Economic
Consequences
and Positive
Accounting Theory
Financial Accounting Theory:
Chapter 8
Cathy Phung
Jaspreet Sidhu
Neil Ganatra
Yashar Davarpanah
1
2
3
4
• Economic Consequences
• Employee Stock Options
• Positive Accounting Theory
• Summary
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
Efficient market
Theory
Economic
Consequences
Policy changes do not
affect cash flows and
market value of firm
Policy changes affect
aspects of financial
statements i.e net
income
Thus, the policy
change is irrelevant
under this theory
Despite lack of affect
on cash flows, policy
changes DO mater
Importance of Economic
Consequences
1)
2)
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:
1) Groups that had rarely shown any interest in
the setting of accounting standards began
to intervene actively and powerfully
2) 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
1)
2)
Retain creditability – set up accounting
policies in accordance with financial
accounting models
No clear theory prescribing what
policies to be used – allowing for thirdparties to intervene and argue for their
preferred accounting policies
Delicate Balance Act
Response to challenges
1)
2)
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)
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
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
1.
2.
3.
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...
1.
2.
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
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
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 deepin-the-money  early exercise more likely
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
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.
Opportunistic and Efficient
Contracting Versions of PAT
 The
three hypotheses of PAT are stated:
 Efficiency
 Compensation
contracts and internal control systems,
governance, limit opportunism and motivate managers
to choose accounting policies to control contracting
costs.
Opportunistic and Efficient
Contracting Versions of PAT
 Christie


and Zimmerman:
Concluded if opportunistic accounting policy is taking
place, it would be most rampant in firms that
subsequently were taken over, as existing
management struggled to fend of the takeover bid by
maximizing reported net income and financial
position.
If accruals were to reflect efficiency, net income
would be associated with returns rather than cash
flow.
Opportunistic and Efficient
Contracting Versions of PAT
 Portfolio


Delta:
A CEO’s temptation to behave opportunistically by
his/her portfolio delta is the change in value of his/her
holdings of company stock and options following a $1
change in the companies share price.
The higher the portfolio delta suggests the manager
has more to gain from opportunistic behaviour
designed to increase share price.
Opportunistic and Efficient
Contracting Versions of PAT


To understand managements interests in
financial reporting, it is necessary to
appreciate the concept of economic
consequences, namely the role of Positive
Accounting Theory.
PAT attempts to understand and predict firms’
accounting policy choices.

Asserts that’s accounting policy choice is part of
the firms overall need to minimize its costs of
capital and other contracting costs.
Opportunistic and Efficient
Contracting Versions of PAT
 Accounting
policy choice is part of the overall
process of corporate governance
 Efficient for management to have a set of
accounting policies to choose from, does not need
to be uniquely specialized.
Conclusions
 Efficiency

Perspective
Large set of available policies enables the firm to
respond efficiently to unforeseen events that affect
existing contracts
 Opportunistic

Perspective
large set of available policies gives management the
ability to select accounting policies for its own
advantage.
Conclusions
 Where
there is evidence of manager opportunism,
there is also evidence of efficient contracting:

Thus it suggests that it is possible to align managers
interests with those of shareholders.
Case Study: eToys Inc.
-
-
-
In 1996, founded eToys Inc., using the business
model used by Amazon
After their IPO, the company reached a peak
market capitalization of $10.3 billion (2.5 times
that of Toys “R” Us)
Their distribution centers were not able to
keep up with large their large growth resulting
in costs > revenue and orders not being
shipped on time
Their stocks fell from a high of $86 to $0.09 per
share in 2001 - bankruptcy