@iar-lelt-lans Economic Consequences and Positive Accounting Theory Ge mee RU .| Bonus plan /7| hypothesis eae cera = i al Maererne re eae eee ee Cree Mireet a Maes eelaer WU rery eae Raa) od | a wi l | i 7 aoe Aiea Ce a Pied Cn: ce ior me 8.1 OVERVIEW You may have noticed chat here has been little discussion of management's interest financial reporting to this point oxher than several references to management skeptic about current value accounting. As mentioned earlier, a thesis of this book is chat mot vation of responsible manager performance, that is, providing information to evaluate manager stewardship, is an equally important role of financial accounting as the provision of useful information to investors. Ik should be noted, however, that standard setters do not fully ageee with this dichotomy. In Section 3.8, we described the acceptance by standard setters of che decision usefulness approach, where the first objective of financial reporting is to provide useful information to present and potential investors for rational decision-making. Thus,274 reporting on stewardship is not a main objective. Indeed, in its 2006 Preliminary Views on an Improved Conceptual Framework for Financial Reporting, the [ASB regards reporting on stewardship as part of its broader objective of providing useful information, but states (paragraph BC1.38) that “to make stewardship a separate objective might exaggerate what is feasible for financial reporting to accomplish.” Tt seems that they feel it is not possible ao separate the effects of manager stewardship from random state realization when reporting on firm performance. Interestingly, though, the SEAS 157 opportunity cost approach to fair value accounting can be interpreted from a stewardship perspective—see our discussion in Section 7.1. Nevertheless, regardless of the standard setters’ position, itis necessary that account- ants understand and appreciate management's interests in financial reporting given the extensive interaction and conflict between managers, accountants, and auditors. This will involve us in a new line of thought that, at first glance, differs sharply from the investor decision-based and efficient market-oriented theories discussed earlier. Out first task is to understand the concept of economic consequences. In che process, we will also learn about some of the accounting problems in a major area of accounting policy choice—stock-based compensation. Economic consequences is a concept that asserts chat, despite the implications of efficient securities market theory, accounting policy choice can affect firm value Essentially, the notion of economic consequences is that firms’ accounting policies, and changes in policies, matter. Primarily, they macter to management. But, if they mat- ter to management, accounting policies matter to the investors who own the firms, because managers may well change the actual operation of their firms due to changes in accounting policies. For example, managers may cut maintenance and R&D to compen- sate for a new accounting policy that lowers the bottom line. Ic is important to point out that the term “accounting policy” refers to any account- ing policy, not just one that affects a firm’s cash flows. Suppose that a firm changes from declining-balance to straight-line amortization. This will not in itself affect the firm's operating cash flows. Nor will there be any effect on income taxes paid, since tax author- ities have their own capital cost allowance regulations. However, the new amoctization policy will certainly affect reported net income. Thus, according to economic conse- quences doctrine, the accounting policy change will mater, despite che lack of cash flow effects, Under efficient markets theory the change will not matter (although the marker may ask why the firm changed the policy) because future cash flows, and hence the mar- ket value of the firm, are not direcely affected. An understanding of the concept of economic consequences of accounting policy choice is important for two reasons. Fist, the concept is interesting in its own tight. Many of the mast interesting events in accounting practice derive from economic consequences. Second, a suggestion chat accounting policies do not matter is at odds with accountants? experience. Much of financial accounting is devoted to discussion and argument about which accounting policies should be used in various circumstances, and many debates and Chapter 8conflicts over financial scatement presentation involve accounting policy choice. Economic consequences are consistent with real-world experience. The presence of economic consequences raises che question of why they exist. To answer this question, we begin with positive accounting theory. This theory is based on the contracts that firms enter into, in particular executive compensation contracts and debe contracts, These contracts are frequently based on financial accounting variables, such as net income and various measures of liquidity. Since accounting policies affect the values of these variables, and since management is responsible for the firm's contracts, it is natural chat management be concerned about accounting policy choice. indeed, man- agement may choose accounting policies so as £0 maximize the firen’s interests, or its own, interests, relative to these contracts. Positive accounting theory attempts to predict what accounting policies managers will choose in order ro do this Figure 8.1 outlines the organization of this chapter. 8.2 THE RISE OF ECONOMIC CONSEQUENCES One of the most persuasive accounts of the existence of economic consequences appears in an early article by Stephen Zeff (1978) enticled “The Rise of ‘Economic Consequences.” The basic questions that it raises are still relevant today. Zeff defines economic consequences as “the impact of accounting reports on the decision-making behaviour of business, government and creditors.” The essence of the definition is that accounting reports can affect the ceal decisions made by managers and others, rather than simply reflecting the results of these decisions. Zeff documents several instances in the United States where business, industry asso- ciations, and governments attempted to influence, or did influence, accounting standards set by the Accounting Principles Board (predecessor to the FASB) and its predecessor, the Committee on Accounting Procedure (CAP). This “third-party intervention,” as Zeff calls ie, greatly complicated the setting of accounting standards. If accounting policies did not matter, choice of such policies would be strictly between the standard-secting bodies and the accountants and auditors whose task was to implement the standacds. If only these parties were involved, the traditional accounting model, based on well-known concepts such as macebing of coses and revenues, realization, and conservatism, could be applied and no one other than the parties involved would care what specific policies were used. In other words, accounting policy choice would be neueral in its effects. ‘As an example of an economic consequences argument, Zeff discusses the attempts by several ULS. corporations to reduce reported earnings by implementing replacement cose accounting during 1947 to 1948, a period of high inflation. Here, the third-party constituency that intervened was management, who, unlike their more recent skepticism abour current value accounting, argued in favour of eplacement cost amottization to bolster arguments for lower taxes and lower wage increases, and to counter a public perception of excess profitability. The efficient marker argument would be that such Economic Consequences and Positive Accounting Theory 275.276 intervention was unnecessary because the policy change would not affect cash flows, and the marker would see through the high reported net incomes produced by historical cost amortization during inflation. If so, it should not be necessary to remind users by formal adoption of replacement cost amortization, It is interesting to note that the CAP held ies ground in 1948 and reaffirmed historical cost accounting. Zeff goes on to outline the response of standard-secting bodies to these various inter- ventions. As described in Section 1.9.5, one response was to broaden constituency tepre- sentation on the standard-setting bodies themselves. Also, the use of exposure drafts of proposed new standards became common as a device to allow a variety of constituencies co comment on proposed accounting policy changes. As Zeff puts it, standard-setting bodies face dilemma, To retain credibility with accountants, they need co set accounting policies in accordance with the financial accounting model and ics traditional concepts of matching and realization (recall chat Zeff is describing practices prior co the increased emphasis on the measurement approach). Yer, such historical cost-based concepts seldom lead to a unique accounting policy choice, as we saw in Section 2.5.2 with respect to amortization policy and the full-cost versus successful-efforts controversy in oil and gas accounting. That is, since net income does not exist as a well-defined economic construct under non-ideal conditions, there is no theory that cleatly prescribes what accounting policies should be used, other than a vague requiement that some tradeoff between relevance and celsability is necessary. This opens the door for vatious other constituencies to get into the act and argue for their preferred accounting policies. In short, standard-setting bodies must operate not only in the account- ing theory domain, but also in. the political domain. Zeff refers to this as a “delicate balancing act.” That is, without a theory % guide accounting policy choice, we must find some way of reaching a consensus on accounting policies. In a democratic secting, this implies involvement in the political domain. While a need for delicate balancing complicates the task of standaed setters, it makes the study of the standard-serting process, and of accounting eheory in general, much more challenging and interesting. 8.2.1 Summary Despite the implications of efficient market theory, it appears that accounting policy choices have economic consequences for the various constituencies of financial statement users, even if these policies do nor dicectly affect firm cash flows. Furthermore, different constituencies may prefer different accounting policies. Specifically, management's pre- ferred policies may be at odds with those that best inform investors. Economic consequences complicate the setting of accounting standards, which require a delicate balancing of accounting and political considerations. Standard-setting bodies have responded with due process, such as bringing different constituencies onto their boards and by issuing exposure drafts to give all interested parties an opportunity to comment on proposed standards. Chapter &8.3 EMPLOYEE STOCK OPTIONS We now examine an area where economic consequences have been particularly apparent. This is the accounting for stock options issued to management and, in some cases, to other employees, giving them the right to buy company stock over some time period. We witl refer to these options as ESOs. Until relatively recently, accounting for ESOs in the United States and elsewhere was based on the 1972 Opinion 25 of the Accounting Principles Board (APB 25). This standard required firms issuing fixed! ESOs to record an expense equal to the difference between the market value of the shares on the date the option was granted to the employee (the grant date) and the exercise, or strike, price of the option. This difference is called the intrinsic value of the option. Most firms granting ESOs set the exercise price equal to the grant date market value, so that the intrinsic value is zero. As a result, no expense for ESO compensation was recorded. For exaruple, if the underlying share has a market valve of $10 on che grant date, setting the exercise price at $10 triggers no expense recognition, whereas setting che exercise price at $8 triggers an expense of $2 per ESO granted In the years following issuance of APB 25, this basis of accounting became widely rec ognized as inadequate. Even if there is no inteinsic value, an option has a fair value on the grant dave, since the price of the underlying share may rise over the term ro expiry (the expiry date) of the option. Failure to record an expense understates the firm’s compensa- tion cost and overstates its net income. Furthermore, a lack of earnings comparability actoss firms results, since different firms have different proportions of options in theit coral compensation packages. These problems worsened as a result of a dramatic increase in the use of ESO compensation since 1972, particularly for small, start-up, high-tech fiems These firms parcicularly like the non-cash-requiring aspect of ESOs and their motiva- tional impact on the workforce, as well as the higher reported profits that resulc compared «co other forms of compensation Also doring this period, executive compensation came under political scrusiny, due to the high amounts of compensation thar top executives received. Firms were perhaps motivated to award seemingly excessive amounts of ESO compensation since such com- pensation was “free.” Charging the fair value of ESOs to expense would, some felt, help investors co see che real cost to the firm of chis component of compensation. Indeed, in February 1992, a bill was introduced into the U.S. Congress requiring ESOs to be valued and expensed. One of the reasons why the APB had not required fair value accounting for ESOs was the difficulty of establishing this value. This situation changed somewhat with the advent ‘of the Black/Scholes option pricing formula {see Section 7.3.4). However, several aspects of ESOs are not captueed by Black/Scholes. For example, che model assumes tha options can be freely traded, whereas ESOs cannot be exercised until che vesting date, which is typically one or more years after they are granted. Also, if the employee leaves the ficm prior co vesting the options are forfeited or, if exercised, there may be restrictions on the employee's ability to sell the acquired shares. In addition, the Black/Scholes formula Economic Consequences and Positwe Accounting Theory 2728 assumes that the option cannot be exercised prior to expity (a European option), whereas ESOs are an American option (can be exercised prior to expiry). Nevertheless, it was felt by many that Black/Scholes provided a reasonable basis for estimation of ESO fait value. Consequently, in June 1993, the FASB issued an exposure draft of a proposed new standard. The exposure draft proposed that firms record compensation expense hased on. the fair value at the grant date (also called ex ante value) of ESOs issued during the period. Fair value could be determined by Black/Scholes or other option pricing formula, with adjustment for the possibility of employee retirement prior to vesting and for the possibil- ity of early exercise. Early exercise was deale wich by using the expected time to exercise, based, for example, on past experience, rather than the time to expiry, in the Black/ Scholes formula. The exposure draft attracted extreme opposition from business, which soon extended into the U.S. Congress. Concems were expressed about the economic consequences of the lower reported profits that would result. These claimed consequences included lower share prices, higher cost of capital, a shortage of managerial alent, and inadequate manager and employee motivation. This would particularly disadvantage small start-up companies that, as mentioned, were heavy options users. To preserve their boctom lines, firms would be forced to reduce ESO usage, with negative effects on cash flows, motiva- tion, and innovation. This, ic was claimed, would threaten che competitive position of American industry. Business was also concerned that the draft proposal was politically motivated. Ifs0, opponents of the proposal would feel justified in attacking it with every means at theie disposal Another series of questions related to the ability of Black/Scholes to accurately and reliably measure ESO fair value. To see these concerns, we first need to consider just what the costs to the firm of ESOs are, since, unlike most costs, ESOs do not require a cash out- lay. Essentially, the cost is bore by the fiem’s existing shareholders ehrough dilution of their proportionate interests in the firm. Thus, if an ESO is exercised at a price of, say, $10 when the market value of che share is $30, the ex post cost to the firm and its share- holders is $20. This $20 is called the ex post cost since after an ESO is exercised, its actual cost is known. We can also think of the $20 as an opportunity cost since, by admitting the new shareholder at $10, the firm forgoes the opportunity co issue the shace at the market price of $30. That is, the $20 opportunity cost measures the dilution of the existing share- holders’ interests. The faie value of the ESO at che grant date, hence the ex ante cost to the firm, is the expected present value of the ex post cost.? Recognizing this cost as an expense increases relevance, since future dividends per share will be reduced to the extent dividends are diluted over a larger number of shares. The reduction in earnings from expensing ESOs anticipates these lower dividends, thereby helping investors to better predice future cash. flows from their investments. Bus, this ESO expense is very difficult to measure reliably. As mentioned, the employee may exercise the option at any time after vesting up to expiry. The ex post cost co the firm will then depend on the difference between the market value of the share and Chapter &the exercise price at that time. In order to know the fait value of the ESO it is necessary to know the employee's optimal exercise strategy. This straregy was modelled by Huddart (1994), As Huddare pointed out, determining the employee's strategy requires knowledge of che process generating the firm's furure stock price, the employee's wealth and utility function (in particular the degree of tisk aversion), whether the employee holds or sells the acquired shares (many firms require senior officers 10 hold large amounts of company stock) and, if sold, what investment altematives are available. Matters are further complicated if the firm pays dividends on its shares and if the motivational impact of the ESO affects share price. By making some simplifying assumptions (including no dividends, no motivational impact), Huddart showed that che Black/Scholes formula, assuring ESOs held to expiry date, does indeed overstate the fair value of an ESO at the grant date. To see why, we first note three option characteristics: 1. The expected retum from holding an option exceeds the expected retuen on the underlying share. This is because the option cannot be worth less than zero, but the share price can fall below the option’s exercise price. As a result, a risk-neutral employee would not normally exercise an ESO before maturity. 2. The “upside potential” of an American option (its propensity to increase ip value) increases with the time co macurity. The longer the time, the greater the likelihood that during this interval che underlying share price will take off, making the option more valuable. Early exercise sacrifices some of this upside potential. 3. If an option is “deep-in-che-money,” that is, if che value of the underlying share greatly exceeds the exercise price, the set of possible payoffs from holding the option and theic probabilities closely resembles the set of payoffs and probabilities from hold- ing the underlying share. This is because for a deep-in-the-money option the proba- bility of share price falling below exercise price is low. Then, every realizacion of share price induces a similar realization in the option value. As a result, if the employee is cequired to hold the shares acquired, he or she might as well hold the option to matu- rity. The payoffs are che same and, due co che time value of money, paying the exer- cise price at expiry dominates paying it sooner. The question then is, ate there circumstances where che employee will exercise che option early? Huddare identifies two. First, if the ESO is only slightly in-the-money (substantial risk of zero payoff), che time to maturity is short (little sacrifice of upside potential), and the employee is required to hold the shares acquired, risk aversion can trigger carly exercise. Since there is substantial risk of zero return, the risk-averse employee (who trades off risk and return) may feel that the reduction in risk from exer- cising the option now rather than continuing to hold it outweighs che lower expected retum from holding the share. The second circumstance accurs when the ESO is deep-in-the-money, the time to expiry is short, aru the employee can either hold the acquired share or sell it and invest che proceeds in a riskless asset. If the employee is sufficiently risk-averse, the riskless asset Economic Consequences and Positive Accounting Theory 279280 is preferred to the share. Because the option is deep-in-the-money, the payoffs and their probabilicies are similar for the share and ESO. Thus the employee is indifferent to hold- ing che ESO or the share. Since holding the riskless asset is preferred to holding the share, it is also preferred (o holding the option. Then, the employee will exercise the option, sell the share, and buy the riskless asset. In 2 follow-up empirical study co test che early exercise predictions, Huddart and Lang (1996) examined the ESO exercise pacterns of the employees of eight large U.S. cor- porations over a cen-yeat period. They found that early exercise was common, consistent with Huddart’s risk aversion assumption. They also found that the variables that explained empirically the early exercises, such as time to expiration and extent to which the ESO was in-the-money, were “broadly consistene” with the predictions of che model. The significance of early exercise is that the fair value of ESOs at grant date is less than the value determuined by Black/Scholes which, as mentioned, assumes the option is held to expiry. This is particularly apparent for the first early exercise scenario outlined above. If the ESO is barely in-the-money, the ex post cost of the option to the employer (share price less exercise price) is low. While the cast savings from the second circum- stance are less, the cost co che employer is still less than Black/Scholes, as Huddart shows. Subsequenc research has tended to confirm the tendency of Black/Scholes to over- state ex post ESO cost. Hall and Murphy (2002), using different approach than Huddact, also demonstrated a substantial probability of early exercise, and showed that this signif- icantly reduces the firm's ESO cost below Black/Scholes. Their analysis also suggested considerable variability in employees’ exercise decisions. Early exercise, presumably, is the reason the 1993 FASB exposure draft proposed using expected time to exercise, rather than expiry date, in the Black/Scholes formula. However, as Huddart pointed out, use of expected time to exercise reduces the over- statement of ESO cost, but does not eliminate it, as also demonstrated by Hemmer, Matsunaga, and Shevlin 1994) (HMS). In an empirical study, Marquardt (2002) exam. ined the accuracy of che Black/Schotes formula based on expected time to exercise. In a sample of 966 option grants by 57 large U.S. companies over 1963-1984, she found chat Black/Scholes tended co produce positively biased estimates of ex post ESO cost, consis- tent with the analyses of Huddart and HMS. She also found that the accuracy of this esti- mated cost varied widely for different firms. We conclude that ESO fair value estimates may be unreliable, due both to upward bias and the need to estimate the timing of employees’ early exercise decisions in the face of wide variability of these decisions. Furthermore, other Black/Scholes model inputs, such as the share variability parameter, create additional reliability problems Asone can imagine, cheoty and evidence suggesting that the exposure draft, if imple- mented, may not produce accurate estimates of ESO expense would be seized upon by crit- ics, particularly if the estimates tended to be too high. Asa result, in December 1994 the FASB announced chat it was dropping the exposure draft, on the grounds chat it did not have sufficient support. Instead, the FASB tumed to supplementary disclosure. In SEAS 123, issued in 1995, ic urged firms to use the fair value approach suggested in the exposure Chapter &draft, but allowed the APB 25 intrinsic value approach provided the firm gave supplemen- tary disclosute of ESO expense, determined by amortizing over their vesting periods the fair value of awarded ESOs based on expected time to exercise. More recently, financial reporting scandals such as Enron and WorldCom led to renewed pressure to expense ESOs. In retrospect, it seems that manipulations of stock price by these and other companies were often driven by senior executives’ tactics to increase the values of their ESOs. One of these tactics was pump and dump, whereby managers would rake actions to increase share value shorily before exercising options, then sell the shares before shate price fell back (sometimes in a manner to disguise the transaction) and, presumably, invest the proceeds in less tisky securities. Bartov and Mohanram (2004) tested a sample of 1,218 US. companies with large ESO exercises by senior executives, during 1992-2001. They found a significant decrease in average abnormal share price and catnings in the two years following such exercises, relative co a concrol sample of similar firms with no large ESO exercises. They also show evidence of abnormally large income-increasing accruals in the two years prior to exer- cise, The authors concluded that the senior managers in cheir test sample were aware of deteriorating profitability, and pumped up earnings and share price to delay che market's awareness of the deterioration. They then exercised theit ESOs and, presumably, dumped the acquired shares immediately so as to maximize their cash proceeds. The lower earn- ings and share prices in the two years following exercise were driven by the reversal of the prior accruals and the market's belated awareness of the declining profitability. Another strategy was reported by Aboody and Kastnik (2000) (AK), who studied the information release practices of CEOs around ESO grant dates. They confined their study to CEOs because it is the CEO that controls the firm's release of information. Their results are based on a sample of 4,426 ESO awards to CEOs of 1,264 different U.S. firms during 1992-1996. Of these awards, 2,039 were by firms with scheduled grant dates. That is, awards were made on the same dates each year.4 Thus, CEOs of these firms knew when. che ESO awards were coming. AK found that, on average, CEOs of firms with scheduled ESOs used a variety of tactics to manipulate shate price downwards just prior to the grant date, and to manipulate price up shortly after. One tactic was to make an early announce- ment of an impending BN quarterly earnings report, but ro make no such announcement for an impending GN report. Other tactics included influencing analysts’ earings fore- casts and selective timing of release of their own forecasts. Ic also appears that some managers manipulated the ESO award date itself. This was investigated by Yermack (1997), who reported evidence chat managers pressured compen- sation commictees to grant unscheduled ESOs shortly before good earnings news (a tactic called spring loading). This gives the CEO a low exercise price and subsequent benefit as share price rises in response to the GN. Yet another tactic was late timing. Late timing is the backdating of ESO awards to a dace when share price was lower than at the actual ESO grant date. This confers an imme: diate benefit on the recipient, since, in effect, the ESO was in-the-money on the actual Economic Consequences and Positive Accounting Theory 281grant date; that is, intrinsic value was positive. While awarding ESOs that are in-the- money is not in itself illegal, backdating of ESO awards does violate GAAP. This is because, under APB 25, in effect when much of the late timing took place, an expense had to be recognized for ESOs awarded with positive intrinsic value. Late timing disguised this expense recognition. Discovery of late timing thus leads to restatement of prior years? earnings. If ESOs were expensed, earnings would still be overstated since, holding share price constant, a decrease in exercise price increases ESO fair value. Other parameter inputs to Black/Scholes (Section 7.3.4) may also change. Lack of disclosure of the late ciming also subjects those involved to liability under securities laws. SEC and company board investigations of late timing have led co a number of CBO resignations, and thei widespread nature threatens to erode public confidence in financial reporting at least es much as the Enron and WorldCom scandals. The common theme of all these tacties is zo increase the likelihood that ESOs will be deep-in-he-money. This increases che likelihood of early exercise since, according to Huddart’s analysis, deep-in-the-money ESOs are more likely to be exercised early Obviously, managers would be unlikely to admit to che behaviours just described Nevertheless, if ESOs had to be expensed, their usage as a compensation device would decrease, thereby reducing managers’ scope to manipulate ESO values for their own benefit. This undoubtedly added fuel to their economic consequences arguments against ESO expensing. On July 20, 2006, the SEC announced criminal and civil charges for securities fraud against the former CEO, vice-president human resources, and CFO of Brocade Communications Systems, Inc., a California-based developer of networking data storage products These were the first charges resulting from ‘SEC investigations of numerous companies for late timing of ESO awards. The defendants, it was alleged, backdated employee ESO awards to 2 time when the company's share price was lower than the real date of the award, thereby confer- ring an immediate benefit on the recipients by lowering the exercise price. in effect, the ESOs were issued in-the-money. Under APB 25, in effect at the time, an expense had to be recorded for in-the-money options, but this was disguised by the backdating In 2005, possibly in anticipation of forthcom- ing SEC charges, Brocade issued revised financial 282 Chapter 8 statements for 1999-2004 inclusive to correct for the APB 25 earnings overstatements. It increased compensation expense and decreased reported earnings by a total of $285 million. In July 2006 the company issued a statement indicating that the executives involved were no longer with the ‘company and reporting a provision of $7 million for settlement of its own liability resulting from the actions of its former executives. In May 2007 the financial media reported that Brocade agreed to pay a $7 million U.S. penalty to settle the SEC charges. In August 2007 the former Brocade CEO was found guilty by a jury in San Francisco on conspir- acy and fraud charges for misleading investors. He faces millions of dollars in fines and up to 20 years in prison.The combined effect of the above-described abuses, plus improved ability of account- ants to model complexities such as early exercise, enabled standard setters to overcome the opposition. SFAS 123R, effective in 2005, requires ESO expensing, as does IFRS 2 of che IASB. These standacds were implemented despite the raising by many managers of economic consequences and reliability concems similar to those expressed over the 1993 exposure draft. ‘As expected, an economic consequence of ESO expensing has been to greatly reduce the usage of ESOs as a compensation device. For example, The Economist (2006) quotes an investment banker's estimate that the fair value of options granted by the top 500 U.S. firms fell from $104 bitlion in 2000 to $30 billion in 2005 While, ia this case, che standard setcers ultimately “won,” we may conclude that the accounting for ESOs is a prime illustration of Zoff’s argument that third-party interven tion greatly complicates the setting of accounting standards. The intensity of management’ economic consequences arguments is particularly noteworthy given that ESO expensing does not directly affect operating cash flows. 8.4 THE RELATIONSHIP BETWEEN EFFICIENT SECURITIES MARKET THEORY AND ECONOMIC CONSEQUENCES At this point, we may have another anomaly. Efficient securities market theory predicts no price reaction to accounting policy changes that do not impact underlying prof itability and cash flows. If there is no securities price reaction (implying no change in firms’ costs of capital), it is unclear why management and regulators should be particu- lacly concerned about che accounting policies chat firms use. In other words, efficient market theory implies the importance of full disclosure, including disclosure of accounc- ing policies. However, once full disclosure of accounting policies is made, the market will interpret the value of the firm’s securities in the light of the policies used and will not be fooled by variations in reported net income that arise solely from differences in accounting policies Yer, in an important area of accounting policy choice, namely che accounting for ESOs, we have seen that the management constituency has indeed reacted to paper changes in accounting policy. The strength of management reaction seems particularly surprising, even involving appeals 0 government authority to intervene on its behalE. ‘These various reactions are summarized in the concept of economic consequences. That is, accounting policy choice can matter even in the absence of cash flow effects Thus, accounting policies have the potential to affect real management decisions, including decisions to intervene either for or against proposed accounting standards, This “twill wagging the dog” aspect of economic consequences is all the more interesting in view of the empirical results described in Chapter 5. These results are remarkable in the sophi tication they document of the markec’s response to financial accounting information. The question then is, does the existence of economic consequences reinforce the theory and Economic Consequences and Positive Accounting Theory 283284 evidence that securities markets are not fully efficient, as discussed in Section 6.2, or can efficient securities markets and economic consequences be reconciled? Our nexe task is to do what any discipline does when confronted with observations, specifically, economic consequences, that are inconsistent with existing theory. We search for a more general theory that may include the existing theory but that also has the poten- tial co explain the inconsistent observations. This brings us to positive accounting theory. 8.5 THE POSITIVE THEORY OF ACCOUNTING 8.5.1 Outline of Positive Accounting Theory For our purposes, the term “positive” refers to a theory that attempts to make good pre: dictions of real-world events. Thus: Positive accounting theory (PAT) is concemed with predicting such actions as the choices of accounting policies by firm managers and kow managers will respond to proposed new accounting standards For example, can we predict different degrees of manager opposition to expensing ESOs, or predict which managers will react favourably to fair value accounting standards for financial instruments and which will be opposed? While PAT may not capture the actual thought processes of individuals, it does help us to understand the important fac- tors that underlie cheir actions. PAT takes the view that firms? organize themselves in the most efficient manner, so as to maximize their prospects for survivalS—some firms are more decentralized than oth- ers, some firms conduct activities inside while other firms contract out the same activi- ties, some firms finance more with debt than others, etc. The most efficient form of organization for a particular firm depends on factors such as its legal and institutional environment, its technology, and the degree of competition in its industry. Taken together, these factors determine the set of investment opportunities available to the firm, and hence its prospects. A firm can be viewed as a nexus of contracts, that is, its organization can be largely described by the set of contraces it enters into. For example, contracts with employees (including managers), with suppliers, and with capital providers are central to the firm's operations. The fiem will want to minimize the various contracting costs associated with these conceacts. These include costs of negotiation, costs arising from moral hazard and monitoring of contract performance, costs of possible renegotiation or contract violation should unanticipated events arise during the term of the contract, and expected costs of bankruptcy and other types of financial distress. Contracting costs atso affect che firm’s cost of capital, since bonds and shares represent contracts between the firm and its capi- tal providers. Contracts with the lowest contracting costs are called efficient contracts. Many of these contracts involve accounting variables. Thus, employee promotion and remuneration may be based on accounting-based performance measures such as net income, or the meeting of pre-set individual targets, such as cost control. Contracts with Chapter 8