Chapter 8
Economic Consequences and
Positive Accounting Theory
Agenda
 Employee stock options
 Positive Accounting Theory (PAT)
 Bonus plan hypothesis
 Debt covenant hypothesis
 Political cost hypothesis
 Empirical research
 Opportunistic versus efficient contracting versions of PAT
 eToys Inc: A Case Examining Pro Forma Financial Reports, Analysts’
Forecasts and Going Concerns Disclosures
Terminology
 Economic Consequences:
A concept asserts that, despite the implication of efficient
securities market theory, accounting policy choice can affect
firm value
 Positive Accounting Theory:
Theory that attempts to predict what accounting policies
managers will choose in order to maximize the firm’s interests
relative to executive compensation contacts or debt contracts
The Rise of the Economic
Consequences
Stephen Zeff – 1978
“The impact of accounting reports on decision-making
behaviour of business, government and creditors”
“Replacement costs accounting”
=> third-party intervention/management, attempted to
reduce earnings
 Lower taxes & wages increase
 Cover to the public perception of excessive
profitability
The Rise of the Economic
Consequences
 Assumption:
 Market efficiency
 Non-ideal condition: net income is not well-defined
 Conclusion:
 Governance bodies of accounting standard must
must balance both the accounting and political
domains
 Refers to as “delicate balancing act”
Questions
 What is Employee Stock Options (EPOs)?
 What is grant date?
 What is vesting period?
 What is the intrinsic value mean?
 Why do you think it is important to understand the EPOs?
Employee Stock Options (EPS)
 Accounting Principles Board (APB 25)
 Intrinsic Value
= Market Value(Grant Date) – Exercise Price
 Increase in trend when using the EPS since 1972
 Ex: High-tech start-up firms
 Fail to record expenses, overstated net income
Black/Scholes Formula
Black/Scholes Formula’s Flaws
 Not transferable
 Cannot exercise until the vesting date (1 to 2
years after the grant date)
 If resigned before the vesting date, options
may became forfeit
 Not exercise until the expiry date (European
option)
Ex ante Value
 Recorded expenses based on the fair value at the grant date
 Known as “ex ante value”
 With adjustment for the probability when employee
exercise based on the expected time to exercise
 Based on the past experience rather than the time to
expiry
 Fair market value estimated by Black/Scholes or others
formulas
Opposition to Ex ante Value
 Extended this matter to US congress
 Lower share prices
 Higher cost of capital
 Shortage of managerial talent
 Inadequate manager and employee
motivation
Adjusted Black/Scholes…
 Requires no cash flow
 Employees are diluted the interested of existing
shareholders by purchasing shares at a discount
 Opportunity costs = ex post value
 Example
 Ex ante is the present value of the ex post value
Adjusted Black/Scholes…
 Increase in relevancy
 Decrease in reliability
 Decrease in earning due to the increase in
expenses
 Better prediction of the future cash flows
Huddart (1994)
 Employee’s optional exercise strategy
 Assumptions: no dividends and no motivation
impact
 Claimed that Black/Scholes formula is indeed
overstated the fair value of the an ESO at the
grant date
 Assuming the option is heard to expiry date
 Two circumstances lead to exercising the option early
Huddart : Early-Exercise
 If the ESO is slightly-in-money (probability of payoff
might be zero)
 Time to maturity is short
 Employees are required to hold the share that acquired
 Risk averse employees might exercise the options early
 If the ESO is deep-in-money (probability of payoff is
high)
 Time to maturity is short
 Risk averse employees might be more likely to sell the
shares and buy something less risky to invest
Huddart: Empirical Studies
 8 large U.S. corporations over a 10-year period
 Early time to expiration
 Whether the options are in-the-money or not
 Other studied => same result
 Hall and Murphy (2002), Different approaches
 Marquard (2002), 966 options, 57 companies, 21
years
 Governance Body of Accounting Proposed to use the
expected time to exercise as suppose to expiry date
Huddart Conclusion
ESO fair value maybe unreliable because of the
upward bias and possible error and bias in estimating
the timing of employee’s early exercise decision
Tactic to Manipulate Share Prices
 Pump and dump: management intervention to increase the
share price temporally
 Studied: Bartov and Mohanram (2004), 1218 US, 9 years
 Scheduled grant dates options
 BN (Bad news), lower the share prices, thus lower the exercise
price
 Studied: Aboody and Kasznik (2000)
 Unscheduled grant dates
 Studied: Baker, Collins and Reitenga (2009)
 Lower earning: Write off large assets / accrued large ceiling test
Tactic to Manipulate Share Prices
 “Spring loading”, Unscheduled ESOs
 CEO would pressure compensation committees to grant
unscheduled ESOs shortly before good news
 Studied: Yermack (1997)
 “Late timing”, backdating of ESO awards to be lower than the
grant date
 Intrinsic value was positive, violate GAAP and SEC
 Studied: Bernil and Jarrell (2009), 129 firms
Outcome
 Affective in 2005, SFAS 123 R, IFRS 2 of the IASB
required the firm to expense the ex ante ESO
cost
 Resulted in a great reduction in the usage of
ESOs compensation device
 From 2000 to 2005, ESOs fell from 104 billions
to only 30 billions
Relationship between ESMT and
Economic Consequences
 ESMT doesn’t work if accounting policies changes
don’t impact underlying profitability and cash flow
 APs are matter even without the cash flow effects
 APs have the potential real management decisions
Positive Accounting Theory
Outline of PAT
 Concept
 Maximizing firms’ prospects
for survival
 Nexus of the contracts they have
entered into
Positive Accounting Theory
Outline of PAT
 Choosing APs -- need for minimize the contract
costs
 Problem of attaining efficient corporate
governance
 Changing circumstances require managers to have
flexibility in choosing APs
 Wouldn’t tell individuals or what they should do
Positive Accounting Theory
Three Hypotheses
(1) Bonus plan hypothesis
(2) Debt covenant hypothesis
(3) Political cost hypothesis
Positive Accounting Theory
Three Hypotheses
(1)
Bonus plan hypothesis

Concept

The hypothesis seems reasonable

If manager is risk-averse – smooth reported earning comes
out
Positive Accounting Theory
Three Hypotheses
(2) Debt covenant hypothesis
 Concept
 Why we do this hypothesis?
 The manager may object to accounting policies that
increase earnings volatility
Positive Accounting Theory
Three Hypotheses
(3) Political cost hypothesis
 Concept
 It introduces a concept into accounting political choice
 Firms may face political costs at particular points in time
Conclusion
They are important component of PAT
and can be interpreted from an efficient
contracting or stewardship perspective
Efficient Contracting and Conservative Accounting
 CA requires a high degree of verification before making a
legal claim to any profit
 The questions about conservative accounting in debt
contracts are raised
 The demand for conservative accounting may decrease
Recap
1. What are the three hypotheses under PAT?
2. Could you generally state the concept of PAT?
3. Under the hypothesis, why do the manager object
to accounting policies when the probability of
earnings volatility is increase?
Empirical PAT Research
 Bonus plan hypothesis – Healy 1985
 Dept covenant hypothesis – Dichev and Skinner 2002
 Covenant slack – difference between firm’s actual current ratio
at the end of quarter and current ratio firm is required to
maintain under agreement
 Zero or positive slack
 Initial violations
 Political cost hypothesis – Jones 1991
 International Trade Commission (ITC)
 Lower reported net income
Political Cost Hypothesis – Jones 1991
 Discretionary accruals
 Increasing amortization charges
 Recording excessive liabilities for product guarantees,
contingencies, and rebates
 Recording generous provisions for doubtful accounts and
obsolescence of inventories
 Calculating firm’s total accruals for the year:
 Change in non-cash working capital for the year from the
comparative balance sheets, plus amortization expense
 Discretionary versus non-discretionary
Regression Equation Prior to ITC
Tajt = αj + β1jΔREVjt + β2jPPEjt + Єjt
TAjt = total accruals for firm j in year t
ΔREVjt = revenues for firm j in year t less revenues for year t -1
PPEjt = gross property, plant, and equipment for firm j in year t
Єjt = a residual term that captures all impacts on TAjt other than
those from ΔREVjt and PPEjt
αj, β1j, and β2j are constants
Regression Equation During ITC
Ujp = TAjp - (αj + β1jΔREVjp + β2jPPEjp)
p is the year of investigation
TAjp is firm j’s total accruals for this year
Quantity in brackets = non-discretionary accruals for the year
Ujp = an estimate of discretionary accruals for year p for firm j
Jones (1991)
 Expected:
 Ujp will be negative
 firm is using discretionary accruals to reduce reported
net income
 Results:
 Discretionary accruals were significantly negative in
the ITC investigation years
 Chose accrual policies so as to improve their case
Opportunistic Versus Efficient
Contracting
 Opportunistic form
 Maximize own expected utility
 Efficiency form
 Compensation contracts and internal control systems
limit opportunism
 Motivate managers to control costs
 Benefits the firm and its shareholders
Opportunism or Efficiency
 Mian and Smith Study
 Christie and Zimmerman (1994)
 Income-increasing
 Takeover targets
 Dechow (1994)
 Net income more highly associated with returns than cash
flow
 Dichev and Skinner (2002)
 Variability over time of each firm’s covenant ratios
Opportunism or Efficiency Continued
 Guay (1999)
 Studied derivatives activities
 Reduce firm-specific price risks
 Take on other firm-specific risks that are in
the shareholders’ interests
 R&D, exploration, and new investment
Guay (1999)
 Hedging is consistent with efficient contracting
 Firms experienced a significant reduction in several measures
of firm risk relative to a control sample of firms that did not
use derivatives
 Consistency between type of risk exposure and type of
hedging instrument used.
 Interest rate swaps = agreement between two parties where
one stream of future interest payments is exchanged for
another based on a specified principal amount.
Opportunism or Efficiency Continued
 Hope and Thomas Study
 Multinational firms under SFAS 131
 Disclose foreign earnings
 By geographic area is voluntary
 Increased foreign sales
 Decreased total foreign earnings
 “Empire building” – increase firm size; growing firm
 Behaving opportunistically
Opportunism or Efficiency Continued
 Armstrong, Jagolinzer, and Larcker (AJL) – 2010
 Efficient contracting
 CEO’s “portfolio delta”
 Change in value of CEO’s holdings of stock and options
following a $1 change in share price
 Identified similar firms
 CEO’s had differing portfolio delta
 No evidence high portfolio delta cause opportunistic
behaviour
 Therefore, efficient contracting
Conclusions on Economic Consequences and PAT
 Accounting policies matter
 PAT understands and predicts accounting policy choices
 Minimize costs
 Determined by organizational structure (determined by
environment)
 Large set of accounting policies is efficient
 New standards interfering and management reactions
 Aligning management and shareholders’ interests
eToys Inc.: A Case Examining
Pro Forma Financial Reports,
Analysts’ Forecasts & Going
Concern Disclosures
Case Overview
 Internet toy company that was modelled after Amazon
 Pubic in 1999 & lost $190M in 2000 by spending more than they
earned
 Important Issues:
 Cost Control
 Recording Acquisitions & Goodwill
 Raising Capital
 Going Concern
 Press Releases using Pro Forma
 Analysts’ Forecasts
The Early Years (1997-March 2000)
 Toby Lenk – Economics Graduate - Walt
Disney – 9 years
 Followed model for Amazon & Barnes/Nobel
to have online only toy store
 Advantage: first to have online toy website
 Revenue: 500K to 30M (Loss?)
 Acquired BabyCenter – July 1 1999
 Media perception impacts earnings
 Major stock value decrease
Discussion: Analysis of Financial Statements
The Final Year (April 2000-March 2001)
 Ernst & Young gave eToys clean
audit opinion YE March 2000
 Leased 2 new distribution centres
in April 2000 – Cost: 95% of total
revenue
 Strategic issues
 Not efficient distribution
 Major stock price decrease
 Sold segments of company by
various competitors
Discussion: Essential Operating Decisions
 Audit decision made by EY?
 Unqualified, Clean Opinion
 Agree/Disagree?
 Expenditures vs. Revenue
 Spending more than earned! How much?
 Cash Shortages
 Led to bankruptcy?
 How to avoid?
Pro Forma Financial Statements &
Accounting For Goodwill
 eToys issued $190M (16M share)
of stock to acquire BabyCenter
 Goodwill of 184M recorded
(excess of price paid over net
asset value – amortized over 5
years
 Goodwill recorded consistent with
accounting standards in effect
Discussion: Pro Forma Disclosures
 Pro Forma Statements in annual reports to
provide “as if” information on acquisitions
 Pro Forma earnings in Reporting
 Calculation of Goodwill (for acquisitions)
 FASB 142 on Pro Forma footnote
disclosure
Quarterly Earnings Reports, Press
Releases & Analysts’ Forecasts
 eToys filed quarterly Q-10s with SEC - GAAP
 At the same time, different financial results issued
in press releases
 Press releases contain GAAP & Pro Forma –
however Pro Forma is compared to Analysts’
expectations
 Use of Pro Forma is linked to company's desire to
meet expectations
Discussion: Quarterly Earnings, Press
Releases & Analysts’
 GAAP Earnings vs. Pro Forma
Earnings
 EPS calculation in Pro Forma
 Relationship between analysts’
forecasts & Quarterly Pro
Forma Earnings
The End
Thank you
Questions?