Economic Consequences & Positive Accounting Theory

Economic Consequences

100

According to Stephen Zeff’s research “The Rise of Economic Consequences”, what factor complicated the setting of accounting standards?

third-party intervention

200

What are some of the important reasons why the management is so concerned about the choice of accounting policies?

Many contracts the firms enter into such as executive compensation contracts and debt contracts are frequently based on financial variables like net income or various measurement of liquidity. Since accounting policies affect the value of these variables and the management is responsible for the firms’ contracts, it is nature that the management may choose accounting policies so as to maximize the firm’s interest or its own interest, relative to these contract.

300

Why does the firm’s accounting policy choice matter to investors?

Because managers may well change the actual operation of their firms due to changes in accounting policies. For example, managers may cut maintenance and R&D to compensate for a new accounting policy that lowers the bottom line.

400

The concept of Economic consequences is inconsistent with which existing theory? Briefly explain.

Efficient securities market theory predicts no price reaction to accounting policy changes that do not impact underlying profitability and cash flows. Since the theory assume when full disclosure is made, the market can predict the firms future value and not fooled by the variation in reported income that arise solely from the difference in accounting policies. Economic consequences concept concludes that accounting policy choice can matter even in absence of cash flow effect.

ESO

100

True or False?

Intrinsic Value is the difference between market value on the date options were issued and the exercise price.

True

200

After SFAS decision to use fair value to record ESO in 2005; use of ESO droped from $ 104 billion in 2000 to ______ in 2005.

A. 60 Billion

B. 30 Billion

C. 20 Billion

D. 80 Billion

B. 30 Billion

300

Name 2 of the 4 tactics managers use to abuse ESOs?

Pump and dump

Information release practice

Manipulate ESO award date ( Spring loading)

Late timing

400

What are the 3 Assumptions Huddart made regarding employee’s optimal exercise strategy?

Expected return from holding an option exceeds the expected return on the underlying share

Upside potential

Deep in the money

Hypothesis & PAT

100

According to the bonus plan hypothesis, the managers are more likely to choose accounting procedures

A. That shift reported earnings from future periods to the current period

B. That shift reported earnings from the current period to future periods.

C. None of them is correct.

A. That shift reported earnings from future periods to the current period

200

Managers of firms with bonus plans are predicted to choose

A. Less conservative and more volatile accounting policies

B. Less conservative and less volatile accounting policies

C. More conservative and more volatile accounting policies

D. More conservative and less volatile accounting policies

B. Less conservative and less volatile accounting policies

300

The political cost hypothesis predicts that managers of very large firms will

A. Choose more conservative accounting policies than managers of smaller firms

B. Choose less conservative accounting policies than managers of smaller firms.

C. More likely to oppose new standards that may lower reported net income.

A. Choose more conservative accounting policies than managers of smaller firms

400

Why the most favorable accounting policies are a balance of minimal cost, and flexibility to give management the option of changing accounting policies.

(hint: opportunistic behavior）

On the one hand, tightly prescribing accounting policies beforehand will minimize opportunistic accounting policy choice by managers but incur costs of lack of accounting flexibility to meet changing circumstances, such as new accounting standards that affect net income. On the other hand, allowing the manager to choose from a broad array of accounting policies will reduce costs of accounting inflexibility but expose the firm to the costs of opportunistic manager behaviour.

Empirical PAT Research

100

Define opportunistic behavior?

Opportunistic behavior- Given the available set, managers may choose accounting policies from their set for their own interests.

200

Delaying payment of current liabilities, writing off large amounts of slow moving inventory , and lowering receivables are all examples of

a) total accruals

b) negative accruals

c) discretionary accruals

d) positive accruals

c) discretionary accruals

300

What did Christie and Zimmerman found in their studies?

(hint: opportunistic vs. efficient contracting of PAT)

Christie and Zimmerman found that although firms who have become takeover targets were expected to have behaved opportunistically. showed that income-increasing accounting policies were relatively small.

400

How defaulting firms confirm assumptions made by the debt covenant hypothesis?

The debt covenant hypothesis implies that a firm's main managerial objective is to minimize problems with creditors. Especially at times where firms are close to violating accounting-based debt covenants, they are more likely to select accounting procedures that shift reported earnings from future periods to the current period. Basically firms choose accounting procedures that increase income to avoid these violations with creditors.