on predicting human's behavior Normative | ® Normative theory judged on logical consistency with the underlying assumptions of how rational theory (eg. Individuals should behave expect utity) | * _Postive theories help to keep normative predictions on track