Module 6: Economic Consequences

OVERVIEW

Economic Consequences - accounting policies used by firms do matter to various constituencies (management, investors, creditors,government).

Primarily they matter to management – but if they matter to mgmt then they also matter to investors –> managers may change the way the actual operation of the firm in order to mitigate the impact of the accounting policy changes.

Change in accounting policy also includes changes which do not have a direct cash flow effect since there would be a change in reported income. (aside note: although there maybe no direct cash flow effects from a change in accounting policy there could be an indirect cash flow effect)

WHY DO ACCOUNTING POLICIES MATTER?  companies want to show favourable NI (capital market transactions)  mgmt compensation contracts (  NI =  Bonus)  maintain D/E ratios, WC for debt covenants  conversely, avoid political reaction to excessive corporate profits

Accounting policies affect contracts that the firm enters into (compensation contracts, debt contracts) - typically these contracts depend on accounting variables such as net income and D/E ratios. Accounting policies affect NI, thus affect contracts. Firm will choose accounting policies to minimize contracting costs. If accounting standards change while these contracts are in place, contracting costs will be affected.

Rise of Economic Consequences

Stephen Zeff (1978) defines economic consequences as “the impact of accounting reports on the decision-making behavior of business, government and creditors.” i.e. can affect the real decisions made by managers & others.

Zeff documents several examples in US where business, industry associations and governments attempted to or did influence accounting stds set by APB. This intervention greatly complicated the setting of accounting standards.

If accounting policies did not matter, choice of accounting policies would be b/w standard setting bodies and the accountants/auditors who had to implement these standards. (i.e. accounting policy choice would be neutral).

Standard setting bodies - was procedural (accounting policy was derived by reference to accounting framework –> set in accordance with the financial accounting model and its traditional concepts of matching & realization.)

Then major constituencies intervened in the standard setting process because of the economic consequences arising from the accounting policy changes

Recap:

1 Module 6: Economic Consequences

 accounting policies have economic consequences for the various constituencies, even if these policies do not affect cash flow  Different constituencies may prefer different accounting (mgmt and investors interests don’t necessarily match)

standard setters are expected to take into consideration possible adverse consequences of proposed accounting standards (could have economic & social consequences) and find a way to reach a consensus. They cannot simply impose stds that benefit investors -> must also take managers and other constituencies into account.

Refer to Module 10 - standard setters address this by - broadening representation on standard setting bodies - use of exposure drafts ("feedback" solicited from constituencies)

Employee Stock Options

ESO – employee stock options – options issued primarily to mgmt, giving them the right to buy company stock at a stated price during some specified period of time.

This is a common form of compensation – employees who hold stock options have an incentive to work hard in order to increase the company share price increase. Benefits both firm and its shareholders.

Grant date – date on which the option is granted to the employee. Exercise price – amount which employee will pay to purchase the share when option is exercised. Intrinsic value – difference b/w exercise price and the market value of the underlying share on the grant date. Vesting date – date on which the employee can first exercise the option. Expiry date – date that the option contract expires. Fair value – typically would be the expected present value of the value of the option at exercise date. Opportunity cost – difference between the price the option is exercised at and the market value of the share at that time

APB25 – firms which issue fixed ESO’s are to record an expense equal to the difference b/w the market value of the shares on the date the option was granted and the exercise price of the option (intrinsic value).

Concerns:  An option would have a fair value on the grant date, since share price may rise over the term to expiry date. Thus failure to record an expense would understate compensation & overstate NI. Investors cannot easily see the real cost of this type of compensation.  Would be a lack of comparability across firms since diff firms have diff proportions of options in their compensation packages

One of barriers to recording fair value for options was difficulty of establishing this value – introduction of Black/Scholes option pricing model addressed this.

Black/Scholes model – measures the opportunity cost to the firm of issuing the option to the employee.  By issuing option to the employee, firm gives up the opportunity to sell the share at market value to investors.  Fair value of the ESO at grant date = expected present value of the opportunity cost  Black/Scholes formula, with expected time to exercise substituted for time to expiry, is a measure of fair value.  Cost is borne by shareholders in the form of a dilution in their equity in a firm (since new shareholders come in at a price less than share values). If I/S omits the cost of ESO’s then earnings are overstated.

Relevance: recording an expense is useful for investors. This may reveal inside info about the options’ real cost to the firm. Reliability: calc. of expense needs to be reasonably reliable. Black Scholes model is considered reasonably reliable (although it could provide upwardly biased measures of fair value – thus supporting concerns about the ED*.)

*Black/Scholes model is designed to value options which can be freely traded by the holder and assumes that the options will be exercised only at expiry. - ESO’s typically have restrictions on trading (reduces their fair value if holder is risk averse) - ESO’s may be exercised prior to expiry.

Huddart (1994) showed that the Black/Scholes formula can significantly overstate the fair value of an ESO at grant date -> early exercise would reduce the ESO expense relative to Black/Scholes (Huddart identified circumstances when the option holder would exercise the option earlier – a highly risk averse holder is most likely to exercise an ESO before its expiry date.) Followup study with Huddart and Lang (1996) looked at 8 large U.S. corporations over a period of 10 years and found early exercise was common, consistent with Huddart’s risk aversion assumption.

FASB issued an ED in 1993 - proposed firms would record compensation expense equal to the fair value at the grant date of ESO’s issued during the period. Fair value could be determined by Black Scholes or other option pricing model, with adj for early retirement prior to exercise and possibility of early exercise. This was met with extreme opposition from business - concerns were expressed about economic consequences of the lower reported NI. Consequences would include lower reported profits, lower share prices, higher cost of capital, shortage of managerial talent, inadequate motivation due to lower bonuses, potential violation of debt covenants, cash flow problems for start up companies that may need to pay other compensation rather than options in order to preserve bottom lines.

FASB withdrew this ED then issued SFAS123  Encourages firms to recognize ESO cost in the F/S proper using fair value  But can use APB25 intrinsic value method as long as firm provides supplementary disclosure of ESO fair value expense in F/S notes

HB 3870 similar to SFAS 123 2002:

 Can use intrinsic value method as long as fair values are reported as supplementary info.

Revised 2004:  Fair value of ESO’s awarded to be charged to expense over related service period.

Fair value can be determined through use of Black-Scholes or other option pricing model – with adj. for ESO characteristics such as early exercise.

Benefits: . Increased relevance – better measure of compensation cost (also note that existing shareholders ultimately bear the cost through reduced cash flows from dividends) . Better control of overuse of this method of compensation (less pressure to manipulate F/S to CEO advantage)

Aboody & Krasnik (2000) studied info release of CEO’s around ESO grant dates. On average, CEO’s used a variety of tactics to manipulate share price downwards just prior to the grant date and to manipulate price upwards shortly after. ESO’s become “deep in the money” (i.e. market value becomes significantly higher than exercise price), thus increasing the expected value of the reward to the CEO’s. Increases the likelihood of early exercise (per Huddart - “deep-in-the-money” ESO’s are more likely to be exercised early).

Bartov and Mohanram (2004) – found evidence of abnormally large income- increasing accruals in 2 years prior to exercise. Conclusion was that senior managers in the sample were aware of deteriorating profitability so they inflated earnings & share price to delay market knowledge. Mgrs then exercised ESO’s.

Efficient Securities Market Theory and Economic Consequences Anomaly exists in that efficient securities market theory predicts no price changes for accounting policy changes that do not impact cash flows.

But management constituency has reacted to paper changes in accounting policy, indicating that accounting policies do have the potential to affect real management decisions.

Positive Theory of Accounting

Positive Accounting Theory (PAT) – concerned with predicting actions such as the accounting policy choices made by firm mgrs and how mgrs will respond to proposed new accounting standards. Assumes managers are rational and will act in their own best interests (not necessarily the interests of the shareholders).

Opportunistic behavior – given an available set of accounting policies, managers may choose accounting policies from the set for their own purposes.

PAT assumes that managers are rational and will choose accounting policies in their own best interests if able to do so.

Optimal set of accounting policies will represent a compromise.  If accounting policies are tightly prescribed beforehand this will minimize opportunistic accounting policy choice by mgrs but incur costs of lack of accounting flexibility to meet changing circumstances  If the mgr can choose from a broad array of accounting policies this will reduce costs of accounting inflexibility but will expose the firm to costs of opportunistic mgr behavior.

BONUS PLAN HYPOTHESIS If a new std seems likely to decrease NI (in short run) and/or increase volatility mgmt will object - PV of expected utility from future bonus will be decreased

DEBT/EQUITY HYPOTHESIS If a new std seems likely to decrease NI (in short run) and/or increase volatility over the life of existing debt agreements mgmt will object - due to probability of debt covenant violation increasing

POLITICAL COST HYPOTHESIS If a new std seems likely to increase NI mgrs of large firms will object - concern with being more "in the public eye: higher visibility attracts more regulations and taxes.

Note: desirable to give managers some flexibility to choose accounting policies so that they can adapt to new or unforeseen circumstances.

There is considerable room to manage reported net income under historical cost accounting within GAAP (for example):  choice of depreciation policy,  choice of full cost versus successful-efforts for costs of oil and gas exploration  being conservative or optimistic about provisions for warranties and bad debts Thus, management can still choose accounting policies under PAT without being fraudulent or unethical, particularly if the policies chosen are responsible and clearly.

EMPIRICAL RESEARCH Sweeney (1994) – 130 firms which are first time debt covenant violators, 130 firm control sample (non debt covenant violators). Found defaulting firms made significantly more voluntary income increasing accounting policy changes; av. cumulative impact on NI was significantly higher. Also manipulated NI by timing of adoption of new standards –> adopted mandatory income-decreasing stds late and income-increasing stds early. Consistent with opportunistic accounting policy choice by managers, at expense of creditors.

Jones (1991)examined whether firms used discretionary accruals to lower reported earnings. Looked at 23 firms affected by import relief investigations by the ITC. Political cost hypothesis predicts that firms will use discretionary accruals to force down NI. Found discretionary accruals were significantly negative in the ITC investigation years, but not preceding or following ITC investigation.

(Review Jones formula text page 292, 293 -> segregate discretionary and non- discretionary accruals.)

Opportunistic and Efficient Contracting form of Positive Accounting Theory

Research supports position that mgrs’ concerns about accounting policies & stds are driven more by efficient contracting version of PAT than by the opportunistic version.

Efficient contracting version suggests that firm will limit its risk.

For example, derivatives are an effective way to do this. Depending on how firm uses derivatives:  Used primarily to hedge -> supports efficient contracting version  Used primarily to speculate -> supports opportunistic version

More to follow on “good: earnings management (efficient form) and “bad” earnings management (opportunistic) in module 8.

CONCLUSIONS Accounting policy choice is part of the firm’s overall need to minimize its cost of capital and contracting costs.  Allowing mgmt some flexibility in accounting policy choice enables a flexible response to changes in the firm’s environment and to unforeseen contract outcomes (potential covenant violation, bonus implications for risk-averse managers)  But does open the door to opportunistic mgmt behavior in accounting policy choice

Can see why accounting policy changes have economic consequences:  From an efficiency perspective, the set of available policies affects the firm’s flexibility  From an opportunistic perspective, the ability of mgmt to select accounting policies for its own advantage is affected.

Either way, changes in the set of accounting policies will matter to mgmt.