Semester 2, 2009 1

306-684 Financial Accounting

Seminar 6 – Economic Consequences & Positive Accounting Theory

Semester 2, 2009 2

First – some revision

Measurement perspective applications -The pressures for a measurement perspective in

accounting practice face two main obstacles:

1 the sacrifice of reliability for relevance

2 management’s concern over inclusion in net income of unrealized gains and losses

(See chapter 7 for more details)

Semester 2, 2009 3

Measurement perspective applications

The lower of cost or market rule –A long established example of a

measurement perspective

Once an asset is written down it forms the new “cost” – it is conservative but is it decision useful? It reduces the chance of overstatement

Semester 2, 2009 4

Measurement perspective applications (cont.)

Ceiling test for property, plant and equipment –

Assets are to be written down when net carrying value exceeds net recoverable value (an estimate of future direct net cash flows from the asset)

Then, to determine a fair value (estimate of PV of future direct net cash flows)

Note: no write-up if fair value rises

Semester 2, 2009 5

Measurement perspective applications (cont.)

Valuation of debt and equity securities

On acquisition assets are classified as:1 Held-to-maturity –valued at amortised cost2 Trading securities – valued at fair value; unrealised

gains and losses included in income3 Available for sale – valued at fair value; unrealised

gains and losses included in other comprehensive income

Semester 2, 2009 6

Measurement perspective applications (cont.)

Hedge accounting –Hedge instruments are used to manage risk.

Gains and losses on fair value hedges are included in current earnings. The related gain or loss on the hedged item is also included in current earnings. Thus, net income is affected only by extent that the hedge is not completely effective.

Semester 2, 2009 7

Measurement perspective applications

Intangibles –Example: Goodwill (two forms)1 Purchased goodwill – retained on balance sheet unless

evidence of impairment

2 Self-developed goodwill – not readily recognised - usually a cost and may be recognised in future income statements as recognition lag. Perhaps recognised as a capitalisation of expense if pass a feasibility test?

Semester 2, 2009 8

PART IIIThe Preparer Perspective –

Managers and

Financial Accounting Information

Semester 2, 2009 9

Learning Objectives

• To develop the concept of economic consequences;

• To understand the nature of the firm in relation to contracting theory;

• To introduce the three hypotheses of positive accounting theory [PAT];

• To distinguish the opportunistic and efficient contracting versions of PAT;

Semester 2, 2009 10

Important terms/concepts

• Positive accounting theory

• Agency costs

• Bonus hypothesis

• Debt hypothesis

• Political cost hypothesis

Semester 2, 2009 11

The Story So Far….

• In the real world accounting reports have a conservative bias

• To the extent that markets operate efficiently– investors are price protected,– users can determine firm value given full disclosure; – accounting policy choices and changes are therefore

price irrelevant (no impact on future cash flows) – the information perspective

• If markets have some inefficiency, then preparers and standard setters should disclose ‘FV’ for items.

Semester 2, 2009 12

The Problem

• HOWEVER, managers, investors and regulators all behave as if accounting policy choice does matter – considerable time, effort & cost devoted to

accounting choices and lobbying of regulators

• adoption of IFRS• mandatory expensing of ESOs

• WHY???

Semester 2, 2009 13

The Answer: Economic Consequences

• Accounting choices have economic consequences– Can affect firm value– Can affect reported net income (from which

dividends are paid)– Therefore affect the distribution of wealth in the

economy

• So we need a theory to explain manager’s accounting policy choices

Semester 2, 2009 14

Positive v. Normative Theories

• Theories that prescribe are called normative theories– E.g. single person decision theory and the

theory of investment– That is, rational decision makers should use

Bayes’ theorem

• Theories that explain or predict are called positive theories– They are empirical – i.e. based on real world

data/observations

Semester 2, 2009 15

Economic consequences – example

Employee stock options (ESO)(Regulator response to management accounting policy)

Previously, ESOs were not required to be valued or expensed.

Management claimed that lower profits would be reported – hence lower share prices, higher cost of capital, reduced management motivation

Dilution of shareholder value

Semester 2, 2009 16

Economic consequences – example

Successful efforts (SE) accounting (investor reaction to accounting policy)

Lev’s research indicated that investors responded negatively to SE accounting policy when required to switch from full cost (FC) accounting and hence report lower net income and more difficult to raise capital –even though there were no cash flow effects

Semester 2, 2009 17

Positive Accounting Theory

• Concerned with explaining and predicting managers’ accounting choices and reactions to accounting standards

• Rationale – we need to understand existing practice (positive objective) in order to improve it (normative objective)

Semester 2, 2009 18

Theory of the Firm

• The firm is the nexus of direct contractual relationships among individuals who are assumed to be rational, evaluative utility maximisers;

• A firm exists as efficient means of organizing economic activity;

• Assumed corporate objective: maximise firm value

Semester 2, 2009 19

Theory of the Firm

THE FIRM -MANAGEMENT

DEBTHOLDERS

SHAREHOLDERS

ECONOMIC, POLITICAL & SOCIAL CONTEXT

Semester 2, 2009 20

The Agency Problem & Costs

• An agency relationship arises where there is a contract under which one party (the principal) engages another party (the agent) to perform some service on the principal’s behalf.

• Under the contract, decision-making authority is delegated to the agent

Semester 2, 2009 21

The Problem of Agency arises if...• The interests of the principal and

agent may not be aligned – agent may make decisions to maximise his/her own utility, not that of the principal

• Q: how can the agent be induced to maximise the principal’s welfare?

• What are the potential costs of doing this?• What is the role of accounting in doing so??

Semester 2, 2009 22

The Problem of Agency

INFORMATION ASYMMETRY

ADVERSE SELECTIONMORAL HAZARD

Capital Markets PerspectiveRole of accounting reports to improve decision making

Contracting PerspectiveRole of accounting reports to reduce agency costs (opportunism)

Semester 2, 2009 23

Manager-Shareholder Contracts

• Separation of ownership and control

• Partial or non-ownership of firm by managers provides incentives for managers to act contrary to shareholders’ interests because they do not bear the full cost of dysfunctional behaviour

Semester 2, 2009 24

The Bonus Plan Hypothesis

• All other things being equal, managers of firms with bonus plans are more likely to shift reported earnings from future periods to current periods

(More on this in Seminar 8 on Management Compensation)

Semester 2, 2009 25

Shareholder-Debtholder Contracts

• Assumption that interests of managers and shareholders are aligned

• The debtholder is the principal and the manager acting on behalf of shareholders is the agent

Semester 2, 2009 26

Debt Covenant Hypothesis

All other things being equal, the closer a firm to violation of accounting-based debt covenants, the more likely a firm manager is to choose accounting methods that shift reported earnings from future periods to the current period

• Also called the “debt-equity hypothesis”

Semester 2, 2009 27

The Political Costs Hypothesis

All other things being equal, the greater the political costs faced by a firm, the more likely the manager to choose accounting methods that defer current earnings to future periods

Semester 2, 2009 28

The Role of Accounting• Management compensation contracts and

debt contracts are based on accounting numbers

• Accounting used to align interests and minimize contracting costs – efficiency

• But managers choose the accounting – possible opportunism!

Semester 2, 2009 29

Opportunism v. Efficiency – choice of accounting policies

• Opportunism – change in allocation of resources between competing parties– Choose accounting policies to create a biased

measure of manager’s performance

• Efficiency – increase in total resources available for allocation– Choose accounting policies to lower contracting costs

(e.g. costs of negotiating contracts, costs of monitoring contract performance and possible renegotiation or contract violation should unanticipated events arise during the term of the contract)

Semester 2, 2009 30

Conclusions• Contracting theory can explain why

accounting policy matters (even in the absence of direct cash flow effects)

• Accounting numbers have economic consequences – they affect the distribution of wealth in the economy