If there is no cash flow consequences, accounting policies dont matter as long as they are disclosed because investors will

incorporate those
information share prices

React to employee stock options o

Accounting for financial instruments o
Accounting for leases o
Therefore: there is an inconsistency o
Market should not react to accounting policies, however, we observe managers, governments, other users reacting strongly to s ome accounting policies
that have no cash flow implications

As accountant, we generally we reporting on transaction of the firm (neutral)

Economic consequences is how we report the transaction of the firm
Before Economic consequences
Economic Consequences
Firms's accounting policies and changes in policies matters to both management and investors
Ex., change amortization method from declining to straight line; this will not affect the firms operating cash flow or income taxes paid; however,
it will affect reported net income
o
Accounting policy change will matter despite the lack of cash flow effects
Under efficient market, accounting policy changes will not matter
Scott: Economic consequences is a concept that asserts that, despite the implications of efficient securities market theory, accounting policy choice can
affect firm value (p. 294)

Accounting reports can affect the real decisions made by managers and others, rather than simply reflecting the results of th ese decisions
Zeff: the impact of accounting reports on the decision-making behavior of business, government, unions, investors and creditors
IAS trying to change lease accounting rules
Lease accounting is for renting an item
Help management determine whether to rent or purchase an item
Lease Accounting
Efficient securities market theory predicts no price reaction to accounting policy changes that do not impact underlying prof itability and cash flows
Efficient market theory implies the importance of full disclosure, including disclosure of accounting policies
Implying that accounting policy choice can matter even in the absence of cash flow effects o
Thus, accounting policies have the potential to affect real management decisions, including decisions to intervene either for or against proposed
accounting standards
o
Management constituency has indeed reacted to paper changes in accounting policy, particularly in ESOs
How you accounting for transaction is affecting management behaviour
Management behaviour influenced by accounting rules
Efficient Securities Market Theory versus Management Behavior
The efficient market theory doesnt hold entirely
Investors aren't properly incorporating the information
Explanations
Employee Stock Options
Failure to record an expense understates the firm's compensation cost and overstates its net income
A lack of earnings comparability across firms results, since different firms have different proportions of options in their total compensation package
Charging the fair value of ESOs to expense would help investors to see the real cost to the firm of this component of compensation
It is hard to measure ESO expenses reliably
Recognizing the fair value of the ESO as expenses at grant date increases relevance
Expected return from holding exceeds the expected return on underlying shares (option cannot worth less than 0; share price can fall be low
the exercise price, which is<0)

The upside potential of an American option increases with time to maturity

If an option is deeply in the money, the probability of share price falling below exercise price is low
Three option characteristics: o
Huddart showed that Black/Scholes overstate the fair value of ESO at grant date
If the ESO is slightly in the money, the time to maturity is short, and the employee is required to hold the shares required, risk aversion o
When the ESO is deep in the money, the time to expiry is short, and the employee can either hold the acquired share or sell i t and invest the proceeds
in a riskless asset
o
Under what circumstances will employee exercise option early
Pump and dump managers would take actions to increase share value shortly before exercising option, then sell the shares before share price fell back and
invest the proceed in less risky securities

Spring loading managers manipulated the ESO award date ( managers pressure compensation committees to grant unscheduled ESOs shortly before good
earnings news)

Late timing back dating ESO awards to a date when share price was lower than at the actual ESO grant date
Positive Accounting Theory
What is suppose to happen
Two forms of PAT: 1) opportunistic form, 2) efficient contracting form
Takes the view that firms organize themselves in the most efficient manner so as to maximize their prospects for survival
Help understand the important factor that underlie managers' actions
Nexus of contracts a firms organization can be largely described by the set of contracts it enters into
Contracting costs include costs of negotiation, costs arising from moral hazard and monitoring of contract performance, cost of possible renego tiation
or contract violation, expected costs of bankruptcy and other types of financial distress

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 (p. 304)

Chapter 8 - ECONOMIC CONSEQUENCES AND POSITIVE

ACCOUNTING THEORY
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5:08 PM
Chapter 8 Page 1
Contracts with the lowest contracting costs are called efficient contracts
An efficient contract minimizes costs of moral hazard, by motivating managers to act in the shareholders' best interests
or contract violation, expected costs of bankruptcy and other types of financial distress
It would probably be less costly for management to switch from LIFO to the FIFO inventory method, or liquidate LIFO inventorylayers, or
issue preferred stock in place of debt than to renegotiate the debt contract or suffer the expected costs of technical violations

A new accounting standard that lowers reported net income, such as the expensing of ESOs, may reduce a firm's times interest earned ratio to the
point where violation of debt covenants is of concern
o
PAT argues that firms' accounting policies will be chosen as part of the broader problem of attaining efficient corporate gov ernance
Reduce contract efficiency
Opens up the possibility of opportunistic behaviour ex post, where they may choose from the set for their own purpose
Will not act to maximize firm profit
Will maximize profits only if he/she perceives this to be in his/her own best interests
PAT assumes that managers are rational and will choose accounting policies in their own best interest if able to do so, risk averse, and
efficient market

It is desirable to give managers some flexibility to choose from a set of available policies so that they can adapt to new or unforeseen circumstances
Tightly prescribing accounting policies will minimize opportunistic choice by managers, but incur cost of lack of accounting flexibility to meet
changing circumstances

Allowing managers to choose accounting policies will reduce costs of accounting inflexibility, but expose the firm to the cost of opportunistic
manager behaviour

The optimal set of accounting policies for the firm represent a compromise
Ultimate objective of PAT: to predict managerial accounting policy choice in different circumstances and across different fir ms
Managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the
current period
o
However, this will tend to lower future reported earnings and bonuses
To do so, choose accounting policies that increase current reported earnings
If manager's remuneration depends on a bonus related to reported net income, then they may be able to increase their current bonus by
reporting as high a net income as possible

Derived from looking at manager's compensation plans

Managers are likely to prefer accounting policies that would increase current income
The present value of the manager's utility from his or her future bonus stream will be increased by shift it towards the present
Smoother bonus stream is better than a variable bonus stream
If manager is risk averse, he/she will prefer accounting policies that smooth reported earnings, since a less variable bonus stream has higher
expected utility than a volatile one

Reasoning o
Would also oppose proposed accounting standards that may lower reported net income, such as the expensing of ESOs
E.g., current value accounting, particularly if unrealized gains and losses are included in net income
Managers may also object to volatility increasing accounting standards
Predicts that managers will choose less conservative and less volatile accounting policies than managers of firms without bonus plans o
Bonus Plan Hypothesis
The closer the firm is to violation of accounting based debt covenants, the more likely the firm manager is to select accounting procedures that
shift reported earnings from future periods to the current period
o
Increasing reported net income will reduce the probability of technical default
If debt covenants such as maintaining specified levels of interest coverage, debt to equity, working capital, and/or shareholders' equity, are
violated, the debt agreement may impose penalties, such as constraints on dividends or additional borrowing

Because managers are risk averse, they would prefer to have accounting policies to smooth income to avoid violation of debt covenants
If a firm is close to violating debt covenants, then managers are likely to choose accounting policies that shift future income into the current
period

As the firm approaches default, or if it actually is in default, it is more likely to do this

To prevent or at least postpone such violation, management may adopt accounting policies to raise current earnings
Based on observing debt contracts as frequently debt contracts involves covenants based on accounting variables
Reasoning o
Predicts that managers are likely to choose less conservative accounting policies than managers of firms with low debt to equity ratio, and will be
more likely to oppose new standards that limit their ability to do this and/or that increase earnings volatility
o
Debt Covenant 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 periods
o
When a firm is highly profitable, which may attract media and consumer attention, such attention can quickly translate into political "heat"
on the firm, and politicians may respond with new taxes or other regulations (political scrutiny)

Large firms may be held to higher performance standards, and if these large firms are also highly profitable, political costs are magnified
When a firm faces larger political cost, then its likely to make accounting policies choices that would decrease income, so the firm because
less visible

Managers would prefer to defer income into the future to reduce current income
Switching to LIFO would increase cost of goods sold, hence decreases current income, which avoid public attention
Can be done through adopting income decreasing accounting policies in an attempt to convince the government that profits are
suffering

Foreign competition may lead to reduced profitability unless affected firms can influence the political process to grant import protection
Reasoning o
Predicts that managers of very large firms will choose more conservative accounting policies than managers of smaller firms, and it will be less
likely to oppose new standards that may lower reported net income
o
Political Cost Hypothesis
Three hypotheses in their opportunistic form(managers choose accounting policies in their own best interest instead of firms)
The three hypothesis can be explained in opportunistic views, and from efficient contract views
Opportunistic and efficient contracting views make similar predictions
Opportunistic view: Managers wanting to make accounting policies choices to put him or herself first in terms of bonus, etc.
Limits opportunism and motivate managers to choose accounting policies to control contracting costs, thereby aligning the interests of the firm o
Efficient contracting view: Accounting policies choices are made to minimize contracting cost for the company as a whole as it benefits the
shareholders

Opportunistic vs. Efficient Contracting Views

Chapter 8 Page 2
Limits opportunism and motivate managers to choose accounting policies to control contracting costs, thereby aligning the interests of the firm
and its shareholders
o
Lower or more volatile earnings reduce the expected utility of future bonuses for risk averse managers, forcing the firm to p ay more to
compensate

Firms will benefit by excluding policies that lower reported net income or produce volatile earnings
Bonus plan hypothesis o
Firm will benefit by excluding accounting policies that lower earnings or increase their volatility, since such policies increase the probability
of debt covenant violation and resulting expected costs of financial distress

Debt covenant hypothesis o

Policies that lower reported earnings help to avoid political costs, thereby maintaining profits
Political cost hypothesis o
What should happen
Theories that attempt to tell individuals or constituencies what they should do, known as normative (PAT does not do this)
If individuals wish to make a decision in the face of uncertainty so as to maximize expected utility, they should proceed as the theories
recommend
o
Example: single decision theory & theory of investment
It is judged by its logical consistency with underlying assumptions of how rational individuals should behave o
Unlike positive theory, predicative ability is not the main criterion by which a normative theory should be judged
May take time for people to figure out the theory
Can have good normative theory even though it doesn't make good predictions
There is no right or wrong between normative and positive theories
Normative Theories
Testing PAT
An effective way to reduce reported earnings in a hard to detect manner is to manipulate accounting policies relating to accruals
Total accruals = operating cash flows - net income
A firm increases amortization charges, it may record excessive liabilities for product guarantees, contingencies, and rebates, and it may record
generous provisions for doubtful accounts and obsolescence of inventories
o
Accruals that are controllable by the firm o
Discretionary Accruals
Correlates with level of business activities o
Non-discretionary Accruals
Net income = operating cash flows +/- net accruals (net discretionary and net non-discretionary)
TAjt = total accruals from firm j in year t (+ means income increasing)
REVjt = revenues from firm j in year t less revenue for year t-1
PPEjt = gross PPE for firm j in year t
Discretionary term
jt = a residual term that captures all impacts on TAjt other than those from REVjt and PPEjt

1j is expected to be positive and 2j is expected to be negative

TAjt= j +1jREVjt + 2jPPEjt + jt

Ujp is the estimate of discretionary accruals for year p for firm j

Ujp = TAj (j +1jREVjt + 2jPPEjt)
If net accruals is lowered, through a negative discretionary accruals, then net income will be lower o
Political hypothesis predicts that Ujp will be negative, implying that the firm is using discretionary accruals to force down reported net income
Jones Model
Articles
Leverage Ratios Surge at Large Companies
Companies have deliberately increase their leverage ratios
Increases the risk in violating debt covenants
Contradictory in the sense that potential future risk with debt covenants if interest rate goes up or decline in profitability, for current profit benefits
Wait Continues for Lease Accounting Clarity
Accounting policies for lease accounting for equipment or retail space is ambiguous
Continual disagreement on how to recognize equipment and real estate lease obligations on a firms income statement
The adoption of new accounting policies for lease accounting will have economic consequences
Chapter 8 Page 3