chapter 8 Flashcards
Economic consequences
Accounting policies matter (especially to managers_ even if it has no effect on cash flows. Manageres may change actual operations due to changes in policy.
rigid contracts are based on accounting variables (compensation or debt). will choose policy to max firm or own interests.
implications of investors not bearing costs of information disclosure.
will demand standard setters to mandate more info than is socially desirable.
positive accounting theory
attempts to predict what policy will be chosen to max firm/own interests. and how managers will respond to new standards.
What are the effects of ESOs on firms?
dilute share base and lowers future dividends. Expensing ESO FV helps investor better predict future CFs from investment
Why employees hold option to expiry?
1) E(r) from holding options exceed E(r) from holding shraes
2) value includes time to maturity. early exercise sacrifices upward potential
3) if deep in the money, payoff from holding option closely resembles holding share. might as well hold to maturity (time value of money)
Why exercise early?
slight in the money increases the risk of zero payoff.
2) low time to maturity = low upside potential
3) deep in the money & expiry time is short
Problem with using BS to calculate the value of ESOs
1) early exercise was common: FV is lower than value determined by BS.
2) ESOs can’t be freely traded. Value is lower.
Problems with ESOs
1) Senior managers pump and dump.
2) annouce bad news to lower ESO exercise price, then manage earnings up after ESO issue. (only done if ESO grant date were unscheduled, otherwise investors discount this info)
3) spring loading: grant ESO before GN
4) late timing: backdating of ESO awards (violate GAAP)
PAT implication for manager compensation contract.
Assumption: managers are rational and will choose accounting pols in in their own best interest. Opportunistic behaviour will be anticipated when contract is negotiated and firm will price protect itself. (gives manager incentive to behave opportunistically give lower compensation)
3 hypothesis of PAT
1) bonus plan: managers of firms with bonus plans are more likely to choose accounting policies that shift Earnings to curremt period. also prefer policies that smooth earnings –> higher utility if less volatile
2) debt covenant: the closer a firm is to violating its debt covenants, the more likely a manager is to shift reported earnings to current period
3) political cost: managers are more likely to defer earnings to future period if there is higher political cost.
effect of conversatism on debt
higher conservatism decreases the risk of excessive dividends because firms have to keep more capital in order to stay within its covenants. This allows firm to issue debt at lower interests
Income escalator clause
increase covenant level required by a percent of net income. greater incentive for managers to be conservatism in accounting practices
Efficient contract cost approach
If accruals are largely the result of opportunistic maniplation, market will reject them in favour of CFs. NI found to be more highly associated with share returns than CFs.
