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 = 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

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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, 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 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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