Economic Consequences and Positive Accounting Theory

8.1 Overview

You may have noticed that there has been litle discussion of management's inter- ests in
financial reporting to this point othcr than several references to manage- ment scepticism about
fair vaue accountung. As mentioned carliet, a thesis of this book is that motivation of
responsible manager performance is an equally impor- tant role of financial accounting as the
provision of useful information to investors. If so, it is necessary that accountants understand
and appreciate man- gcment's interests in financial reporting
This will involve us in a new line of thought that, at first glance, differs sharply from the
investor decision-based and efficient market-oriented theories discussed earlier Our first task
is to understand the concept of economic conse- quences. In the process, we will also learn
about some of the accounting problems in three major areas of accounting policy choice-stock-
based compensation, government assistance, and costs of oil and gas exploration.
“Economic consequences is a concept that asserts that, despite the implications of
efficient securities market theory, accounting policy choices can affect firm value”

Essentially, the notion of economic consequences is that firms' accounting policies, and
changes in policies, matter. Primarily, they matter to management. But, if they matter to
management, accounting policies matter to the investors who own the firms, because managers
may well change the actual operation of their firms due to changes in accounting policies. An
example would be changes in accounting policies relating to oil and gas company reserves.
Changes in such accounting policies, according to economic consequences arguments, may
alter managers' exploration and devclopment activities, which in turn may affect firm value. If
these changes are potentially negative and if many investors are affected investors may bring
pressure to bear on their elected representatives. Indeed, managers will lobby these same
representatives if they feel that a proposed accounting standard negatively affects their
interests. Consequently, politicians will also be interested in firms' accounting policies and in
the standard setting bodies that determine them.
It is important to point out that the term "accounting policy" refers to any accounting policy,
not just one that affects a firm's cash flows Suppose that a firm changes from declining-balance
to straight-line depreciation. This will not in itself affect the firm's cash flows. Nor will there
be any effect on income taxes paid, since tax authorities have their own capital cost allowance
regulations. However, the new depreciation policy will certainly affect reported net income,
Thus, according to economic consequences doctrine, the accounting policy change will matter,
despite the lack of cash flow effects. Under efficient markets theory the change will not matter
(although the market may ask why the firm changed the policy) because future cash flows, and
hence the market value of the firm, are not directly affected.
An understanding of the concept of economic consequences of accounting policy choice is
important for two reasons. First, the concept is interesting in its own right. Many of the most
interesting events in accounting practice derive frorm economic consequences. Second, a
suggestion that accounting policies do not matter is at odds with accountants' experience. Much
of financial accounting is devoted to discussion and argument about which
accounting policics should be used in various circumstances, and many debates and conflicts
over financial statement prescntation involve accounting policy choice. Economic
consequences An are consistent with real-world experience.
The presence of economic conscquenccs raises the question of why they exist. To begin to
answer this question, we introduce positive accounting theory. This theory is based on the
contracts that firms enter into, in particular executive com- pensation contracts and debt
contracts. These contracts are frequently based on al accounting variables, such as net income
and the ratio of debt to equity. Since accounting policies affect the values of these variables,
and since manage- ment is responsible for the firm's contracts, it is natural that
management be con- cerned about accounting policy choice. Indeed, management may choose
accounting policies so as to maximize the firm's interests, or its own intercsts, re ative to these
contracts. Positive accounting theory attempts to predict what accounting policies managers
will choose in order to do this.

The Rise Of Economic Consequences

One of the most persuasive accounts of the existence of economic consequences appears in an
early article by Stephen Zeff (1978) entitled "The Rise of 'Economic Conscquences.'" The basic
questions that it raises are still relevant today
Zef defines economic consequences as "the impact of accounting reports on the decision-
making behavior of business, government and creditors"The essence of the definition is that
accounting reports can affect the real decisions made by managers and others, rather than
simply reflecting the results of these decisions
Zeff documents several instances in the United States where business, indus try associations,
and governments attempted to influence, or did influence, accounting standards set by the
Accounting Principles Board (predecessor to the FASB) and its predecessor, the Committee on
Accounting Procedure (CAP) .
This "third-party intervention," as Zeff calls it, greatly complicated the setting of accounting
standards. If accounting policies did not matter, choice of such policies would be strictly
between the standard setting bodies and the accountants and auditors whose task was to
implement the standards. If only these parties were involved, the traditional accounting model,
based on well-known concepts such as matching of costs and revenues, realization, and
conservatism, could be applied and no one other than the parties involved would care what
specific policies were used. In other words, accounting policy choice would be neutral in its
effects.
As an example of an economic consequences argument, Zeff discusses the attempts by several
U.S. corporations to implement replacement cost accoun during 1947 to 1948, a period of high
inflation. Here, the third-party con- stituency that intervened was management, who argued
in favour of replacement cost amortization to bolster arguments for lower taxcs and lower
wage increases, and to counter a public pcrception of excess profitability. The efficient market
argument would be that such intervention was unneccssary because the market would see
through the high reported net incomes produced by historical cost amortization during inflation.
If so, it should not be necessary to "remind" users by formal adoption of replacement cost
amortization. It is interesting to note that the CAP held its ground in 1948 and reaffirmed
historical cost aceounting.
Zeff goes on to outline the response of standard sctting bodies to these vari- ous interventions.
One response was to broaden the representation on the stan- dard setting bodies themselves;
for example, the Financial Executives Institute, representing management, is represented on
the Financial Accounting Foundation (the body that oversees the FASB). Also, the use of
exposure drafts of proposed new standards became common as a device to allow
a lyariety of con- stituencies to comment on proposed accounting policy changes.
As Zeff puts it, standard setting bodies face a dilemma. To retain credibility with accountants,
they need set accounting policies in accordance with the financial accounting modei and its
traditional concepts of matching and realiza- tion (recall that Zeff is describing practices prior
to the increased emphasis on the measurement perspective). Yet, as we have seen in Section
2.5 such historical cost-based concepts seldom lead to a unique accounting policy choice.
That is, since net income does not cxist as a well-defined economic construct under non- ideal
conditions, there is no theory that clearly prescribes what accounting poli- cies should be used,
other than a vague requirement that some tradeoff between relevance and reliability is
necessary. This opens the door for various other con- stituencies to get into the act and argue
for their preferred accounting policies. In short, standard setting bodies must operate not only
in the accounting theo domain, but also in the political domain. Zeff refers to this as a "delicate
balancing" act. That is, without a theory to guide accounting policy choice, we must find some
way of reaching a consensus on accounting policies. In a democratic setting, this implies
involvement in the political domain. While a need for delicate balancing complicates the task
of standard setters, it makes the study of the standard setting process, and of accounting theory
in general, much more chal lenging and interesting.

Summary
Despite the implications of efficient market theory, it appears that accounting policy choices
have economic consequences for the various constituencies of financial statement users, even
if these policies do not directly affect firm cash flows. Furthermore, different constituencies
may prefer different accounting poli- cics. Specifically, management's preferred policies may
be at odds with those that best inform investors.
Economic consequences complicate the setting of accounting standards, which require a
delicate balancing of accounting and political considerations. Standard setting bodies have
responded by bringing different constituencies in to their boards and by issuing exposure drafts
to give all interested parties an oppor- tunity to comment on proposed standards.

Employee stock options

We now examine three areas where economic consequences have been particu larly apparent.
The first of these is accounting for stock options issued to man- agement and, in some cases,
to other employees, giving them the right to buy company stock over some time period. We
will refer to these options as ESOs.
Accounting for ESOs in the United States has traditionally been based on the 1972 Opinion
25 of the Accounting Principles Board (APB 25). This stan- dard required firms issuing fixed
ESOs ence betwcen the markct value of the shares on the date the option was granted to the
employee (the grant date) and the exercise, or strike, price of the option. This difference is
called the intrinsic value of the option. Most firms granting ESOs set the exercise price equal
to the grant date market value, so that the intrinsic value is zero. As a result, no expense for
ESO compensation need be recorded. For example, if the underlying share has a market value
of 810 on the grant date, set- ting the exercise price at $10 triggers no expense recognition,
whereas setting the exercise price at $8 triggers an expense of 82 per ESO granted.
In the years following issuance of APB 25, this basis of accounting became widely recognized
as inadequate. Even if there is no intrinsic value, an option has a fair value on the grant date,
since the price of the underlying share may rise over the term to expiry (the expiry date) of the
option. Thus failure to record an expense understates compensation cost and overstates net
income. Furthermore, a lack of earnings comparability across firms results, since different
firms have dif- ferent proportions of options in their total compensation packages. These prob-
lems worsened as a result of a dramatic increase in the use of ESO compensation since 1972,
particularly for small, start-up, hi-tech firms. These firms particularly like the non-cash-
requiring aspect of ESOs and their motivational impact on the workforcc, as well as the higher
reported profits that result compared to other forms of compensation
Also during this period, executive compensation came under political scrutiny, due to the high
amounts of compensation that top executives received. Firms were perhaps motivated to
award scemingly excessive amounts of ESO compensation since such compensation was free."
Charging the fair value of ESOs to expense would, some felt, helo investors to see the rcal cost
of this comFebruary 1992 a bill was introduced into the U.S. Congress requiring ESOs to be
valued and expensed.
One of the reasons why the APB had not required fair value accounting for ESOs was the
difficulty of establishing this value. This situation changed some- what with the advent of the
Black/Scholes option pricing fomula (see Section 7.4.3). However, several aspects of ESOs arc
not captured by Black/Scholes. For example, the model assumes that options can be freely
traded, whereas ESOs can not be exercised until the vesting date, which is typically one or
more years after they are granted. Also, if the employee leaves the firm prior to vesting the
options are forfeited or, if exerciscd, there may be restrictions on the employee's ability to sell
the acquired shares. In addition, the Black/Scholes formula assumes that the option cannot be
exercised prior to expiry (a European option), whereas ESOs are American (can be exercised
prior to expiry). Nevertheless, it was felt by many that Black/Scholes provided a reasonable
basis for reliable estimation of ESO fair value.
Consequently, in June, 1993, the FASB issued an exposure draft of a pro posed new standard.
The exposure draft proposed that firms record compensation expense equal to the fair value at
the grant date of ESOs issued during the period. Fair value could be determined by
Black/Scholes or other option pricing formula, with adjustment for the possibility of employee
retirement prior to vesting and for the possibility of carly excrcise. Early exercisc, for example,
was dealt with by using the expected time to exercise based on past experience, rather than the
time to expiry, in the Black/Scholes formula
The exposure draft attracted extreme opposition from business, which soo extended into the
Congress. Concerns were expressed about the economic conse- quences of the lower reported
profits that would result. These claimed conse- quences included lower share prices, higher
cost of capital, a shortage of managerial talent, and inadequate motivation. This would
particularly disadvantage small start-up companies that, as mentioned, were heavy options
users. To preserve their bottom lincs, firms would be forced to reduce ESO usage, with
negative effects on cash flows, employee motivation, and innovation. This, it was claimed,
would threaten the competitive position of American industry. Business was also con-
cerned that the draft proposal was politically motivated. If so, opponents of the proposal would
feel justificd in attacking it with every means at their disposal.
Another series of questions related to the ability of Black/Scholes to reliably measure ESO fair
value. To see these concerns, we first need to consider just what the costs of ESOs are, since,
unlike most costs, they do not require any cash out- lay. Essentially, the cost is borne by the
firm's shareholders through dilution of their proportionate interests in the firm. Thus, if an ESO
is exercised at a price of, say, $10 when the market value of the share is $30, the ex post cost
to the firm and its shareholders is $20. By admitting the new sharcholder at $10, the firm fore-
goes the opportunity to issue the share at the market price of $30. That is, the $20 opportunity
cost measures the dilution of the existing sharcholders'interests. The fair value of the ESO at
the grant date is then the expected present value of this opportunity cost.
However, this expected valie is very difficult to measure. As mentioned, the employee may
exercise the option at any time after vesting up to expiry. The ex post cost to the firm will then
depend on the difference between the market value of the share and the exercise price at that
time. In order to know the fair value of the ESO it is necessary to know the employee's optimal
exercise strategy owever, this expected value is very
This strategy is modelled by Huddart (1994). As Huddart points out, deter- mining the
employee's strategy requires knowledge of the process generating the firm's future stock price,
the employee's wealth and utility function (in particular the degree of risk aversion), whether
the employee holds or sells the acquired shares (many firms require senior officers to hold large
amounts of company stock) and, if sold, what investment alternatives are available. Matters are
further complicated if the firm pays dividends on its shares and if the motivational impact of
the ESO affects share price.
By making some simplifying assumptions (including no dividends, no moti- vational impact),
Huddart showed that the Black/Scholes formula can substan tially overstate the fair value of
an ESO at the grant date. To see why, we first note three option characteristics:
 1. The expected return from holding an option exceeds the expected return on the
underlying share. This is because the option cannot be worth less than zero, but the
share price can fall below the option's exercise price. As a result, a risk-neutral
employee would not normally exercise an ESO before maturity
2. The "upside potential" of an American option (its propensity to increase in value)
increases with the time to maturity. The longer the time, the greater the likelihood that
during this interval the underlying share price will take off, making the option more
valuable. Early exercise sacrifies some of this upside potensial
3. If an option is deep-In-the-money, that is, if the value or tne underlying share greatly
exceeds the exercise price, the sct of possible payoffs from holding the option and their
probabilities closely resembles the set of pay offs and probabilitics from holding the
underlying share. This is because for a deep-in-the-money option the probability of
share price falling below exercise price is low. Then, every realization of share price
induces a similar realization in the option value. As a result, if the employee is required
to hold the shares acquired, he or she might as well hold the option to maturity. The
payoffs are the same and, due, to the time value of money, paying the exercise price at
expiry dominates paying it sooner.

The question then is, are there circumstances where the employee will exer- cise the option
early? Huddart identifies two. First, if the ESO is only slightly in- the-money (substantial risk
of zero payoff), the time to maturity is short (little sacrifice of upside potential), and the
employee is required to hold the shares acquired, risk aversion can trigger early exercise. Since
there is substantial risk of zero return, the risk-averse employee (who trades off risk and return)
may feel that the reduction in risk from exercising the option now rather than continuing to
hold it outweighs the lower expected return from holding the share.
The second circumstance occurs when the ESO is deep-in-the-money, the time to expiry is
short, and the employee can either hold the acquired share or sell it and invest the proceeds in
a riskless asset. If the employee is sufficiently risk averse, the riskless asset is preferred to the
share. Because the option is deep-in-the-money, the payoffs and their probabilities are similar
for the share and ESO. Thus the employee is indifferent to holding the ESO or the share. Since
holding the riskless asset is preferred to holding the share, it is also preferred to holding the
option. Then, the employee will exercise the option, sell the share, and buy the riskless asset.
In a follow-up empirical study to test the early exercise predictions, Huddart and Lang (1996)
examined the ESO exercise patterns of the employees of eight large U.S, corporations over a
ten-year period. They found that early exercise was common, consistent with Huddart's risk
aversion assumption. They also found that the variables that explained empirically the
early exerciscs, such as time to expiration and extent to which the ESO was in-the- money,
were "broadly con- sistent" with the predictions of the model.
The significance of early exercise is that the fair value of ESOs at grant date (hence the expense
to be recorded under the FASB exposure draft) is less than the fair value determined by
Black/Scholes. This is particularly apparent for the first ex post cost of the option to the
employer (share price less exercise price) is low. Since the Black/Scholes formula assumes the
option is held to maturity, it does not allow for cost reductions such as this. While the cost
savings from the second circumstance are less, the cost to the employer is still less than
Black/Scholes, as Huddart shows.
As one can imagine, theory and evidence suggesting that the exposure draft, if implemented,
may not produce reliable estimates of ESO post would be seized upon by critics, particularly
if the estimates tended to be too high. As a result, in december, 1994, the FASB announced
that it was dropping the exposure draft, on the grounds that it did not have sufficient support.
Instead, the FASB turned to supplementary disclosure. In SFAS 123, issued in 1995, it urged
firms to use the fair value approach suggested in the exposure draft, but allowed the APB 25
intrinsic value approach provided the firm gave supplementary disclosure of fair value-based
ESO expense. As an example of supplementary disclosure under SFAS 123, consider the
following summary from the 2000 annual report of Microsoft Corporation:

SFAS 123 amounts are based on the Black/Scholes formula with an expected time to exercise
of 6.2 years. The decline in net income and earnings per share is about 13 % . The decline in
operating income of $ 1,893 , or over 17 % , is even more striking. This material effect on
income is consistent with the results of Botosan and Plumlee (2001), who found, in a 1998
sample of 100 fastest - growing US . firms , that earnings were reduced on average by about
14 % on application of SFAS 123.
Above, we outlined Huddart's result that early ESO exercise can be triggered by risk aversion.
This, however, is not the only possible explanation for exercise. More recently, Aboody and
Krasznik (2000) (AK) studied the information release practices of CEOs around ESO grant
dates. They confined their study to CEOs because it is the CEO that controls the firm's release
of information.Their results are based on a sample of 4,426 ESO awards to CEOs of 1,264
different U.S. firms during 1992-1996. Of these awards, 2,039 were by firms with scheduled
grant dates. That is, awards were made on the same dates each year. Thus, CEOs of these firms
knew when the ESO awards were coming.
AK found that, on average, CEOs of firms with scheduled ESOs used a vari- ety of tactics to
manipulate share price downwards just prior to the grant date to manipulate price up shortly
after. One tactic was to make an early announce- ment of an impending BN quarterly earnings
report, but to make no such announcement for an impending GN report. Other tactics included
influencing analysts' earnings forecasts and selective timing of release of their own forecasts.
Since the exeraise price of an ESO is usually set equal to share price on the grant date to avoid
expense recognition under APB 25, a low share price on this date increases the extent to which
the ESO will be in the money during the exer- cise period. This increases the expected value
of the award to the CEO. It also increases the likelihood of early exercise since, according to
Huddart's analysis, deep-in-the-money ESOs are more likely to be exercised early Thus, to the
extent early exercise leads the Black/Scholes formula to overstate the fair value of ESOs, the
problem is worsened. Furthermore, if implementation of the FASB exposure draft would cause
compensation committees to reduce usage of ESOs, the ability of CEOs to engage in this
opportunistic behaviour would be reduced, further increasing the intensity of their objections
Since the exposure draft was abandoned, we do not know whether its cco- nomic consequences
would have been as severe as its critics claimed. The firm's cash flows would not be directly
affected by the recording of an expense for stock options. Nevertheless, despite the prediction
of efficient securities market theory that accounting policy changes without cash flow effects
will not affect share price, business did perceive economic conscquences. Otherwise, it would
not have opposed the exposure draft to the extent it did.