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CHAPTER 8
Economic Consequences and Positive Accounting Theory
8.1 Overview
8.2 The Rise of Economic Consequences
8.2.1 Summary
8.3 Employee Stock Options
8.4 The Relationship Between Efficient Securities Market Theory and Economic
Consequences
8.5 The Positive Theory of Accounting
8.5.1 Outline of Positive Accounting Theory
8.5.2 The Three Hypotheses of Positive Accounting Theory
8.5.3 Empirical PAT Research
8.5.4 Distinguishing the Opportunistic and Efficient Contracting Versions of PAT
8.6 Conclusions on Economic Consequences and Positive Accounting Theory
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GENERAL OUTLINE OF CHAPTERS 8 AND 9
This chapter begins the third component of the text, oriented to a moral hazard problem.
The development includes, in Section 8.3, a specific illustration, using the controversy
over expensing of employee stock options (ESOs), that accounting policies matter. The
chapter also describes positive accounting theory and explains how the contracts that
firms enter into provide reasons why accounting policies matter, even in the absence of
cash flow effects. Chapter 9 digs more deeply into why important types of contracts,
namely, compensation and debt contracts, are frequently written in terms of accounting
variables. To do so, Chapter 9 draws on concepts of game theory and agency theory.
The demonstration of economic consequences in Chapter 8 is sometimes criticized as
lacking in theory. This is correct (the lack of theory is correct, not the criticism). While a
number of technical aspects of the fair value of ESOs are discussed in Section 8.3, no
theory is presented to predict why expensing of employee stock options is so
controversial. The primary purpose of the ESO illustration is simply to demonstrate that
economic consequences exist.
This is by design. My own view is that it is better to sneak up on theories such as
game theory and agency, by first motivating their relevance to a whole new class of
financial accounting and reporting problems. These problems arise because of
managements reaction to accounting policy choices imposed by standard setters. Thus,
the main purpose of the discussion of economic consequences is to build up student
interest in the underlying theories that follow, by showing that managers and others do
take accounting policy choice seriously, despite the implications of efficient securities
markets theory as described by Beaver (1973) (Section 4.3).
Having said this, there is no reason why instructors cannot cover the material in
Chapters 8 and 9 in any order, if so desired.
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LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES
1. To Develop the Concept of Economic Consequences
Here, I point out that the term economic consequences simply means that accounting
policy choice matters. I also emphasize that, at first glance, economic consequences fly
in the face of efficient securities market theory, which suggests that accounting policies
do not matter as long as they are disclosed and have no cash flow effects. At this point I
remind the class of Beavers 1973 paper reviewed in Section 4.3, which exemplifies
accountants early enthusiasm for efficient markets.
I usually leave the students to read Section 8.2 for themselves, describing Zeffs well-
known 1978 article.
2. To Illustrate Economic Consequences
I find that students are often unable to define the term economic consequences on
exams. Furthermore, it takes time for students to see the conflict implications of
accounting policy choice.
Consequently, I spend time on the ESO illustration in Section 8.3, usually based on
discussion of a media article. The expensing of ESOs is still topical, and certainly
illustrates the conflict aspects of accounting policy choice. Question 12 of this chapter
relates to these conflict issues. Parts of Question 4 of Chapter 13 could also be used in
this regard. Numerous media articles can serve as a basis for discussion of ESO issues,
for example:
The stockpot, The Economist, included in A special report on executive
pay, J anuary 18, 2007.
Former Brocade chief convicted for backdating stock options,
Bloomberg, August 8, 2007. Reprinted in The Globe and Mail, August 8,
2007. See also Theory in Practice vignette 8.1 in Section 8.3.
FASB looks likely to win stock options showdown, The Wall Street
Journal, reprinted in The Globe and Mail, March 9, 2004, page B10.
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A New Years stock option resolution, The Globe and Mail, December 22,
2003.
Microsoft to award stock, not options to employees, The Wall Street
Journal, reprinted in The Globe and Mail, J uly 9, 2003, page B10.
As an alternative to the economic consequences discussed in the text, instructors may
wish to use other examples. The problem material contains several of these, namely
accounting for OPEBs (Problem 8), foreign currency gains and losses (Problem 9), and
oil company excessive profits (Problem 10)
3. To Develop the Concept of a Positive Accounting Theory
My goals in developing what a positive theory is are quite limited. I emphasize that the
objective of such a theory is to explain and predict, in contrast with a normative theory,
for which the governing word is should, that is, a normative theory recommends what
should be done.
As an example of a positive theory, I interpret the simple micro-economic model of the
firm as such a theory, since most students will have taken a course in micro-economics.
I suggest that the role of this theory is to explain and predict firm behaviour, not to tell
managers what they should do. Furthermore, I argue that the model makes reasonable
predictions (at an aggregate level) even though it may not capture precisely how
managers make decisions. As an illustration, I ask what a firm would do if the price of
one of its raw materials was to rise, and argue that even though managers probably
dont go through the marginality calculations of the micro-economic model, the model
makes reasonably good predictions of the actions of the firm in response to the price
increase.
I also contrast the concept of a positive theory with the normative investor decision-
making theories of Chapter 3, which I interpret as prescribing how investors should
make investment decisions if they wish to maximize their expected utility.


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An important aspect of a positive theory of accounting is its assumption that managers
are rational. Again, I refer to the micro model of the firm and discuss with the class
whether the models implicit assumption that managers act so as to maximize firm
value is a reasonable one.
As is apparent from the foregoing, I tend to avoid philosophy of science issues of
positive accounting theory. Several excellent discussions are available for instructors
who wish to delve into these issues. These include Watts and Zimmerman themselves
(1986, Chapter 1; 1990). Demskis (1988) critique of positive accounting theory, and
Boland and Gordons (1992) discussion are also worth discussing in this regard.
4. To Introduce the Three Hypotheses of Positive Accounting Theory
Students usually find these three hypotheses quite intuitive and I usually only outline
them briefly in class, emphasizing that they predict the economic consequences
described earlier in the chapter.
5. To Distinguish the Opportunistic and Efficient Contracting Versions of PAT
These two versions of PAT provide a good opportunity to discuss manager motivation
and the extent to which it is aligned with shareholder interests.
The research designs to distinguish these two versions tend to be subtle. Instructors
who pursue these issues may wish to consult the Dichev and Skinner (2002), Dechow
(1994), Guay (1999), Subramanyam (1996) and/or Xie (2001) papers (these latter 2
papers are discussed in Chapter 11). The Subramanyam paper, in particular, contains
interesting evidence that managers on average use discretionary accruals efficiently (as
opposed to opportunistically). It also anticipates the question of whether earnings
management is good or bad, which is discussed in Chapter 11. However, as
Subramanyam points out, his results depend on the ability of the J ones model to
reasonably capture the discretionary portion of total accruals. Also, the results of Xie
(2001) raise questions about the extent to which Subramanyams findings support an
interpretation that earnings management is on balance good (see Section 11.5.2 for a
brief discussion).
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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS
1. A normative theory is a theory that prescribes how persons should behave in
order to accomplish a given objective. Examples include single-person decision
theory and the theory of investment, which lay down procedures for decision-
making under uncertainty when the decision makers objective is to maximize
expected utility.
A normative theory is judged by its consistency with underlying theories of
rational behaviour.
A positive theory is a theory that attempts to predict the results of individuals
actions. Such a theory does not profess to tell individuals what they should do. An
example of such a theory is the micro-economic theory of the firm, which predicts
how firm managers will react to changes in product and factor prices, technology,
etc. Another example is efficient securities market theory, which helps to predict
and explain the process of security price formation.
A positive theory is judged by the accuracy of its predictions. It need not capture
the actual thought processes of individuals, although good predictive ability helps
us to understand the reasons why individuals behave as they do.
2. Yes. Decision-making procedures will vary across individuals, so that it can be
difficult to predict the actions of any one person. However, a positive theory can
make good predictions at an aggregate level (i.e., aggregated across the actions
of a large number of individuals) if it captures in an unbiased manner the average
or long-run behaviour of decision makers. This is because individual
idiosyncrasies will tend to cancel out at an aggregate level. Thus, the micro-
economic theory of the firm may make good predictions of average firm
behaviour even though individual managers may not make decisions as the
model suggests. Also, efficient securities market theory can make good
predictions of security price response to new information even though all
individual investors do not necessarily make decisions as the theory of
investment prescribes.
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3. A firms susceptibility to political costs is often measured by its size, as proxied,
for example, by total balance sheet assets, sales or number of employees. This is
a reasonably valid measure of susceptibility to political costs, one reason being
that size is relatively easy to measure. Also, large firms tend to attract more
public and media attention, and may be held to a higher standard of social
responsibility than small firms.
However, size may also be correlated with other firm characteristics, such as
monopoly power, riskiness and corporate governance. Consequently, it is a noisy
and possibly biased measure of susceptibility. These other characteristics would
need to be controlled for when using size as a proxy for political costs.

4. a. Lev selected this date because of efficient securities market theory, which
predicts that if the market is going to react to the imposition of successful-efforts
accounting, it will do so at the earliest moment it becomes aware of this
possibility. While the exposure draft did not impose successful-efforts accounting
(this came later with the issuance of SFAS 19 on December 5, 1977), it was
apparently the first solid indication the market had that the FASB was leaning
towards successful-efforts accounting. In other words, the probability that
successful-efforts accounting would be imposed increased substantially on J uly
18, and this was sufficient to trigger an efficient market reaction to the expected
economic consequences.
b. According to PAT, the prospect of lower and more volatile reported profits
for the concerned firms will increase the likelihood of violation of debt covenants.
Alternatively, or in addition, lower and more volatile reported earnings will reduce
the expected utility of manager bonuses based on earnings. This could change
how management operates the company. For example, management might react
to the greater volatility of earnings under successful efforts accounting by
avoiding risky exploration programs, which would tend to lower program expected
values and returns.
Efficient securities market theory predicts that investors would respond to
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increased likelihood of covenant violation by bidding down share prices of
affected firms. Share prices would also be bid down by diversified investors if the
manager avoids risky exploration programs, since the effect is to lower expected
returns without decreasing investor risk (since diversified investors have already
diversified firm-specific risk away). Avoiding risky projects will tend to decrease
the likelihood of debt covenant violation, but it is unlikely to decrease it to levels
below those prior to SFAS 19. The net effect will then be a decrease in share
prices of oil and gas firms.
Also, efficient securities market theory explains the rapid (3 day) share price
reaction to the exposure draft. If an efficient market is going to react to an
information event, it will do so quickly.
c. If investors have limited attention, they may not process all available
information in a timely manner. That is, it may take them some time to figure out
and appreciate the economic consequences of switching to successful efforts. As
a result, a reaction to the exposure draft would be expected, but it would take
place over time as lower and more volatile earnings were reported, not on the day
the exposure draft was released.
An alternative answer is that if investors have limited attention they may not have
noticed the exposure draft at all, even though the exposure draft was announced
by the FASB and presumably was reported in the media. If so, there would be no
effect on share prices until some time after the effective date of the standard.
Herd behaviour may also explain the declines in price. Investors may have
noticed a fall in affected firms share prices (perhaps driven by rational investors
concerns about debt covenant and bonus plan considerations). They may have
then rushed to sell, further driving prices down.
d. To distinguish between these two hypotheses, the following procedures
could be applied:
Read the managerial compensation contract. Does it depend on reported
net income? If it does not, the bonus plan hypothesis does not explain the
negative securities market reaction.
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Read the debt contract. Does it contain covenants that depend on ratios
based on reported net income and/or equity? If not, the debt covenant
hypothesis does not explain the negative market reaction.
If the answer is no in both cases, neither hypothesis is driving the
market reaction.
If the answer is yes in one case and no in the other, or yes in both cases,
further tests are required:
(i) Calculate how close the firm is to violating debt covenant
ratios. The closer it is, the more likely it is that the debt covenant
hypothesis underlies the markets response, other things equal.
(ii) From the managerial compensation contract, determine what
proportion of the managers compensation comes from earnings-
based bonus. The higher it is, the more likely it is that the bonus
plan hypothesis underlies the markets reaction, other things equal.
If the firm is both close to violation of debt covenants and has a
high proportion of manager compensation from earnings-based bonus, it is
likely that both hypotheses are driving the negative share price reaction.
Note: the above assumes that you have access to the companys managerial
compensation and debt contracts. If not, matters are more complicated. The
debt-to-equity ratio is sometimes used as a proxy for closeness to covenant
constraints. Details of top manager compensation can be obtained from the
annual meeting proxy form, a public document mailed to shareholders.
Note: Instructors may wish to point out that in 1978 the SEC overrode SFAS 19
by Accounting Series Release 253 (1978). The FASB subsequently issued SFAS
25, allowing either method.
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5. Under the efficient contracting form of PAT, managers wish to minimize the firms
contracting costs. One such cost arises from the fact that unforeseen
circumstances may arise during the life of the contract. As an example, contracts
often depend on accounting variables such as reported net income or debt-to-
equity. Such contracts can be in force for a long time and it is difficult to anticipate
changes in GAAP that might take place over the life of the contract and allow for
them in the contract itself. As a result, if GAAP does change, this can affect the
amount of manager compensation and/or induce technical violation of debt
covenants, both of which can impose costs on the firm. However, the manager
may be able to work out from under these costs by managing accruals or
changing accounting policies. That is, allowing managers some flexibility to
choose from a set of accounting policies can reduce expected costs of contract
violation or renegotiation following from unforeseen state realizations.

Note: This illustrates the concept of an incomplete contract, that is, a contract
that does not anticipate all possible realizations of states of nature. The concept
of an incomplete contract is introduced formally in Section 9.8.2.
Under the opportunistic form of PAT, firm managers will prefer a set of
accounting policies from which to choose so as to be able to influence reported
net income and debt in their own interests. Then, they can use accounting policy
choice so as to maximize their bonuses, and to make life easier for themselves
by minimizing political costs or the probability of technical violation of debt
covenants.

6. The following accounting policy choices are suggestive of what could be done to
lower the probability of technical violation:
(i) Increase equity by increasing current reported earnings. This can be done
by managing discretionary accruals. Possibilities include:
Minimize provisions for doubtful accounts receivable and for warranties.
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If LIFO inventory method is allowed under GAAP and the firm uses this
method, and if prices have risen since adoption, run down LIFO cost
layers, or switch to FIFO. Both of these possibilities have problems,
however. Running down inventory levels may interfere with operations.
Also, if the firm is in a jurisdiction where LIFO is allowed for tax purposes
and prices are rising, increased taxes resulting from switching to FIFO
would reduce cash flows.
Lengthen estimates of useful lives of capital assets, and/or, if currently
using accelerated amortization, perhaps switch to straight line.
Change pension plan and other postretirement benefits assumptions. For
example, the rate of interest used to discount future obligations, and/or the
expected rate of return on plan assets, could be raised.
Delay adoption of new income-decreasing accounting standards, or speed
up adoption of income-increasing ones, to extent allowed by the standard.
(ii) Reclassify long-term liabilities as equity:
Argue that future income tax liabilities be excluded from debt for purposes
of the debt/equity ratio calculation.
If allowed by GAAP, include minority interest in subsidiary companies as
part of shareholders equity.
(iii) Increase equity by increasing assets:
Defer advertising and R&D costs, to extent allowed by GAAP. For
example, IFRS 3 allows capitalization of development costs.
(iv) Decrease volatility of reported net income, hence of equity:
If an oil and gas company, switch from successful efforts accounting to full
cost.
To extent possible, include unrealized gains and losses in other
comprehensive income (SFAS 130) or shareholders equity (IFRS), if
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allowed by GAAP. For example, designate as many hedges as possible
under IAS 39 or SFAS 133, and include as many securities as possible in
the available for sale category under these standards.
(v) Other possibilities include:
Cling to historical-cost-based accounting to the extent allowed by GAAP,
as opposed to adopting more volatile fair value accounting.
Trigger extraordinary gains and losses, such as sales of capital assets and
subsidiary companies, to compensate for earnings shocks. These are
included in operating income (see Section 5.5 for Section 3480 of the
CICA Handbook. In the United States, see APB 30). Such sales could
possibly hamper the firms real operations, however.
If unrealized gains are available, and if GAAP does not require fair value
accounting for the related assets and liabilities, use the fair value option of
IAS 39 or SFAS 159 if possible to trigger recording of the gain. Recording
a gain on long-term debt following a credit downgrade is an example of the
use of this tactic.
7. Conservative accounting, by lowering accounts receivable, current earnings, and
shareholders equity decreases working capital, increases the debt-to-equity ratio,
and lowers times interest earned, thereby tightening debt covenant constraints.
As a result, the likelihood of excessive dividend payments is reduced. This
increases cash available for interest and debt repayments. Lenders anticipate this
and are willing to accept lower interest rates. Thus, conservative accounting
contributes to efficient debt contracts.
8. a. This would depend on the tax deductibility of the accruals for other
postretirement benefits. If these are not deductible, there would be no effect of
OPEB standards on cash flows following their adoption, to the extent the
company continues to pay these benefits.
If the accruals are tax deductible, this would increase after-tax cash flows, at least
in the short run. After a few years, when the new accounting approaches steady
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state, accruals and cash payments for benefits may be approximately equal, in
which case the after-tax cash flow effects would be minimal.
b. The answer is not completely clear, since the OPEB standards do not
increase amounts of benefits.
One possible reason is that firms did not realize how much other postretirement
benefits were costing them until the expenses generated by the new accrual
accounting became apparent.
Another possibility is that firms were quite aware of these costs and were using
the major liabilities recorded under the OPEB standards as an excuse to cut
benefits. Then, the benefit cuts can be blamed on the accountants rather than the
firm itself.
c. Share price would rise, given efficient securities markets, if it became apparent
that firms' cash flows and future reported profitability would increase. This could result
from a cut in benefits following implementation of the OPEB standards.
Share price would also rise if the amount of the accrued OPEB obligation was less
than the market had expected.

9. a. From an efficient securities market perspective, the EnCana manager
need not be concerned. Given full disclosure, the efficient market will look
through the increased earnings volatility and realize that there is no effect on
cash flows. Furthermore, prior to the 2002 changes in Section 1650, the market
would have known the amounts of foreign exchange gains and losses from
financial statement information about U.S. denominated debt outstanding and
knowledge about exchange ratesthe 2002 changes do not add to what the
market already knows in this regard. Consequently, there should be no effect on
share prices or the firms cost of capital. Thus there should be no effect on its
ability to lock in new financing at favourable rates.

b. From the perspective of positive accounting theory, The EnCana manager
may be correct to be concerned. Increased earnings volatility increases the
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probability of violation of debt covenants based on net income (such as debt-to-
equity ratio and times interest earned), other things equal. Lenders will be
concerned about the increased probability of violation and may be reluctant to
lend at current rates. The firm may have to ask for less stringent covenants in
new lending agreements, to keep the probability of violation at reasonable levels.
However, less stringent covenants reduce lenders protection, again leading to
higher rates.

Manager concern would also arise if his/her compensation depended on reported
net income. Then, increased earnings volatility may lead to increased
compensation volatility. This reduces the expected utility of compensation for risk
averse managers.

Manager concerns would be enhanced if the set of allowable accounting policies
available to the manager restricted his/her ability to manage earnings to offset
their increased volatility.

10. a. The bonus plan and debt covenant hypotheses predict that oil companies
will want to report high profits sooner rather than later. This is because the
managers of these companies would prefer high bonuses now rather than some
time in the future, other things equal, since the present value of a dollar of bonus
is higher the sooner it is received. Also, higher reported profits will reduce the
probability of technical default on debt covenants. Thus, the oil companies would
be predicted to increase the price of gasoline and to avoid excessive reserves for
environmental costs, maintenance and legal claims.
b. According to the political cost hypothesis, the largest oil companies would
be most concerned because big companies are more in the public eye and,
because of their size and economic power, they tend to attract media and political
attention. Also, they may be under greater pressure to behave responsibly than
smaller firms that attract little or no public attention. Thus, big oil companies are
the ones most likely to suffer adverse consequences such as higher taxes if they
take advantage of the rising price of crude oil to earn high profits.
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c. LIFO would be most effective in holding down profits. On a rising market
for crude oil, and assuming shortages do not unduly deplete inventory levels,
LIFO will report a higher cost of gasoline sales than FIFO or average cost
methods.
d. Efficient securities markets theory predicts that the strategy would not be
effective, given full disclosure, since the securities market would see through the
accounting policy choices that hold down reported profits. Indeed, the oil
companies may well end up subject to greater political costs than if they had not
used accounting policy choice to reduce reported profits. They would be open to
charges of trying to hide their excess profits.
However, several arguments suggest that the policy may be effective in reducing
political pressure:
Given the theory and evidence that securities markets are not fully
efficient, the market may not fully appreciate the extent to which
accounting policy choices are driving down profits, particularly if gasoline
prices are being held down at the same time.
Since the amounts and timing of the various provisions are subject to
management determination of amounts and timing, they are included in
operations rather than extraordinary items. Then, it may be possible for the
companies to disguise their strategy by less than full disclosure. For
example, it is not clear that provisions for maintenance programs would
need complete disclosure. Even with full disclosure, good arguments can
be made for environmental, maintenance and legal claims provisions,
independently of the price of crude oil.
The efficient markets hypothesis applies primarily to investor and securities
price behaviour. It is less clear that politicians and the general public would
appreciate the impact of accounting policy choices on reported profits. One
reason is simply that they may be less knowledgeable about accounting
matters. However, a more fundamental reason is that they may have less
incentive to dig into reported profits. Individual consumers may not be
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sufficiently affected that they will bother to go on the warpath. Politicians
may be content with the appearance of lower profits if the public is not
aroused, since otherwise they would have to confront a large and powerful
industry.
Thus, the strategy may well be effective. Any increase in the price of
gasoline can be blamed on events outside the oil companies control and,
if reported profits do not significantly increase, politicians and the public
may accept the higher prices.
11. a. Firms with large ESO plans buy back their stock on the market to counter
the dilution of shareholder interests that ESOs cause. Since the exercise price of
ESOs is below the market price of the underlying stock, their issuance creates an
opportunity loss for existing shareholders, forcing down share price. While the
buyback does not directly affect net income, the reduction in number of shares
outstanding creates an increase in earnings per share, thereby exerting upward
pressure on share price.
Purchasing shares on the open market also reduces company cash. But,
remaining shareholders will benefit to the extent share price does not fall by the
full amount of cash paid out. For example, the company may have surplus cash
and retaining it in the company at low return constitutes a drag on stock price. If
underutilized cash is paid out, the market would anticipate a further increase in
earnings per share in future.
b. Yes, you would be concerned. The increase in earnings per share
resulting from this tactic may be transitory, since share prices tend to increase
over time. Therefore, the firm is quite likely to have to pay more than current
share price when it actually buys its shares later, exerting downward pressure on
future earnings per share. If so, and if you bought shares on the strength of the
apparent earnings per share increase, share price may suffer later.
12. Relevant information helps investors to estimate future cash flows from their
investments. The relevance of Black/Scholes measures of ESO fair value is high,
because of the dilution that ESOs create. The company receives less cash from
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issuing ESOs than it would receive if the shares were sold at their market value.
Thus, there is less capital on which to earn a return, reducing future earnings
accordingly. Also, future dividends are spread over more shares. Expensing
ESOs lowers current reported net income, thereby anticipating the lower per
share dividends to investors that ESOs create.
Reliable information faithfully represents without bias what it is intended to
represent, and is verifiable. The reliability of Black/Scholes as a measure of ESO
cost is low:
Like any model, Black/Scholes requires parameter inputs, including, in
particular, variability of share price and time to expiration. These inputs are
subject to error and bias, and may lack verifiability.
Since Black/Scholes applies to European options, whereas ESOs are
American options, it is necessary to estimate ESO holders exercise
strategy. The expected time to exercise that results can be substituted for
the expiry date in the Black/Scholes formula. However, this estimate is
subject to error and bias, and may not be verifiable, particularly for firms
with little past ESO history and/or few employees receiving ESOs.
This point is based on Note 3 of this chapter, and should be expected only
from students with mathematical and statistical training:
The Black/Scholes option value is often concave in time to expiry,
particularly if issued with zero intrinsic value. Then, even if expected time
to exercise is accurate, use of this expected value as time to expiry in the
Black/Scholes formula will produce upwardly biased estimates of ESO
value.
b. Some people claim that the cost of ESOs is zero because the firm does
not have to pay the recipients for their employee services. Indeed, some cash
(i.e., the exercise price) is received instead.
These claims are incorrect because they ignore the concept of opportunity cost.
Issuance of shares by means of ESOs dilutes the equity of existing shareholders
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because the shares are issued at less than their market value. This cost shows
up as less-than-proportionate future dividends received by existing shareholders.
Ignoring this cost understates the cost of the firms employee compensation.
c. Firms may oppose the expensing of ESOs for the following reasons:
Economic consequences. The bonus plan and debt covenant
hypotheses of PAT predict that firms with manager compensation
and debt covenants that are based on earnings and other financial
statement variables will object to accounting policies that lower
reported net income.
Securities market inefficiency. To the extent that securities markets
are not fully efficient, firms share prices may fall and costs of capital
rise as a result of lower reported earnings.
Relevance versus reliability. Firms may believe that the increase in
relevance from expensing ESOs is outweighed by low reliability of
ESO cost estimates. This is particularly the case if Black/Scholes (or
other estimates of ESO cost) have an upward bias.
d. A firm may voluntarily adopt ESO expensing for the following reasons:
Political cost hypothesis. Very large firms may wish to lower the
amount of reported net income so as to reduce political visibility. The
voluntary adopters given in the question, such as Microsoft, are very
large.
Little impact on reported net income. Some firms use ESOs more
than others. Firms that do not issue very many ESOs can afford the
impact of expensing. This argument is enhanced if securities markets
are not fully efficient.
To change compensation policy. A firm may want to reduce or
eliminate its use of ESOs, particularly since they have become
questionable compensation devices. This is due to numerous
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instances where ESOs may have driven dysfunctional management
practices leading to financial reporting scandals (e.g., Enron,
WorldCom, backdating). Expensing ESOs may be a first step to
reducing ESO use, since the firm can better point to the fact that
ESOs do indeed have a cost.
Reputation. Some firms may want to build up a reputation for
transparency and full disclosure. Voluntary adoption of improved
financial reporting policies provides a signal in this regard.
Note: Reputation and signalling are not fully discussed in the text
to this point. Nevertheless, this point, if made, should be accepted.


13. a. Yes, the accusations are consistent with the findings of Aboody and
Kasznik (2000), assuming that ESO awards were scheduled in advance so that
the former Big Bear CEO knew they were coming, or had enough control over the
compensation committee of the Board that he could control ESO timing. The
former CEO could have chosen to feed the bad news to the market shortly before
the ESO award date. Then, at time of award, share price would be low. By setting
the ESO exercise price equal to share price at the grant date, the options would
greatly increase in value when news that Blue Range had sprung back became
known. The CEO could then exercise the options and reap a profit by holding or
selling the acquired shares.
b. This episode is consistent with the opportunistic version of PAT. The CEO
is charged with using his inside information to manipulate the firms stock price
for his own advantage, at the expense of shareholders, whose interests are
diluted by the ESO issue.

c. Not necessarily. Deep-in-the-money ESOs are likely to be exercised early
according to Huddarts (1994) analysis and the empirical results of Huddart and
Lang (1996). Then, using the ESO expiry date in Black/Scholes overstates option
value. If, as is the case for ESOs, expected time to exercise is used in the
Black/Scholes formula instead of the expiry date, the resulting value is still
unreliable, due to possible error or bias in estimates of parameter inputs such as
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share price variability and time to exercise.


14. a. The answer depends on my risk aversion, my beliefs about the state of the
economy, and the investment alternatives available to me.

With respect to investment alternatives, I would be willing to invest in covenant-
lite debt to the extent that safer debt, such as government debt and debt issued
with covenants attached, offered a return less than the return offered on the
covenant-lite tranches. I would be willing to bear greater risk in order to obtain a
higher return.

With respect to the state of the economy, the higher are my beliefs that the state
is high, the more likely that I would be willing to invest in covenant-lite debt. This
is because the higher the state of the economy, the less likely that firms will
default on their debt, other things equal.

With respect to my risk aversion, the greater it is, the less likely that I would be
willing to sacrifice greater security on government and covenant-attached debt for
a higher return. However, my risk will be reduced to the extent the tranche of
covenant-lite debt in which I invest is spread over a large number of firms and
different industries. Risk will be further reduced to the extent the tranche is
protected by CDS.

b. The moral hazard problem is that if debt has no covenants attached, the
firm issuing such debt has little incentive to protect the interests of the
debtholders by maintaining ratios such as debt-to-equity and interest coverage,
by protecting working capital and equity by maintaining specified levels of these
items. Payment of excessive dividends, for example, would reduce both.

Furthermore, purchasers of the covenant-lite debt may have little motivation to
monitor firm performance. The bank that buys the debt in the first place will
typically package and resell it quickly, thereby passing the default risk on to the
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tranche purchasers. The tranche purchasers are farther removed from the firms
in their tranche, and may not even know what firms are included. Even if they do,
their risk is spread, reducing motivation to monitor performance of specific firms,
particularly if CDSs are involved.

c. Covenant-lite debt will reduce the validity of the debt covenant hypothesis,
since, without covenants, firm managers have little need to choose accounting
policies to reduce the probability of covenant violation.

d. A downside to CDS is that there may be a downturn in the economy. If this
downturn is serious, many firms in the tranche may default on their debt,
particularly in view of the moral hazard problem discussed in c. Then, interest
and principal payments to tranche holders will be reduced. Furthermore, if
enough firms default, even the counterparties of CDSs may be unable to meet
their obligations. These concerns are increased since tranche investments lack
transparency--investors are unlikely to know which firms and CDS parties are
included in the tranche. It then it becomes particularly difficult to determine
tranche fair value. Lack of information about tranche fair value would likely cause
the market to assume a worst case scenario, and refuse to buy should you wish
to sell your investment, except at a greatly discounted price. This would seriously
reduce the liquidity of your tranche investments.

Investors may be particularly insensitive to the possibility of a downturn in the
economy if they are subject to behavioural biases such as representativeness,
overconfidence and self-attribution bias.