Tugas Positive accounting theory Chapter 9

There are many more covenant restricting managers actions in debt agreement, but the preceding are the principal types that use numbers in the audited financial statement. Public debt contracts typically use reported number and require them to be consistent with generally accepted accounting principles (GAAP). In contrast, private debt occasionally adjust the reported numbers to “undo’ some GAAP procedures. For example, some of prudential insurance company’s contract require the use of the cost method of reporting unconsolidated subsidiaries in situations where GAAP requires the equity method.

Gaap are accounting principles, that have “substantial authoritative support” in the opinion of the SEC. This is distinct from our term “accepted procedures” which is the set of accounting procedures used in contracts.

The used of GAAP in debt contract

Even if some GAAP procedures are undone, debt agreement basically use reported GAAP accounting numbers. The variations take the form of bottomline adjustment rather than complete recalculation of accounting numbers. For example, the income form subsidiaries under the equity method is deducted from GAAP earning and tge cost method income added. The spesification and preparation of an additional set of accounting statement solely for a debt contract is costly. Given that cost, it is probably cheaper for the shareholder to use GAAP and bear any additional cost of “creative accounting “ via the debtholders’ price protecting themselves when the debt is initially sold.  

The reason GAAP variation are more common in private debt contract than in public debt contract is probably the difference in renegotiation costs for the two types of debt. Private debt is usually placed with a few insurance companies or banks. These private lender are well informed and are usually ready to renegotiate contracts if a technical breach occurs in situation where the value of the firm is not below the face value of the debt. This type of breach occurs if a change in GAAP causes the debt/equity ratio to change for example. Such technical default are probably more expensive to renegotiate in the case of public debt. The trustee for the debt usually has to obtain approval of the holders of two thirds of the outstanding debt to change the contract. And buying some of the debt will not help the firm renegotiate, since it is allowed to vote the debt it holds. The more costly it is to renegotiate technical breaches of covenant, the less restrictive covenant we except to observe.

A change in GAAP can cause a technical default on firm’s existing debt contract because the accounting numbers in the contracts covenant are calculated using GAAP at the time of the calculation, not at the date of the issue of the debt. As a result the covenant and contract are affected as GAAP changes.

DEBT CONTRACTS EFFECT ON ACCOUNTING

Like accounting based compensation plans, accounting based debt covenant will be effective only some restriction are placed on managers abilities to control the calculation of the numbers their choice of accounting procedures is restricted.) consequently, if accounting procedures user to calculated reported numbers were not regulated, a set of accounting procedures that restrict the managers choice and are acceptable to each party would emerge either as common practice or as explicit specification in debt contracts.

The nature of current debt contract variation form GAAP provides evidence as to the nature of accepted procedures that would evolve. If debt contracts influenced accounting practice prior to the regulation of disclosure, the variation would also give insight as to why accounting practice took the form it did in the United States prior to the 1932 and 1933 securities acts.

Accepted procedures

Debt contract variations from gaap typically do not allows certain increases in earnings and assets value permitted by gaap and require certain  decrese in income and assets values or increase in liabilities not necessary  under GAAP. The exclude increases in earning in tend to non cash revenues or credits. For example, the equity method of recording a subsidiarys earnings bring into the parents income the parents share of the subsidiarys earning fot that period. This method is spesified by GAAP, but some debt agreement substitute the cost method whereby only the dividend received by the parent are recorded as income. Assets allowed by GAAP byt excluded in debt contracts consist primarily of intangible assets. For example, goodwill from consolidation if often excluded by the covenants.

One example of a liability that bond covenant have required, but GAAP has not, is the liability. Many lease liabilities were not, until recently, recognize by GAAP. However, some debt agreement required them to be included in calculating the debt/equity and other ratios used by the contract along with an offsetting assets the leased assets. The net effect is to increase the debt/equity ratio and the debt total assets ratio.

All the variation from GAAP are consistent with conservatism. They delay recognition of revenue (cost method for unconsolidated subsidiaries) and choose lower values for assets ( exclude intangible assets). In the one case where an additional asset is included (leasing), the net effect is conservative because the accompanying liability ebsures an increase in the firm debt / equity ratio. The variation appears designed to offset the managers tendency to overstate earning and asstes, to reduce the manager ability to use accounting manipulation to cause debt covenant to be ineffective. The exclusion of itangible assets prevents the manager form inflating those assets to avoid debt/equity or debt/total assets constrains. The undoing of the equity method eliminates form earning funds that many not be legally available to meet the parents interest obligation. Hence, it prevents overstating the parents times charges earned ratio. 

The variations from GAAP in debt contract are attempt to undo GAAP standard and so suggest that in the absence of regulation ans GAAP, the conservatism and objectivity principles would be observed. Debt contract usage of reported accounting numbers reinforces the bonus plans effect on accepted procedures.

The previous discussion is basically an intuively pleasing rationalization of accepted accounting practice prioir to regulation. It is difficult to develop the implications for accepted procedures formally and to formally test them. However, if we take set of accepted procedures and the terms of debt contract as given, we can make formal testable predictions about the managers choice of procedures form among accepted procedures.

Choice among accepted procedures

GAAP leaves managers with consireable discretion i nthe chioce of accounting procedures. For examples, the managers can choose straight line or accelerated depreciation. FIFO or LIFO valuation methods for inventories, and the deferred or flowthrogh method of accounting for investment tax creadit. A default on a debt contract is costly. So contract that define a breach in terms of accounting numbers provide managers with incentives to choose accounting numbers provide managers with incentives to choose accounting procedures that  reduce the probability of a breach. Ceteris paribus, they would like to choose procedures that increase asstes, reduce liabilities, increse revenue and decrease  expense . further, if a breach is going to occur under one accounting method, one would expect managers to switch procedures to avoid the breach.

The preceding analysis provides testable proposition about the variation i naccounting procedures acrosss firm and about the nature of firm that change procedures across firms and about the nature of firms that change accounting procedures across  firms and about the nature of firm that  chnage accounting techniques. For examples, firm with debt contracts are more likely to use earning and assets increasing accpunting procedures (e.g straight line depreciation in most cases) than are firm with no debt. Also, among firms with debt the closer a firm is to its restictive covenant on the ration of unterset to earnings, the more likely the firm will use straight-line depreciation, assuming that straight-line increases earnings. 

The preceding hypothesis on variation in accounting procedures among firms with debt depends on the detail of debt covenant. Just as early reseachs chose to investigate the bonus hypothesis rather than hypothesis based on the details of bouns plans, they also chose to investigate a simple debt contract hypothesis rather than hypotesis  such as the bonus plan hypothesis are on way to see whether incurring that cost is likely to pay off.

      We call the simple hypothesis early researches chose to investigate the debt/equity hypothesis :

Debt/equiy hypothesis. Ceteris paribus, the larger a firm debt/equity ratio, the more likely the firms managers is to select accounting procedures that shift reported earnings from future period to the currentt period .

The debt/equity hypothesis can be derived from the hypothesis (based on debt covenants) that the closer a firm is to particular restrictive accounting-based covenant the more likely the manager is to use procedures that increase current earnings.

To see the connection between the debt/equity hypothesis and the covenant-based hypothesis, consider the inventory of patable funds covenant (equation (9.1). from the stakeholders perspective, there is an equilibrium level of payable funds inventory that is the result of a trade-off between two cost (kalay.1979). One is the cost of the forgone wealth transfer from debt, and it increase as the inventory increase. The other is the expected cost of negative net present value project that have to be taken if the inventory of payable funds is zero and no dividents can be paid. This latter cost increase as the inventory of payable funds decrease. Ceteris paribus, the wealth transfer forgone are larger, the larger the debt/equity ratio, so firms with higher debt/equity ratios have lower equilibrium inventories of payable funds. Hence, firm with higher debt/equity ratios are closer to their inventory of payable funds constraint and are more likely to addopt procedures that shift reported earning from future periods to the current period.

Additional assumptions from required to derrive the debt/equity hypothesis from the inventory of payable funds effect on accounting procedure choice and so it is a less direct and less powerfull test of the theory. Hence, as the literature develops, we expect more researchers to concentrate on testing hypothesis that use the detail of covenants rather than teh debt/equity hypothesis. As we shall see in chapter 11, such a change has occured (holthause 1981).

There are some problems with hypothesis based on covenant details.one is the difficult of observing how close the firm is to ots covenant. Consider the inventory of payable funds. The effective inventory is not necesarryly the inventory of payable funds calculated according to equation(9.1). if a firm is using accelerated depreciation, it can usually increase its earnings and the inventory of payable funds by switching to straight line depreciation. Hence, the effective inventory calculated under existing accounting methods and the “hidden” inventory (i.e.  increase in yhe inventory due to changes in accounting methods). Managers may prefer to let the reported inventory of funds run down first before changing methods to increase method increase other cost (see chapter 10) it may also reduce future dscretion since future debt contract will set the inventory based on earnings using the new method. Offsetting this is incentive to addopt earnings increasing method for compensation purposes.

STOCK PRICES EFFECT OF PROCEDURE CHANGES

accountings role in debt and compensations contract provides the opportunity for changes in tax neutral  accounting procedures to affect stock prices. Changes in accounting procedures affect agency cost and can transfer wealth between parties to the firm. The studies reviewed in chapter 4 did not have a theory to tell them where to look for stock price changes accompanying tax-neutral procedure changes have stock price effect. Waht are the predictions powerfull tests of those predictions?

The analysis of the stock price effect of procedure changes depend on wheter the changes are made voluntary by the managers or are mandated by a FASB statemnt or SEC release.

Voluntary changes

A managers voluntary changes accounting procedures because the firm accepted det of accounting has changed or because the managers optimal choice from among the aceepted set has changed.  The firms accepted set of procedures can changes  can changes for a least two reasons (1) the firm changes industries and the new industry has a different set of accepted procedures, or (2) there has been an accounting innovation such that a new set of procedures is optimal forthe firms industry (i.e maximizes industry market value ). The manageres optimal choice from among eccepted procedures can change because the firms fortunes have changed. For example, the firm has had losses scuh that it is close to a debt covenant ratio and a change is necesarry to prevent technical default.

Changes in the set of accepted procedures

At the present stage of development ot the contracting theory there are no prediction about the stock price effect of changes in accepted procedures. For example, if a firm changes industries, the stock market will expect the firm to adopt the accepted accounting procedures of its new industry. Hence the stock market impounds the expected  agency cost under the expected new procedures at the time it learns of the firms industry change. Expected agency cost borne by in the stock price change due to the changed investment. Further, it isn;t apparent what share of any change in agency cost is borne by the shareholders. Much of it might be borne by the manager.

Changes in the choice among accepted procedures

The stock price effect of these changes depend on whether they are induced by bonus plans or debt contract. An earnings increasing change to increase the managers bonus presumably transfer wealth from the shareholders to the manager and causes stock prices to decrease to the extent it is unexpected. However, the relative price decrease for each share is likely to be trivial and unobservable. An earnings increasing change to prevent an impending technical default increases stock prices to the extent it is unexpected. Since the cost of technical default are limited by the cost of renegotiating the debt or repaying it (the managers will take the least cost alternative), the xtock price increase is likely to be very small and difficult to observe.

The difficult of observing stock price effect of voluntary changes between accepted accounting procedures is increased by the fact that the market is lilely to expect the change. If a firm is in danger of violating a debt/equity constraint because of recent losses, the market will expect the change with high probability (and impound its effect in the stockprice). There will be little surprise (and hence little stock price effect)when the firm actually changes procedures.

Investigating only the largest stock price effect will not produce more powerfull test. There isn’t likely to be any predictable variation in surprise ( and stck price effect on announcement) across firms. The market will assess the firms change as more likely, the higher a technical default cost (e.g., the higher the renegotiation cost ). Hence, the fims with the highest cost will have the lowest change in probability (to one) on announcement may not be higher than those of other firms.

The conclusion is that it is not possible to predict the stock price effect of voluntary changes in accounting procedures resulting from changes in the set of accepted procedures and very difficult to design powerfull test fot the stock proce effect of voluntary changes among accepted procedures.

Investigating only the largest stock price effect will not produce more powerfull test. There isn’t likely to be any predictable variation in surprise ( and stck price effect on announcement) across firms. The market will assess the firms change as more likely, the higher a technical default cost (e.g., the higher the renegotiation cost ). Hence, the fims with the highest cost will have the lowest change in probability (to one) on announcement may not be higher than those of other firms.

The conclusion is that it is not possible to predict the stock price effect of voluntary changes in accounting procedures resulting from changes in the set of accepted procedures and very difficult to design powerfull test fot the stock proce effect of voluntary changes among accepted procedures.

Mandated changes

 A change in accounting standar (via an FASB statement or an SEC release) affect existing contract and culture contract. Existing contract are affected because they use accounting numbers calculated according to current GAAp rather than GAAP in force at the time the contract was wrutten( as discussed earlier). A change in accounting standars changes GAAP and changes existing contract. This can lead to a wealth transfer to shareholders ( a stock price decreaase). Future contract are affected because a change in GAAP makes some accounting procedures more or  less costly and changes the optimal contracting technology. For example , FASB 19s ban on the full cost method of accounting for oil and gas firms increases cost is borne by shareholders in the form of decrease in share prices.

The stock price effect of a change in accounting standart depends on wheteher the change expands or restrict the set of available accounting procedures.

A restriction of the accounting procedure set occurs when an existing procedure is eliminated by a standar. If yhe eliminated procedure is part of a firms optimal contracting technology  ( wolud be an accepted accounting procedure in the absence of regulation ), the firms stock price falls. The fims stock price drops also if the procedure could be used to reduce the probability of default on existing debt. This latter effect is reduced by the managers inability to use the method to increase his or her bonus.

An expansion o fset of accounting procedures occurs when a standar allows a previously dissalowed accounting procedure. If the newly allowed procedure becomes part of the firms optimal contacting technology, the firm stock price rises. That rise is reinforced if the new procedure allows the managers to reduce the probability of default on existing debt contract again, that latter increase in price is partially offset by any increased ability on the managers part to increase his or her bonus. 

Under either a restriction or an expansion of the set of accounting procedures, the stock price effect via existing debt contract id bounded bt the cost of renegotiating the debt or repaying the   debt. The stock price effect via existing bonus plans is bounded by the management compensation commitees cost of adjusting for the change. These make its observation more difficult.

Nevertheless, the stock price effect of mandated chaneg are likely to be more observable than those of voluntary changes. Standards may be less predictable than managers action ( their voluntary accounting changes) and evens if they are not, their stock price effect can vary across firms in a predictable fashion. In voluntary changes, the larger a voluntary changes benefit, the greater probability the market attaches to the change. This greater probability  reduces the announcement stock price effect and offset the larger benefits. Accounting standards typically apply to many firms, so the probability of many firms. If that is the case, the announcement of an aacounting standars is the same for many firms. If that is the case, the announcement stock price effect will vary across firms as the standards cost and benefit vary. If the cross-sectional variation incost and benefit is predictable, the cross sectional variation in stock price announcement effect is predictable.

SUMMARY

Researcher use formal management compensation plans and debt contract to generate hypothese form contracting theory about the managers choice  of accounting procedures and the stock price effects of accounting procedure changes. They use those contract because data are available on their existence and their details. They assume that the contracts on their existence and their details. They assume that the contract function is to reduce agency costs.

Compensation plans and debt contract use accounting numbers. If the accounting based provisions are to be effective in restricting the managers firm value reducing actions, there must be some restriction placed on the managers methods of calculating the accounting method restrictions means that the managers discretion in choosing accounting  procedures is not totally eliminated. Hence, we expect a set of accepted procedures to evolve and the managers to have discretion in choosing form among that set.

We can learn something about the nature of the accepted set of procedures from accounting and auditing texts prior to procedure regulation and from the GAAP variation that accepted procedures are conservative and emphasize objectivity to offset the managers incentive under both contract to overstate earning and assets.

Researchers generate prediction about the manager choice among accepted procedures by assuming that  the compensation plans, commonly tested hypotheses (bonus and debt/equity hypotheses) use simplified version of compensation plans and debt contract. The bonus hypothesis predict to increase current earnings. The debt / equity hypothesis predict is to choose earning encreasing procedures. Later studies ten to generate more powerful test of the theory using the setails of the contract.

The contracting theory implies that changes in accounting procedures can have stock price effect. We are unable to predict the direction of the stock price effect of vloluntary changes in accepted in accounting procedures that occur because of changes  in the accepted set of procedures. The direction is predictable for voluntary changes in accounting procedures that occur to increase bonuses or reduce the probability of default. However the magnitude of those changes is limited and they are likely to be associated with other events and so are expected by the market. Consequently, the stock price effect will be difficult to observe. The stock price effect of accounting procedure changes that are due to changes in standards (mandated charges) deoend on whetger the set of available accounting procedures is expanded or restricted. Expansions tend to increase stock prices and reduction to decrease them.

Accounting procedures can affect the firms cash flows via the political process as well via the contracting process. The next chapter (chapter 10) develops the political process link between accounting procedures and cash flows and generates additional hypotheses about the managers procedure choice and the stock price effects of procedure changers. Chapter 11 reviews empirical test of the accounting procedure choice hypothesis generated in this chapter and in chapter 10. Chapter 12 reviews empirical test of the sotck price effect hypotheses.