8.4 The Relationship Between Efficient Securities Market Theory and Economic Consequences The Three Hypotheses of Positive Accounting Theory

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1 CHAPTER 8 Economic Consequences and Positive Accounting Theory 8.1 Overview 8.2 The Rise of Economic Consequences Summary 8.3 Employee Stock Options 8.4 The Relationship Between Efficient Securities Market Theory and Economic Consequences 8.5 The Positive Theory of Accounting Outline of Positive Accounting Theory The Three Hypotheses of Positive Accounting Theory Empirical PAT Research Distinguishing the Opportunistic and Efficient Contracting Versions of PAT 8.6 Conclusions on Economic Consequences and Positive Accounting Theory Copyright 2009 Pearson Education Canada 231

2 GENERAL OUTLINE OF CHAPTERS 8 AND 9 This chapter begins the third component of the text, oriented to a moral hazard problem. The development includes, in Section 8.3, a specific illustration, using the controversy over expensing of employee stock options (ESOs), that accounting policies matter. The chapter also describes positive accounting theory and explains how the contracts that firms enter into provide reasons why accounting policies matter, even in the absence of cash flow effects. Chapter 9 digs more deeply into why important types of contracts, namely, compensation and debt contracts, are frequently written in terms of accounting variables. To do so, Chapter 9 draws on concepts of game theory and agency theory. The demonstration of economic consequences in Chapter 8 is sometimes criticized as lacking in theory. This is correct (the lack of theory is correct, not the criticism). While a number of technical aspects of the fair value of ESOs are discussed in Section 8.3, no theory is presented to predict why expensing of employee stock options is so controversial. The primary purpose of the ESO illustration is simply to demonstrate that economic consequences exist. This is by design. My own view is that it is better to sneak up on theories such as game theory and agency, by first motivating their relevance to a whole new class of financial accounting and reporting problems. These problems arise because of management s reaction to accounting policy choices imposed by standard setters. Thus, the main purpose of the discussion of economic consequences is to build up student interest in the underlying theories that follow, by showing that managers and others do take accounting policy choice seriously, despite the implications of efficient securities markets theory as described by Beaver (1973) (Section 4.3). Having said this, there is no reason why instructors cannot cover the material in Chapters 8 and 9 in any order, if so desired. Copyright 2009 Pearson Education Canada 232

3 LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES 1. To Develop the Concept of Economic Consequences Here, I point out that the term economic consequences simply means that accounting policy choice matters. I also emphasize that, at first glance, economic consequences fly in the face of efficient securities market theory, which suggests that accounting policies do not matter as long as they are disclosed and have no cash flow effects. At this point I remind the class of Beaver s 1973 paper reviewed in Section 4.3, which exemplifies accountants early enthusiasm for efficient markets. I usually leave the students to read Section 8.2 for themselves, describing Zeff s wellknown 1978 article. 2. To Illustrate Economic Consequences I find that students are often unable to define the term economic consequences on exams. Furthermore, it takes time for students to see the conflict implications of accounting policy choice. Consequently, I spend time on the ESO illustration in Section 8.3, usually based on discussion of a media article. The expensing of ESOs is still topical, and certainly illustrates the conflict aspects of accounting policy choice. Question 12 of this chapter relates to these conflict issues. Parts of Question 4 of Chapter 13 could also be used in this regard. Numerous media articles can serve as a basis for discussion of ESO issues, for example: The stockpot, The Economist, included in A special report on executive pay, January 18, Former Brocade chief convicted for backdating stock options, Bloomberg, August 8, Reprinted in The Globe and Mail, August 8, See also Theory in Practice vignette 8.1 in Section 8.3. FASB looks likely to win stock options showdown, The Wall Street Journal, reprinted in The Globe and Mail, March 9, 2004, page B10. Copyright 2009 Pearson Education Canada 233

4 A New Year s stock option resolution, The Globe and Mail, December 22, Microsoft to award stock, not options to employees, The Wall Street Journal, reprinted in The Globe and Mail, July 9, 2003, page B10. As an alternative to the economic consequences discussed in the text, instructors may wish to use other examples. The problem material contains several of these, namely accounting for OPEBs (Problem 8), foreign currency gains and losses (Problem 9), and oil company excessive profits (Problem 10) 3. To Develop the Concept of a Positive Accounting Theory My goals in developing what a positive theory is are quite limited. I emphasize that the objective of such a theory is to explain and predict, in contrast with a normative theory, for which the governing word is should, that is, a normative theory recommends what should be done. As an example of a positive theory, I interpret the simple micro-economic model of the firm as such a theory, since most students will have taken a course in micro-economics. I suggest that the role of this theory is to explain and predict firm behaviour, not to tell managers what they should do. Furthermore, I argue that the model makes reasonable predictions (at an aggregate level) even though it may not capture precisely how managers make decisions. As an illustration, I ask what a firm would do if the price of one of its raw materials was to rise, and argue that even though managers probably don t go through the marginality calculations of the micro-economic model, the model makes reasonably good predictions of the actions of the firm in response to the price increase. I also contrast the concept of a positive theory with the normative investor decisionmaking theories of Chapter 3, which I interpret as prescribing how investors should make investment decisions if they wish to maximize their expected utility. Copyright 2009 Pearson Education Canada 234

5 An important aspect of a positive theory of accounting is its assumption that managers are rational. Again, I refer to the micro model of the firm and discuss with the class whether the model s implicit assumption that managers act so as to maximize firm value is a reasonable one. As is apparent from the foregoing, I tend to avoid philosophy of science issues of positive accounting theory. Several excellent discussions are available for instructors who wish to delve into these issues. These include Watts and Zimmerman themselves (1986, Chapter 1; 1990). Demski s (1988) critique of positive accounting theory, and Boland and Gordon s (1992) discussion are also worth discussing in this regard. 4. To Introduce the Three Hypotheses of Positive Accounting Theory Students usually find these three hypotheses quite intuitive and I usually only outline them briefly in class, emphasizing that they predict the economic consequences described earlier in the chapter. 5. To Distinguish the Opportunistic and Efficient Contracting Versions of PAT These two versions of PAT provide a good opportunity to discuss manager motivation and the extent to which it is aligned with shareholder interests. The research designs to distinguish these two versions tend to be subtle. Instructors who pursue these issues may wish to consult the Dichev and Skinner (2002), Dechow (1994), Guay (1999), Subramanyam (1996) and/or Xie (2001) papers (these latter 2 papers are discussed in Chapter 11). The Subramanyam paper, in particular, contains interesting evidence that managers on average use discretionary accruals efficiently (as opposed to opportunistically). It also anticipates the question of whether earnings management is good or bad, which is discussed in Chapter 11. However, as Subramanyam points out, his results depend on the ability of the Jones model to reasonably capture the discretionary portion of total accruals. Also, the results of Xie (2001) raise questions about the extent to which Subramanyam s findings support an interpretation that earnings management is on balance good (see Section for a brief discussion). Copyright 2009 Pearson Education Canada 235

6 SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS 1. A normative theory is a theory that prescribes how persons should behave in order to accomplish a given objective. Examples include single-person decision theory and the theory of investment, which lay down procedures for decisionmaking under uncertainty when the decision maker s objective is to maximize expected utility. A normative theory is judged by its consistency with underlying theories of rational behaviour. A positive theory is a theory that attempts to predict the results of individuals actions. Such a theory does not profess to tell individuals what they should do. An example of such a theory is the micro-economic theory of the firm, which predicts how firm managers will react to changes in product and factor prices, technology, etc. Another example is efficient securities market theory, which helps to predict and explain the process of security price formation. A positive theory is judged by the accuracy of its predictions. It need not capture the actual thought processes of individuals, although good predictive ability helps us to understand the reasons why individuals behave as they do. 2. Yes. Decision-making procedures will vary across individuals, so that it can be difficult to predict the actions of any one person. However, a positive theory can make good predictions at an aggregate level (i.e., aggregated across the actions of a large number of individuals) if it captures in an unbiased manner the average or long-run behaviour of decision makers. This is because individual idiosyncrasies will tend to cancel out at an aggregate level. Thus, the microeconomic theory of the firm may make good predictions of average firm behaviour even though individual managers may not make decisions as the model suggests. Also, efficient securities market theory can make good predictions of security price response to new information even though all individual investors do not necessarily make decisions as the theory of investment prescribes. Copyright 2009 Pearson Education Canada 236

7 3. A firm s susceptibility to political costs is often measured by its size, as proxied, for example, by total balance sheet assets, sales or number of employees. This is a reasonably valid measure of susceptibility to political costs, one reason being that size is relatively easy to measure. Also, large firms tend to attract more public and media attention, and may be held to a higher standard of social responsibility than small firms. However, size may also be correlated with other firm characteristics, such as monopoly power, riskiness and corporate governance. Consequently, it is a noisy and possibly biased measure of susceptibility. These other characteristics would need to be controlled for when using size as a proxy for political costs. 4. a. Lev selected this date because of efficient securities market theory, which predicts that if the market is going to react to the imposition of successful-efforts accounting, it will do so at the earliest moment it becomes aware of this possibility. While the exposure draft did not impose successful-efforts accounting (this came later with the issuance of SFAS 19 on December 5, 1977), it was apparently the first solid indication the market had that the FASB was leaning towards successful-efforts accounting. In other words, the probability that successful-efforts accounting would be imposed increased substantially on July 18, and this was sufficient to trigger an efficient market reaction to the expected economic consequences. b. According to PAT, the prospect of lower and more volatile reported profits for the concerned firms will increase the likelihood of violation of debt covenants. Alternatively, or in addition, lower and more volatile reported earnings will reduce the expected utility of manager bonuses based on earnings. This could change how management operates the company. For example, management might react to the greater volatility of earnings under successful efforts accounting by avoiding risky exploration programs, which would tend to lower program expected values and returns. Efficient securities market theory predicts that investors would respond to Copyright 2009 Pearson Education Canada 237

8 increased likelihood of covenant violation by bidding down share prices of affected firms. Share prices would also be bid down by diversified investors if the manager avoids risky exploration programs, since the effect is to lower expected returns without decreasing investor risk (since diversified investors have already diversified firm-specific risk away). Avoiding risky projects will tend to decrease the likelihood of debt covenant violation, but it is unlikely to decrease it to levels below those prior to SFAS 19. The net effect will then be a decrease in share prices of oil and gas firms. Also, efficient securities market theory explains the rapid (3 day) share price reaction to the exposure draft. If an efficient market is going to react to an information event, it will do so quickly. c. If investors have limited attention, they may not process all available information in a timely manner. That is, it may take them some time to figure out and appreciate the economic consequences of switching to successful efforts. As a result, a reaction to the exposure draft would be expected, but it would take place over time as lower and more volatile earnings were reported, not on the day the exposure draft was released. An alternative answer is that if investors have limited attention they may not have noticed the exposure draft at all, even though the exposure draft was announced by the FASB and presumably was reported in the media. If so, there would be no effect on share prices until some time after the effective date of the standard. Herd behaviour may also explain the declines in price. Investors may have noticed a fall in affected firms share prices (perhaps driven by rational investors concerns about debt covenant and bonus plan considerations). They may have then rushed to sell, further driving prices down. d. To distinguish between these two hypotheses, the following procedures could be applied: Read the managerial compensation contract. Does it depend on reported net income? If it does not, the bonus plan hypothesis does not explain the negative securities market reaction. Copyright 2009 Pearson Education Canada 238

9 Read the debt contract. Does it contain covenants that depend on ratios based on reported net income and/or equity? If not, the debt covenant hypothesis does not explain the negative market reaction. If the answer is no in both cases, neither hypothesis is driving the market reaction. If the answer is yes in one case and no in the other, or yes in both cases, further tests are required: (i) Calculate how close the firm is to violating debt covenant ratios. The closer it is, the more likely it is that the debt covenant hypothesis underlies the market s response, other things equal. (ii) From the managerial compensation contract, determine what proportion of the manager s compensation comes from earningsbased bonus. The higher it is, the more likely it is that the bonus plan hypothesis underlies the market s reaction, other things equal. If the firm is both close to violation of debt covenants and has a high proportion of manager compensation from earnings-based bonus, it is likely that both hypotheses are driving the negative share price reaction. Note: the above assumes that you have access to the company s managerial compensation and debt contracts. If not, matters are more complicated. The debt-to-equity ratio is sometimes used as a proxy for closeness to covenant constraints. Details of top manager compensation can be obtained from the annual meeting proxy form, a public document mailed to shareholders. Note: Instructors may wish to point out that in 1978 the SEC overrode SFAS 19 by Accounting Series Release 253 (1978). The FASB subsequently issued SFAS 25, allowing either method. Copyright 2009 Pearson Education Canada 239

10 5. Under the efficient contracting form of PAT, managers wish to minimize the firm s contracting costs. One such cost arises from the fact that unforeseen circumstances may arise during the life of the contract. As an example, contracts often depend on accounting variables such as reported net income or debt-toequity. Such contracts can be in force for a long time and it is difficult to anticipate changes in GAAP that might take place over the life of the contract and allow for them in the contract itself. As a result, if GAAP does change, this can affect the amount of manager compensation and/or induce technical violation of debt covenants, both of which can impose costs on the firm. However, the manager may be able to work out from under these costs by managing accruals or changing accounting policies. That is, allowing managers some flexibility to choose from a set of accounting policies can reduce expected costs of contract violation or renegotiation following from unforeseen state realizations. Note: This illustrates the concept of an incomplete contract, that is, a contract that does not anticipate all possible realizations of states of nature. The concept of an incomplete contract is introduced formally in Section Under the opportunistic form of PAT, firm managers will prefer a set of accounting policies from which to choose so as to be able to influence reported net income and debt in their own interests. Then, they can use accounting policy choice so as to maximize their bonuses, and to make life easier for themselves by minimizing political costs or the probability of technical violation of debt covenants. 6. The following accounting policy choices are suggestive of what could be done to lower the probability of technical violation: (i) Increase equity by increasing current reported earnings. This can be done by managing discretionary accruals. Possibilities include: Minimize provisions for doubtful accounts receivable and for warranties. Copyright 2009 Pearson Education Canada 240

11 If LIFO inventory method is allowed under GAAP and the firm uses this method, and if prices have risen since adoption, run down LIFO cost layers, or switch to FIFO. Both of these possibilities have problems, however. Running down inventory levels may interfere with operations. Also, if the firm is in a jurisdiction where LIFO is allowed for tax purposes and prices are rising, increased taxes resulting from switching to FIFO would reduce cash flows. Lengthen estimates of useful lives of capital assets, and/or, if currently using accelerated amortization, perhaps switch to straight line. Change pension plan and other postretirement benefits assumptions. For example, the rate of interest used to discount future obligations, and/or the expected rate of return on plan assets, could be raised. Delay adoption of new income-decreasing accounting standards, or speed up adoption of income-increasing ones, to extent allowed by the standard. (ii) Reclassify long-term liabilities as equity: Argue that future income tax liabilities be excluded from debt for purposes of the debt/equity ratio calculation. If allowed by GAAP, include minority interest in subsidiary companies as part of shareholders equity. (iii) Increase equity by increasing assets: Defer advertising and R&D costs, to extent allowed by GAAP. For example, IFRS 3 allows capitalization of development costs. (iv) Decrease volatility of reported net income, hence of equity: If an oil and gas company, switch from successful efforts accounting to full cost. To extent possible, include unrealized gains and losses in other comprehensive income (SFAS 130) or shareholders equity (IFRS), if Copyright 2009 Pearson Education Canada 241

12 allowed by GAAP. For example, designate as many hedges as possible under IAS 39 or SFAS 133, and include as many securities as possible in the available for sale category under these standards. (v) Other possibilities include: Cling to historical-cost-based accounting to the extent allowed by GAAP, as opposed to adopting more volatile fair value accounting. Trigger extraordinary gains and losses, such as sales of capital assets and subsidiary companies, to compensate for earnings shocks. These are included in operating income (see Section 5.5 for Section 3480 of the CICA Handbook. In the United States, see APB 30). Such sales could possibly hamper the firm s real operations, however. If unrealized gains are available, and if GAAP does not require fair value accounting for the related assets and liabilities, use the fair value option of IAS 39 or SFAS 159 if possible to trigger recording of the gain. Recording a gain on long-term debt following a credit downgrade is an example of the use of this tactic. 7. Conservative accounting, by lowering accounts receivable, current earnings, and shareholders equity decreases working capital, increases the debt-to-equity ratio, and lowers times interest earned, thereby tightening debt covenant constraints. As a result, the likelihood of excessive dividend payments is reduced. This increases cash available for interest and debt repayments. Lenders anticipate this and are willing to accept lower interest rates. Thus, conservative accounting contributes to efficient debt contracts. 8. a. This would depend on the tax deductibility of the accruals for other postretirement benefits. If these are not deductible, there would be no effect of OPEB standards on cash flows following their adoption, to the extent the company continues to pay these benefits. If the accruals are tax deductible, this would increase after-tax cash flows, at least in the short run. After a few years, when the new accounting approaches steady Copyright 2009 Pearson Education Canada 242

13 state, accruals and cash payments for benefits may be approximately equal, in which case the after-tax cash flow effects would be minimal. b. The answer is not completely clear, since the OPEB standards do not increase amounts of benefits. One possible reason is that firms did not realize how much other postretirement benefits were costing them until the expenses generated by the new accrual accounting became apparent. Another possibility is that firms were quite aware of these costs and were using the major liabilities recorded under the OPEB standards as an excuse to cut benefits. Then, the benefit cuts can be blamed on the accountants rather than the firm itself. c. Share price would rise, given efficient securities markets, if it became apparent that firms' cash flows and future reported profitability would increase. This could result from a cut in benefits following implementation of the OPEB standards. Share price would also rise if the amount of the accrued OPEB obligation was less than the market had expected. 9. a. From an efficient securities market perspective, the EnCana manager need not be concerned. Given full disclosure, the efficient market will look through the increased earnings volatility and realize that there is no effect on cash flows. Furthermore, prior to the 2002 changes in Section 1650, the market would have known the amounts of foreign exchange gains and losses from financial statement information about U.S. denominated debt outstanding and knowledge about exchange rates the 2002 changes do not add to what the market already knows in this regard. Consequently, there should be no effect on share prices or the firm s cost of capital. Thus there should be no effect on its ability to lock in new financing at favourable rates. b. From the perspective of positive accounting theory, The EnCana manager may be correct to be concerned. Increased earnings volatility increases the Copyright 2009 Pearson Education Canada 243

14 probability of violation of debt covenants based on net income (such as debt-toequity ratio and times interest earned), other things equal. Lenders will be concerned about the increased probability of violation and may be reluctant to lend at current rates. The firm may have to ask for less stringent covenants in new lending agreements, to keep the probability of violation at reasonable levels. However, less stringent covenants reduce lenders protection, again leading to higher rates. Manager concern would also arise if his/her compensation depended on reported net income. Then, increased earnings volatility may lead to increased compensation volatility. This reduces the expected utility of compensation for risk averse managers. Manager concerns would be enhanced if the set of allowable accounting policies available to the manager restricted his/her ability to manage earnings to offset their increased volatility. 10. a. The bonus plan and debt covenant hypotheses predict that oil companies will want to report high profits sooner rather than later. This is because the managers of these companies would prefer high bonuses now rather than some time in the future, other things equal, since the present value of a dollar of bonus is higher the sooner it is received. Also, higher reported profits will reduce the probability of technical default on debt covenants. Thus, the oil companies would be predicted to increase the price of gasoline and to avoid excessive reserves for environmental costs, maintenance and legal claims. b. According to the political cost hypothesis, the largest oil companies would be most concerned because big companies are more in the public eye and, because of their size and economic power, they tend to attract media and political attention. Also, they may be under greater pressure to behave responsibly than smaller firms that attract little or no public attention. Thus, big oil companies are the ones most likely to suffer adverse consequences such as higher taxes if they take advantage of the rising price of crude oil to earn high profits. Copyright 2009 Pearson Education Canada 244

15 c. LIFO would be most effective in holding down profits. On a rising market for crude oil, and assuming shortages do not unduly deplete inventory levels, LIFO will report a higher cost of gasoline sales than FIFO or average cost methods. d. Efficient securities markets theory predicts that the strategy would not be effective, given full disclosure, since the securities market would see through the accounting policy choices that hold down reported profits. Indeed, the oil companies may well end up subject to greater political costs than if they had not used accounting policy choice to reduce reported profits. They would be open to charges of trying to hide their excess profits. However, several arguments suggest that the policy may be effective in reducing political pressure: Given the theory and evidence that securities markets are not fully efficient, the market may not fully appreciate the extent to which accounting policy choices are driving down profits, particularly if gasoline prices are being held down at the same time. Since the amounts and timing of the various provisions are subject to management determination of amounts and timing, they are included in operations rather than extraordinary items. Then, it may be possible for the companies to disguise their strategy by less than full disclosure. For example, it is not clear that provisions for maintenance programs would need complete disclosure. Even with full disclosure, good arguments can be made for environmental, maintenance and legal claims provisions, independently of the price of crude oil. The efficient markets hypothesis applies primarily to investor and securities price behaviour. It is less clear that politicians and the general public would appreciate the impact of accounting policy choices on reported profits. One reason is simply that they may be less knowledgeable about accounting matters. However, a more fundamental reason is that they may have less incentive to dig into reported profits. Individual consumers may not be Copyright 2009 Pearson Education Canada 245

16 sufficiently affected that they will bother to go on the warpath. Politicians may be content with the appearance of lower profits if the public is not aroused, since otherwise they would have to confront a large and powerful industry. Thus, the strategy may well be effective. Any increase in the price of gasoline can be blamed on events outside the oil companies control and, if reported profits do not significantly increase, politicians and the public may accept the higher prices. 11. a. Firms with large ESO plans buy back their stock on the market to counter the dilution of shareholder interests that ESOs cause. Since the exercise price of ESOs is below the market price of the underlying stock, their issuance creates an opportunity loss for existing shareholders, forcing down share price. While the buyback does not directly affect net income, the reduction in number of shares outstanding creates an increase in earnings per share, thereby exerting upward pressure on share price. Purchasing shares on the open market also reduces company cash. But, remaining shareholders will benefit to the extent share price does not fall by the full amount of cash paid out. For example, the company may have surplus cash and retaining it in the company at low return constitutes a drag on stock price. If underutilized cash is paid out, the market would anticipate a further increase in earnings per share in future. b. Yes, you would be concerned. The increase in earnings per share resulting from this tactic may be transitory, since share prices tend to increase over time. Therefore, the firm is quite likely to have to pay more than current share price when it actually buys its shares later, exerting downward pressure on future earnings per share. If so, and if you bought shares on the strength of the apparent earnings per share increase, share price may suffer later. 12. Relevant information helps investors to estimate future cash flows from their investments. The relevance of Black/Scholes measures of ESO fair value is high, because of the dilution that ESOs create. The company receives less cash from Copyright 2009 Pearson Education Canada 246

17 issuing ESOs than it would receive if the shares were sold at their market value. Thus, there is less capital on which to earn a return, reducing future earnings accordingly. Also, future dividends are spread over more shares. Expensing ESOs lowers current reported net income, thereby anticipating the lower per share dividends to investors that ESOs create. Reliable information faithfully represents without bias what it is intended to represent, and is verifiable. The reliability of Black/Scholes as a measure of ESO cost is low: Like any model, Black/Scholes requires parameter inputs, including, in particular, variability of share price and time to expiration. These inputs are subject to error and bias, and may lack verifiability. Since Black/Scholes applies to European options, whereas ESOs are American options, it is necessary to estimate ESO holders exercise strategy. The expected time to exercise that results can be substituted for the expiry date in the Black/Scholes formula. However, this estimate is subject to error and bias, and may not be verifiable, particularly for firms with little past ESO history and/or few employees receiving ESOs. This point is based on Note 3 of this chapter, and should be expected only from students with mathematical and statistical training: The Black/Scholes option value is often concave in time to expiry, particularly if issued with zero intrinsic value. Then, even if expected time to exercise is accurate, use of this expected value as time to expiry in the Black/Scholes formula will produce upwardly biased estimates of ESO value. b. Some people claim that the cost of ESOs is zero because the firm does not have to pay the recipients for their employee services. Indeed, some cash (i.e., the exercise price) is received instead. These claims are incorrect because they ignore the concept of opportunity cost. Issuance of shares by means of ESOs dilutes the equity of existing shareholders Copyright 2009 Pearson Education Canada 247

18 because the shares are issued at less than their market value. This cost shows up as less-than-proportionate future dividends received by existing shareholders. Ignoring this cost understates the cost of the firm s employee compensation. c. Firms may oppose the expensing of ESOs for the following reasons: Economic consequences. The bonus plan and debt covenant hypotheses of PAT predict that firms with manager compensation and debt covenants that are based on earnings and other financial statement variables will object to accounting policies that lower reported net income. Securities market inefficiency. To the extent that securities markets are not fully efficient, firms share prices may fall and costs of capital rise as a result of lower reported earnings. Relevance versus reliability. Firms may believe that the increase in relevance from expensing ESOs is outweighed by low reliability of ESO cost estimates. This is particularly the case if Black/Scholes (or other estimates of ESO cost) have an upward bias. d. A firm may voluntarily adopt ESO expensing for the following reasons: Political cost hypothesis. Very large firms may wish to lower the amount of reported net income so as to reduce political visibility. The voluntary adopters given in the question, such as Microsoft, are very large. Little impact on reported net income. Some firms use ESOs more than others. Firms that do not issue very many ESOs can afford the impact of expensing. This argument is enhanced if securities markets are not fully efficient. To change compensation policy. A firm may want to reduce or eliminate its use of ESOs, particularly since they have become questionable compensation devices. This is due to numerous Copyright 2009 Pearson Education Canada 248

19 instances where ESOs may have driven dysfunctional management practices leading to financial reporting scandals (e.g., Enron, WorldCom, backdating). Expensing ESOs may be a first step to reducing ESO use, since the firm can better point to the fact that ESOs do indeed have a cost. Reputation. Some firms may want to build up a reputation for transparency and full disclosure. Voluntary adoption of improved financial reporting policies provides a signal in this regard. Note: Reputation and signalling are not fully discussed in the text to this point. Nevertheless, this point, if made, should be accepted. 13. a. Yes, the accusations are consistent with the findings of Aboody and Kasznik (2000), assuming that ESO awards were scheduled in advance so that the former Big Bear CEO knew they were coming, or had enough control over the compensation committee of the Board that he could control ESO timing. The former CEO could have chosen to feed the bad news to the market shortly before the ESO award date. Then, at time of award, share price would be low. By setting the ESO exercise price equal to share price at the grant date, the options would greatly increase in value when news that Blue Range had sprung back became known. The CEO could then exercise the options and reap a profit by holding or selling the acquired shares. b. This episode is consistent with the opportunistic version of PAT. The CEO is charged with using his inside information to manipulate the firm s stock price for his own advantage, at the expense of shareholders, whose interests are diluted by the ESO issue. c. Not necessarily. Deep-in-the-money ESOs are likely to be exercised early according to Huddart s (1994) analysis and the empirical results of Huddart and Lang (1996). Then, using the ESO expiry date in Black/Scholes overstates option value. If, as is the case for ESOs, expected time to exercise is used in the Black/Scholes formula instead of the expiry date, the resulting value is still unreliable, due to possible error or bias in estimates of parameter inputs such as Copyright 2009 Pearson Education Canada 249

20 share price variability and time to exercise. 14. a. The answer depends on my risk aversion, my beliefs about the state of the economy, and the investment alternatives available to me. With respect to investment alternatives, I would be willing to invest in covenantlite debt to the extent that safer debt, such as government debt and debt issued with covenants attached, offered a return less than the return offered on the covenant-lite tranches. I would be willing to bear greater risk in order to obtain a higher return. With respect to the state of the economy, the higher are my beliefs that the state is high, the more likely that I would be willing to invest in covenant-lite debt. This is because the higher the state of the economy, the less likely that firms will default on their debt, other things equal. With respect to my risk aversion, the greater it is, the less likely that I would be willing to sacrifice greater security on government and covenant-attached debt for a higher return. However, my risk will be reduced to the extent the tranche of covenant-lite debt in which I invest is spread over a large number of firms and different industries. Risk will be further reduced to the extent the tranche is protected by CDS. b. The moral hazard problem is that if debt has no covenants attached, the firm issuing such debt has little incentive to protect the interests of the debtholders by maintaining ratios such as debt-to-equity and interest coverage, by protecting working capital and equity by maintaining specified levels of these items. Payment of excessive dividends, for example, would reduce both. Furthermore, purchasers of the covenant-lite debt may have little motivation to monitor firm performance. The bank that buys the debt in the first place will typically package and resell it quickly, thereby passing the default risk on to the Copyright 2009 Pearson Education Canada 250

21 tranche purchasers. The tranche purchasers are farther removed from the firms in their tranche, and may not even know what firms are included. Even if they do, their risk is spread, reducing motivation to monitor performance of specific firms, particularly if CDSs are involved. c. Covenant-lite debt will reduce the validity of the debt covenant hypothesis, since, without covenants, firm managers have little need to choose accounting policies to reduce the probability of covenant violation. d. A downside to CDS is that there may be a downturn in the economy. If this downturn is serious, many firms in the tranche may default on their debt, particularly in view of the moral hazard problem discussed in c. Then, interest and principal payments to tranche holders will be reduced. Furthermore, if enough firms default, even the counterparties of CDSs may be unable to meet their obligations. These concerns are increased since tranche investments lack transparency--investors are unlikely to know which firms and CDS parties are included in the tranche. It then it becomes particularly difficult to determine tranche fair value. Lack of information about tranche fair value would likely cause the market to assume a worst case scenario, and refuse to buy should you wish to sell your investment, except at a greatly discounted price. This would seriously reduce the liquidity of your tranche investments. Investors may be particularly insensitive to the possibility of a downturn in the economy if they are subject to behavioural biases such as representativeness, overconfidence and self-attribution bias. Copyright 2009 Pearson Education Canada 251