Scott 6e PPT ch08

Financial Accounting Theory
Sixth Edition
William R. Scott
Chapter 8
Economic Consequences and

Positive Accounting Theory
8-1
Copyright © 2012 Pearson Canada Inc
Chapter 8
Economic Consequences and Positive Accounting Theory
8-2
What Are Economic Consequences?
• Answer: Accounting policies matter

– Especially to managers
– Even if no effect on cash flows
• Contrasts with efficient securities market theory
– Accounting policies do not matter if no cash flow
effects, and policies disclosed
8-3
8.3, 8.4 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
8-4
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
» Continued
8-5
(continued)
• June, 1993
– FASB exposure draft to expense ESOs
• Intense opposition from managers
• Claimed reasons for manager opposition
– Lower reported net income
– Low reliability
• FASB backs down, December, 1994

– SFAS 123
• May report ESO expense as supplementary information
8-6
(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
» Continued
8-7
(continued)
• Increasing evidence of abuses led to renewed

pressures to expense ESOs, despite continued strong
manager resistance
– Manager resistance overcome 2005
• IFRS 2, SFAS 123R
» Continued
8-8
(continued)
• Why such strong manager resistance to ESO

expensing, particularly since:
– No effect on cash flows
– ESO expense already reported as supplementary
information
• Market efficiency?
– Possible reasons
• 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?
• Rejection of market efficiency?
8-9
8.5 Positive Accounting Theory
(PAT)
• The firm as a nexus of contracts

• Emphasizes the impact of contracting costs on
firm and manager behaviour
– Good corporate governance requires efficient contracts
• I.e., contracts that minimize contracting costs
– Accounting policies should be chosen to minimize
contracting costs
>> Continued
8 - 10
Positive Accounting Theory (continued)
• Assumptions of PAT
– Managers are rational (like investors)
– Efficient securities markets
>> Continued
8 - 11
• 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’
» Continued
8 - 12
• Opportunistic v. efficient contracting view of the

three hypotheses
– Opportunistic view
• Managers want to choose accounting policies to
maximize their own expected utility
– Efficient contracting view
• Managers want to choose accounting policies to attain
efficient contracting
>> Continued
8 - 13
• Efficient contracting and conservative accounting

– Investors demand timely recognition of losses
– Conservative accounting (conditional conservatism) is
timely in loss recognition
– Debtholder demand for conservative accounting
• Conservatism limits dividends, increasing debtholder
security
• Conservatism gives debtholders early warning of financial
distress
• Debtholders lower required interest rate, increasing debt
contract efficiency
8 - 14
• Empirical PAT research

– Debt covenant hypothesis
• Dichev & Skinner (2002)
– Political cost hypothesis
• Jones (1991)
– Much empirical PAT research requires an estimate of
discretionary accruals
>> Continued
8 - 15
• Concept of discretionary accruals

– NI = OCF ± net accruals
= OCF ± net non-discretionary accruals ± net
– Examples of discretionary accruals
• Allowance for doubtful accounts
• Warranty provisions
• Provisions for reorganization, layoffs, restructuring
• Contract completion costs
– Note discretionary accruals not directly observable by
researcher
8 - 16
• The Jones model (1991) to estimate discretionary

accruals
– TAjt = αj + β1jΔREVjt + ß2jPPEjt + εjt
– Estimate by least-squares regression from past firm data

– Use estimated equation to predict current period non-
– Discretionary accruals = actual – predicted
– This model, and extensions of it, widely used in
subsequent research
>> Continued
8 - 17
• Distinguishing opportunistic v. efficiency
versions of PAT
– Are managers’ accounting policy choices (e.g.,
amounts of discretionary accruals) driven by
• Opportunism: manager benefits at expense of investors
• Efficiency: manager chooses accounting policies to
maximize contract efficiency
» Continued
8 - 18
• Distinguishing opportunistic v. efficiency

versions of PAT (continued)
– Some research consistent with contracting efficiency
• Mian & Smith (1990)
– Consolidated financial statements
• Dechow (1994)
– Net income more highly associated than cash flows with
share returns
• Dichev & Skinner (2002)
– Debt covenants
» Continued
8 - 19
– Some research consistent with contracting efficiency,
(continued)
• Dechow (1994)
– Net income more highly associated than cash flows with
share returns
• Guay (1999)
– Limit firm risk using derivatives
• Armstrong, Jagolinzer, and Larcker (2010)
– No evidence that opportunistic behaviour increases with
manager portfolio delta
– Conclude: significant evidence for efficiency version
8 - 20
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
8 - 21

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Scott 6e PPT ch08

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Financial Accounting Theory

Economic Consequences and

• Answer: Accounting policies matter

• Measuring ESO expense

• FASB backs down, December, 1994

• Manager abuses of ESOs

• Increasing evidence of abuses led to renewed

• Why such strong manager resistance to ESO

• The firm as a nexus of contracts

• The three hypotheses of PAT

• Opportunistic v. efficient contracting view of the

• Efficient contracting and conservative accounting

• Empirical PAT research

• Concept of discretionary accruals

• The Jones model (1991) to estimate discretionary

– Estimate by least-squares regression from past firm data

• Distinguishing opportunistic v. efficiency

• PAT helps us understand why accounting policies

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