Lecture 09

ACCT 332 Accounting Thought and Practice

Economic Consequences and Positive Accounting Theory

- Chapter
p 8
- Zeff (1978) The Rise of Economic Consequences
- Watts and Zimmerman (1990) Positive Accounting
Theory: A Ten Year Perspective

Objectives for Todays Class

What are economic consequences?
Ill t ti
Illustrations
off economic
i consequences?
?
What is the difference between positive and
normative theories?
What is positive accounting theory?
Midt
Midterm
results
lt

No difference in cost to the firm of reporting either

method

Background
Beaver (1973) said:

No cost to statement users in adjusting from one

method to the other
Therefore just report one method, with sufficient
footnote disclosure for adjustment, and let the market
interpret

First. Many reporting issues are trivial and do not warrant an expenditure of FASB resources.
First
resources The
properties of such issues are twofold: (1) There is essentially no difference in cost to the firm of
reporting either method. (2) There is essentially no cost to statement users in adjusting from one
method to the other. In such cases, there is a simple solution. Report one method, with sufficient
footnote disclosure to adjust from one to the other,
other and let the market interpret implications of the
data for security prices.

Implications:

if reporting/disclosure issues are trivial (i.e. how and where

an item is reported should not matter), then management
should be indifferent about these issues

That is obviously not the case management cares intensely

about these issues

Standard setting becomes a political issue even with

efficient securities markets.

Disclosure means that it is in the footnotes, and not recognized

What are Economic Consequences?

Accounting policies matter

Even if there is no direct effect on cash flows

Even if it is only about disclosure (in the footnotes) instead of recognition
They matter especially to managers

Until this chapter, managers have been regarded as

di i t
disinterested
t d spectators
t t
sitting
itti on the
th sidelines
id li
while
hil
standard-setters decide issues related to disclosure and
measurement
Zeff: Economic consequences is the impact of
accounting reports on the decision-making behavior of
business, government, unions, investors, and creditors.

Managers respond to accounting policies. E.g: ESOs v.s. Restricted stocks

IFRS 2 made firms switch to using more restricted stocks as opposed to ESOs

What are Economic Consequences?

Argument has been around since the beginning of time

(
(almost)
)

When the FASB required expensing of R&D in 1974 people

argued that it would lead to curtailment of R&D activity in
the U.S.

Economic consequences of R&D expensing

IAS 38 allows internal development costs to be
capitalized while GAAP requires research and
development costs to be expensed as incurred
incurred.

Economic Consequences in Action

Employee stock options (ESOs)

Prior to IFRS2 and SFAS 123R

Initially, when firms were required to start recognising

expenses on ESOs, managers chose to recognise it
based on the intrinsic value, which was often zero
because when granted, the market price was the exercise
price

No expense need be recorded if intrinsic value is zero

Expensing the fair value of ESOs
- Note: ESO expensing has no effect on cash flows, yet there
was strong manager resistance
- Increasing evidence of abuses of ESOs led to renewed
pressures to expense ESOs, despite strong manager
resistance
- Manager resistance overcome by standard setters IFRS
2, SFAS 123R
Similar examples with pensions, amortization of goodwill,
leases, fair value accounting, etc.

ESOs
1. Typically not transferable
2. Have to vest before they can be exercised
3. Can be exercised before they expire
4. If the employee leaves the company before the options vest, then the options are forfeited even if in the money

Why are there Economic Consequences?

Understanding economic consequences requires two levels

of analysis:

Accounting substance

How do alternative accounting choices affect

accounting numbers?

Economic effects

What are the institutional and economic factors that

suggest
gg
these alternative choices will have a real
effect on the firm?

Positive Accounting Theory (PAT): A Theory to Predict

Managers Accounting Policy Choices
Positive Accounting Theory is a theory that predicts how managers will maximise their own interest, or the
firms interest, relative to the firms compensation contracts, debt contracts, and political costs based on
relevant financial accounting variables.

Positive vs. Normative Theory

A normative theory tries to answer questions like:

What depreciation policy should companies follow?

More prescriptive

A positive theory would try to answer the question:

Why do companies follow different depreciation
policies?

More descriptive

Both approaches
pp
yyield useful results

Key Concepts under PAT

The firm is viewed as a collection of contracts

Contracts are many and varied: suppliers, lenders, customers,
etc.
Managementt picks
M
i k from
f
a menu off options
ti
to
t devise
d i the
th mostt
efficient contracts possible by minimising costs

Minimize among other things:

Costs of monitoring

managers monitor employees, SH monitor managers, and lenders monitor

the company

Costs
C
t off renegotiation
ti ti (b
(by having
h i b
built-in
ilt i flflexibility
ibilit ffor
unexpected events) with lenders, employees, suppliers
Moral hazard and adverse selection problems (aka
agency costs)
Other costs?
Penalty costs (e.g. fines), political costs
(e.g. taxes), default costs

E.g. Leases
Operating leases would reduce monitoring costs (shorter
timeframe), increase renegotiation costs (more transactions), but
increase agency cost (because its off-B/S)

Efficient Contracting

Think of a car dealer at a car shop

The company may give the dealer discretion to lower prices at
her discretion in order to boost sales of slow-moving cars
This flexibility leads to more efficiency in the sense that a local
store can react quickly to local conditions and does not tie up
senior managers
Dealers might favour their friends/relatives in discounts, even if sales would have occurred nonetheless.
Earnings management by dealers (e.g. at fiscal year/month ends to boost sales, show growth, etc.)
However, such a contract might boost monitoring costs, estimations costs, etc.

Efficient Contracting and Accounting

This is a more normative approach

Assume that standard setters mandate that all companies

have to set the allowance for doubtful accounts at 10% of A/R
This would not lead to efficient contracting since most
p
would be above/below this
companies

Would cause estimation risk, which would raise companies

cost of capital

Would not allow management to react to changing

circumstances

Thus, we need management judgment and estimates

Assumptions of PAT

Flexibility in accounting policies is attractive to the firm

Leads to more efficient contracting

(minimises costs)

Can adapt to new, unexpected circumstances without

h i tto renegotiate
having
ti t contracts
t t
The efficient contracting version of why accounting
policies matter

However, managers are rational (like investors)

Managers will
M
ill choose
h
accounting
ti policies
li i th
thatt are iin th
their
i
own best interests

A manager will only maximize profits if the manager

benefits
Problematic if there is a conflict between interests of
managers and investors

The Three Hypotheses of PAT

Managers choose accounting policies in their own best interests

Bonus plan hypothesis

Derives from managerial incentive contracts

Bonus is often based on accounting variables
Implies a stewardship role for financial reporting

Debt covenant hypothesis

Firms choose certain accounting policies to avoid violating certain debt

covenants

Derives from debt contracts

Debt covenants are often based on accounting variables

Political cost hypothesis

High profits may create political heat

which may result in higher tax rates

Managers
g
want to p
preserve flexibility
y to meet these objectives;
j
; will
E.g.: Apple holds a lot of cash on its B/S.
Can accuse them of cash hoarding for
fight proposals that limit flexibility
manager benefit (opportunistic). However

If managers choose policies to maximise the firms interests, its efficient contracting.
If, however, managers choose policies that maximise their own gains, its opportunistic contracting.
It is often hard, however, to distinguish between the two (can always interpret either way).

can also argue that they are trying to avoid

taxes payable if remitted

Managing Reported Earnings Through Discretionary

Accruals

Examples of discretionary accruals: discretionary component of

All
Allowance
ffor d
doubtful
btf l accounts
t
Warranty provisions
Provisions for reorganization, layoffs, restructuring, acquisitions
Valuation accounts for deferred tax assets

Note that discretionary accruals are not directly observable by

investors

Two Versions of PAT

(Key concept)

Efficient contracting version

Managers want to choose accounting policies to attain

corporate governance objectives of the firm

O
Opportunistic
t i ti version
i

Allowing flexibility can lead to opportunistic behavior

In the auto shop example, the local manager may use the
flexibility opportunistically

E
E.g.,
to
t give
i h
her ffriends
i d di
discounts
t ((morall h
hazard)
d)
You would expect that store managers would fight any
attempts to reduce such flexibility

In accounting, managers choose accounting policies for

their own benefit at the expense of shareholders

Conclusions

PAT helps us understand why accounting policies have

economic
i consequences
PAT supported by a large body of empirical evidence
PAT supports a corporate governance (stewardship)
role for financial reporting

Financial reporting, however, has not focused so much on stewardship (moral hazard) as it has on controlling adverse
selection

Group Questions

40 minutes to complete group questions

A i
Assignment
t off di
discussion-leading
i l di groups