Chapter 8 - The Efficient Contracting Approach to Decision Usefulness PDF

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Professor: Kousay Said
Fall 2018
Adv. Accounting Theory...

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Chapter 8 – The Efficient Contracting Approach to Decision Usefulness What is Efficient Contracting Theory?  Focus is on role of financial accounting info in moderating info asymmetry b/w contracting parties o Debt contracts (lenders) and managerial compensation contracts o Lenders’ interests and managers’ interests may conflict with interest of shareholders o An efficient contract generates trust b/w these conflicting interests at lowest cost to firm o Contracts may be formal written documents or implicit  Implicit contracts arise from continuing business relationships  Implicit contracts can be modeled as non-cooperative games Sources of Contracting Demand for Financial Accounting Info:  Lenders o Lenders face payoff asymmetry  They can lose heavily if firm does poorly, but do not directly share in gains if firm does well  As a result, they demand early warnings of financial distress  Shareholders o Managers assumed rational and will act in their own interest, which may conflict with shareholders’ interests  As a result, shareholders demand info to encourage responsible manager effort and limit opportunistic actions Accounting Policies for Efficient Contracting  Reliability o Lenders demand reliable info to help protect against opportunistic manager policies that hide losses and record unrealized gains  Conservatism o Lenders demand conservative info to help predict financial distress  Conditional conservatism  Reporting unrealized losses helps predict financial distress o Shareholders demand conservative info for stewardship purposes  Conservatism makes it difficult for manager to increase reported earnings, and compensation, by recognizing unrealized gains  Efficient contracting demand for reliable and conservative info conflicts with Conceptual Framework o Framework more oriented to future-oriented (i.e. relevant) info (FV Acct)  Reliability downgraded to an enhancing characteristic o Framework more oriented to info needs of investors than to stewardship  Framework does state that investors need info about manager stewardship, but ignores the fundamental problem that best info for investor decision making and for stewardship evaluation need not be the same Contract Rigidity  Many contracts depend on accounting variables o Debt contracts contain accounting-based covenants o Manager compensation contracts depend on NI  Both types of contract lend to be long-term o Accounting standards often change during contract term, affecting NI and debt covenants

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 Profitability of debt covenant violation may increase  Manager compensation may be affected Since contracts are hard to change (rigid), unlikely that contracts can be renegotiated to allow for changes in GAAP As a result, managers are concerned about changes in acct standards and policies, even if no effects on cash flows o May lobby against proposed acct standards o May exploit the flexibility of GAAP to change acct policies to offset effects of changes in accounting standards on contracts (e.g. increase NI by lengthening useful life of capital assets) o May change operating policies (e.g. R&D, extent on hedging) A new acct standard has economic consequences if it motivates managers to change acct and/or operating policies

Employee Stock Options  Until 2005, no expense recorded for ESOs o APB 25 applied until 2004/05 o No expense need be recorded IF Intrinsic value = zero  Are ESOs an expense? YES o Dilution o Opportunity cost  Measuring ESO expense o Black/Scholes option pricing formula  Assumes option held to expiry date  But ESOs can be exercised early, b/w vesting and expiry dates  As a result, B/S overstates ESO expense o Accountants’ answer  Use expected exercise to date in B/S formula  June 1993 o FASB exposure draft to expense ESOs  Intense opposition from managers  Claimed reasons for manager opposition  Lower reported NI  Low reliability  FASB backs down, December 1994 o SFAS 123  May report ESO expense as supplementary info or in FS proper  Most firms chose supplemental option  Manager abuses of ESOs o Since no effect on NI, firms overdosed on ESO compensation  Managers motivated to increase reported NI in short run so as to increase ESO values o Pump and dump o Manipulate share price down prior to scheduled ESO grant dates o Spring loading o Late timing  Increasing evidence of abuses led to renewed pressures to expense ESOs, despite continued strong manager resistance o Manager resistance overcome 2005 (IFRS 2, SFAS 123R)  Why such strong manager resistance to ESO expensing, particularly since:

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o No effect on cash flows o ESO expense already reported as supplementary info Possible reasons o May lead to reduced use of ESOs as compensation  Resulting reduced scope to abuse ESO value? o Concerns about reliability of B/S? o Lower reported NI? o Rejection of market efficiency?

Distinguishing Efficiency and Opportunism in Contracting  A basic question in contract theory o Managers’ accounting policy choices driven by:  Opportunism: managers benefit at expense of investors  Efficiency: manager chooses acct policies to max. contract efficiency (e.g. good corporate governance) o Opportunistic view  Managers choose acct policies to max. their own expected utility o Efficient contracting view  Managers choose acct policies to attain efficient contracting  Some research consistent with contracting efficiency o Mian & Smith (1990)  Consolidated FS o Dechow (1994)  NI more highly associated than cash flows w/ share returns o Dichev & Skinner (2002)  Debt covenants o Wittenberg-Moerman (2008)  Conditional conservatism and info asymmetry (measured by bid-ask spread) positively associated  No association for unrealized gains  Some research consistent w/ opportunistic manager behaviour o Hope & Thomas (2008)  For multinational firms that did not disclose earnings by geographic segment, foreign sales incr. but earnings didn’t  Suggests empire building o Dechow & Shakespeare (2009)  Most firms in sample adopted aggressive FV acct for securitizations so as to avoid reporting a loss  Conclude: while significant evidence for efficiency version, also evidence for opportunistic acct policy choice Implicit Contracts (NO Binding Agreement)

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Nash equilibrium solution o RO: payoffs 35, 30 Cooperative solution o BH: payoffs 60, 40 Single play of the game o Why is BH unlikely?  Is closest to providing both the manager and investor with an equal payoff  If the manager is acting opportunistically, then the investor is not going to want to buy b/c it does not provide them with a good payout, which will cause them to refuse to buy, which provide the manager with a much lower payout compared to if the investor were to buy  Multiple plays: BH more likely o Manager reputation and ethical behaviour o Folk Theorem (Ch. 1, Note 23) Example 8.2: o A 5-period game o If parties do not trust each other, game unravels to single-period o If parties trust each other, game continues with probabilities shown  Note: trust is not complete but depends on difference b/w a player’s expected payoff from continuing and payoff from ending the game o How is trust maintained?  Ethics  Legal liability  GAAP

Conclusions:  Contract theory argues that the role of financial reporting is to generate trust b/w contracting parties o Debt and managerial compensation contracts emphasized  Contract theory conflicts somewhat with Conceptual Framework o Supports increased emphasis on reliability and conditional conservatism  Managers have acct policy choice o Is this flexibility consistent with efficient contracting or with manager opportunism?  Empirical evidence is mixed...