Module 6 summary
This module defines and illustrates the concept of economic consequences. According to this concept, changes in accounting policies, including changes resulting from new accounting standards, matter to firms and their managers, even if those accounting policy changes have no differential cash flow effects. This seems inconsistent with the theory of efficient securities markets, which predicts that the market will see through the financial statement impact of different accounting policies, with the result that firms’ share prices should be unaffected by accounting policy choice. In turn, this implies that accounting policy choice should not matter to firms and their managers.
Examples of economic consequences are described. Based on these examples, it seems that accounting policies do have economic consequences. Not only do accounting policy choices matter to managers, they may also matter to investors, since accounting policies can affect manager actions, hence firm value.
Positive accounting theory asserts that management concern about accounting policies is driven by the contracts that firms enter into, and, for very large firms, by political costs that result if these firms are seen to be highly profitable.
Explain the concept of economic consequences.
- Economic consequences is a concept that asserts that, despite the implications of efficient securities market theory, accounting policy choice can affect firm value.
- If accounting policies affect firm contracts and political heat, they concern management.
Apply the concept of economic consequences to employee stock options (ESOs).
- Many large firms issue stock options to executives, and often to other employees, as part of compensation.
- For many years, no expense needed to be recorded for ESOs providing that exercise price equalled intrinsic value on the grant date.
- Even if intrinsic value is zero, ESOs have a fair value on their grant date. This can be estimated by
- expected value of ESO on exercise date (under very simplifying assumptions)
- modifications of the Black/Scholes option pricing formula
- A 1993 attempt by the FASB to require firms to record an expense for ESOs ran into extreme opposition from management. It had to be withdrawn.
- Recent financial reporting horror stories were often suspected to be driven by ESOs. This led to renewed pressure to expense ESOs.
- Despite concerns about the reliability of estimating ESO expense, expensing is now required in Canada, the United States, and internationally.
Describe the concept of positive accounting theory and its predictions about manager reaction to compensation contracts, debt covenants, and political pressures.
- Positive accounting theory is concerned with predicting firms’ choices of accounting policies and their response to new accounting standards.
- Positive accounting theory is structured around three hypotheses:
- The bonus plan hypothesis predicts that managers who are compensated by means of a bonus plan dependent on reported net income will be likely to maximize current reported profits by choosing accounting policies that shift reported profits from future to current periods.
- The debt covenant hypothesis predicts that the closer a firm is to violating debt covenants based on accounting variables, the more likely is the firm manager to choose accounting policies that shift reported profits from future to current periods.
- The political cost hypothesis predicts that the greater the political costs faced by a firm (for example, very large firms are often felt to be more subject to political scrutiny than smaller firms), the more likely is the firm manager to choose accounting policies that shift reported profits from current to future periods.
- Empirical research has produced a large body of evidence consistent with these predictions.
Compare the opportunistic and efficient contracting versions of positive accounting theory.
- Positive accounting theory assumes that managers are rational, that is, they choose accounting policies to maximize their own expected utility.
- Thus, the accounting policies that managers choose are not necessarily the ones that are best for the firm’s shareholders.
- Managers that choose accounting policies for their own benefit and at the expense of shareholders and lenders are said to be behaving opportunistically (unethically).
- By astute corporate governance, including clever contract design, firms can motivate managers to perceive that choosing accounting policies in the best interests of shareholders is also in their own best interest — this is called the efficient contracting form of positive accounting theory.
- While examples of opportunistic behaviour persist, empirical research has produced considerable evidence consistent with the efficient contracting form.
Understand how positive accounting theory contributes to economic consequences.
- Positive accounting theory shows how accounting policies can have economic consequences:
- Even without cash flow effects, accounting policies matter because they affect the provisions of contracts based on financial statement variables and can affect the firm’s political environment.
- Thus, accounting policies matter to managers — they have economic consequences.