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ACTG 4P11 (6)
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Chapter 8

Chapter 8 Notes (Key takeaways from the chapter) .docx

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Department
Accounting
Course
ACTG 4P11
Professor
Brown
Semester
Winter

Description
Chapter 8 – Economic Consequence and PositiveAccounting Theory Economic Consequences - Argues that accounting policies do matter - Especially to managers, even if there is no cash flow effect - Contrasts with efficient securities market theory Employee Stock Options (ESOs) - Per Accounting Principle Board (APB) expense does not need to be recorded if intrinsic value is zero o Deemed to be inadequate because failure to record an expense understates the firm’s compensation cost and overstates its net income - Solution to this was the Black/Scholes option pricing formula but several aspects of ESOs were not captured by the formula o Assumes options held to expiry date  But ESOs can be exercised early, between vesting and expiry dates o Ended up overstating ESO expense o Accountant’s answer to this was to use expected exercise date - Difficult to estimate ESO expense so FASB backed down on the idea and gave the option to report ESO expense as supplementary information - Diluted EPS is always lower than basic EPS as it considers if all convertible securities were exercised (worst-case scenario) Manager Abuses of ESOs - Overdosed on ESO compensation since there is no effect on net income - Pump and dump – managers would take actions to increase share value shortly before exercising options, then sell the shares before share price fell back (sometimes in a manner to disguise the transaction) o Manipulate share price down prior to scheduled ESO grant dates - Spring loading – options are granted at a time that precedes a positive news event - Late timing – extreme case of award date manipulation (backdating ESO to a date when share price was lower than at actual ESO grant date) - Increasing evidence of abuses led to renewed pressures to expense ESOs, despite continued strong manager resistance o In 2005 – IFRS 2 and SFAS 123R requires expensing of ex ante ESO cost PositiveAccounting Theory (PAT) - Predicting such actions as the choices of accounting policies by firm managers and how managers will respond to proposed new accounting standards - Firms can be viewed as nexus of contracts (organization can be largely described by the set of contracts it enters into) - Emphasizes the impact of contracting costs on firm and manager behaviour o Firms will want to minimize the various contracting costs - Assumptions of PAT are that managers are rational and efficient securities markets Three hypotheses of PAT - Bonus plan hypothesis o Managerial incentive contracts o Bonus based on accounting variables o Implies stewardship role of accounting o Should consider lower and upper thresholds of bonuses Chapter 8 – Economic Consequence and PositiveAccounting Theory  If net income exceeds upper threshold, then preserve it (accrue) and report it next year since no additional bonus will be received  If net income is below lower threshold, make losses even worse so next year’s net income looks even better • These are in line with what a rational manager would do - Debt covenant hypothesis o The closer a firm is to violation of debt covenan
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