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Chapter 8

Efficient Contracting Approach to


Decision Usefulness

8.1 Introduction
Apply theories you learned to date and
discuss:

Do accounting choices matter?

Do Accounting Choices Matter?


EMH (Ch4&5)
No, because
Market is efficient and investors are rational
-> Investors see through financial reports
-> Accounting choices do not matter, if fully disclosed
and if there is no impact on cash flow
-> price reaction would be the same

Cannot explain certain phenomena in real world


Whole industry switch from DDB to SLM in accounting
for PP&E
Most firms choose operating lease over finance lease
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Do Accounting Choices Matter?


Measurement approach (Ch6&7)
Yes, because
Investors are irrational, due to e.g. limited attention
-> Investors cannot see through financial reports
-> Price reaction would be different to different
accounting choices (i.e. acct. choice does matter)

Efficient contracting theory (Ch8-13)


Yes, even without the existence of irrational
investors
Why?
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Efficient contracting theory


Efficient contracting theory (ECT) (8.2)
ECT and accounting

Contracting demand for accounting information(8.3)


Accounting policies for efficient contracting (8.4)
Contract rigidity and accounting choices (8.5)
Illustration: Employee stock options (8.6&8.7)
Special issues
Contract efficiency vs. opportunism (8.8)

Summary (8.9)

8.2 Efficient Contracting Theory


A firm can be viewed as a nexus of contracts
Contracts with employees, managers, creditors,
suppliers, customers, government, etc.

Efficient contracting means


- A firm organizes itself in the most efficient manner, through
contracts with different parties, to maximize prospects for
survival
- An efficient contract generate trust between contractual
parties at lowest contracting costs to firm
- What are possible contracting costs?
- Negotiation, monitoring, contract violation, enforcement, etc.

- Contracts may be formal written or implicit


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8.3 Contracting Demand for


Accounting Information
Discuss
1.Do managers, investors, and creditors interests
always align with each other?
2. If not, how to moderate the conflict of interests?
(Hint: from investors and creditors point of view, what is unobservable of
managers? What is observable of managers?)

- Managers effort & ability not directly observable


Lead to moral hazard and adverse selection

- Accounting information helps to make managers


unobservable behaviors observable
What information should investors/creditors
demand?

Contracting Demand For


Accounting Information (Contd)
Lenders (creditors)
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 warning of financial distress

Shareholders
Managers assumed rational and will act in their own
interest, which may conflict with shareholders interests
As a result, shareholders demand information to
encourage responsible manager effort and limit
opportunistic actions
Note this contracting demand differs from demand under
market efficiency/inefficiency

8.4 Accounting Policies for


Efficient Contracting
Demand under market efficiency
Relevant information => Fair value accounting

Demand under efficient contracting


Reliability
Lenders demand reliable information to help protect against
opportunistic manager policies that hide losses and record
unrealized gains

Conservatism
For lenders: help predict financial distress
Reporting potential losses but not gains
For shareholders: help assess manager stewardship
Conservatism makes it difficult for manager to increase
reported earnings and compensations

ECT and Conservative Accounting


What is conservatism?
to recognize losses but not gains when anticipated
As a result, timely recognition of losses but not gains

Why conservatism? contracting perspective


Makes it more difficult for managers to take advantage of
creditors
e.g., more difficult to pay excessive dividends/bonuses
Remember creditors share in firm value decrease but do not
directly share in firm value increase

May help firm to reduce cost of debt


By giving creditors increased security
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8.5 Contract Rigidity


One way to minimize contracting costs is the use
of accounting-based numbers
Many contracts depend on accounting variables
e.g. Debt contracts contain accounting-based covenants
e.g. Manager compensation contracts depend on net income

Such contract tend to be long-term, and hence is


subject to contract rigidity
That is, once contract is set, its hard to change
Accounting standards often change during contract term
Probability of debt contract violation may increase
Manager compensation may be affected
However, due to contract rigidity, its unlikely for managers to
renegotiate the contract given the the change of standards
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Contract Rigidity (Contd)


As a result, managers
- May lobby against proposed accounting standards
- May exploit the flexibility of GAAP to change accounting
policies
- e.g. by lengthening useful life of capital assets

- May change operating policies


- e.g., by reducing spending in R&D

A new accounting standard has economic


consequences if it motivates managers to change
accounting or operating policies
ECT assume managers, like investors, are rational
Rational managers may tempt to bias or manipulate accounting
variables for their own benefit

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Economic Consequences
A concept that asserts that, despite the implications of
market efficiencies, accounting policy choice can affect
the decision making behavior of business
Hence accounting choices do matter, even without consideration
of market efficiency

Examples of economic consequences

Debt contracting (Ch8) Finance lease vs. operating lease


Employee stock options (ESO) (Ch8)
Executive compensation plan (Ch10)
Earnings management (Ch11)
Accounting standard setting (Ch12&13)
Accounting standard has economic consequences if it affects
managers accounting choices and/or operating policies
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8.6 Employee Stock Options*


GE issued a share of stock option to its employee Mary, allowing Mary to buy GEs
stock at $80 in anytime of the next three years. GEs current stock price is $80. The
fair value of this option (calculated by Black/Scholes option pricing model) is $7.8.

How would GE account for this transaction?


Accounting for ESOs (FASB)

1972: APB 25
1993: FASB Exposure Draft
1994: SFAS 123
2005: SFAS 123R

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Accounting for ESO (1972)


1972: APB 25
ESOs are expensed at the intrinsic value of option
Intrinsic value = Exercise price market price of
share on grant date
Economic consequences
Most firms reported no expenses, by setting exercise
price @ market price

This approach was criticized. Why?


The option has a fair value on grant date, even if the
intrinsic value is zero. Why?
The price of underlying share may rise over the term, and
hence creating an opportunity cost for the firm

Fail to recognize ESO expenses understate firms


compensation expenses and overstate net income

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Accounting for ESO (1993)


1993: SFAS123 (Exposure Draft)
Proposed to expense ESOs at fair value of
option on grant date
Economic consequences
Strong manager resistance, arguing such policy
Leads to reduced use of ESOs as compensation
Uses unreliable FV measurement (e.g. Black-Scholes
formula)
Reduces reported net income

FASB backs down => 1994 SFAS123


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Accounting for ESO (1994)


1994 SFAS123
Fair-value ESO expenses may be reported as
supplementary information
Hence no impact on net income number

Economic consequences
Large scale of manager abuses of ESO
Firms overdosed on ESO compensation (since no
effect on net income)
Manipulate share price up before exercising option
(e.g. pump and dump p.326)
Manipulate ESO grant date (e.g. spring loading, late
timing -p.327)

=> FASB SFAS123R (2005)

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Accounting for ESO (2005)


2005: SFAS 123R
Reinstate requirement to expense ESO at fair
value on grant date
Result in lower net income

Economic consequence
FV of ESOs granted by the top 500 US firms
2000: $104 billion
2005: $30 billion
(Source: The Economist 2006)
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8.8 Efficient Contracting vs.


Opportunism
Are managers accounting choices driven by
Opportunism?
Manager benefits at expense of investors

Efficiency?
Manager chooses accounting policies to maximize
contract efficiency
Manager benefits align with investor benefits

Its hard to differentiate the two motives


Current academic research is inconclusive
Both versions have supporting evidence from
academic research
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8.9 Conclusion
Efficient contracting theory (ECT) focuses on the
role of financial reporting in moderating information
asymmetry between contracting parties
Debt and managerial compensation contracts emphasized

ECT conflicts somewhat with existing Conceptual


Framework
Existing framework emphasizes relevant information
ECT emphasizes reliability and conditional conservatism

Managers have flexibility in choosing accounting


policies
Is this flexibility consistent with efficient contracting or with
manager opportunism? - Empirical evidence is mixed
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Do Accounting Choices Matter?


- Efficient Contracting Theory
Accounting is a tool to facilitate the formation
and performance of contracts
Accounting policies can be used as a mechanism to
minimize contracting costs

However, contracts are


Rigid (not adjustable once made)
Incomplete (cannot factor in all possible situations)

To overcome contracting rigidity and


incompleteness
Managers tend to monitor accounting-based numbers

As a result, accounting choices do matter


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Goal of Financial Reporting


Decision usefulness
Useful to whom?
Chapters 2 to 7: Investors only
Chapters 8-11: other stakeholders considered (creditors, etc.)

Management stewardship
Should this be the primary goal of financial reporting as
well?
Existing conceptual framework puts this goal as secondary to
decision usefulness goal

If yes, required efficient corporate governance


Efficient contracting is one way to achieve efficient corporate
governance
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Why study ECT in accounting


context?
To understand the impact of ECT on
accounting
How ECT affects firms accounting policy choice in
different scenarios and across different firms

To understand the impact of accounting on


ECT
Contracts often based on accounting variables
Accounting information also serves as a checkup

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