!

istory of employee stock options Mangers undertake economic transactions $ample %& "inancial accounting for Accounting system measures these economic employee )mostly transactions e$ecutive+ stock options Aggregates of transactions are reported according to In %19'/ A:4 '; 6 no need to accounting standards e$pense In this model management does not change its In %11;/ S"AS %'( 6 can e$pense if decisions about how and which economic Role of managers want )but nobody wants+ Managers are self interested parties. In ',,-/ S"AS %'(R )and I"RS '+ 6 The reporting of economic transactions impacts must e$pense their self interest The path )A:4 '; to S"AS %'(R+ is So management changes the choice of very interesting economic transactions to enter into Managers with large proportion of options& If Reporting now impacts managements operating e$pense/ 5I will go down/ managers will go behavior and not only reflect the consequences arly employee stock options a*c treatment away/ then no good managers already of operating behavior conomic consequences of reporting not trivial A:4 '; )%19'+ and the <intrinsic value= method& #ompare stock=s "M> with 3 : on date of Regardless of the M! or whether they affect grant $amples of economic consequences "#" If the "M> is greater than 3 : then $ample %& S"AS %'( )employee*e$ecutive stock options+ take the difference as an e$pense $ample '& S"AS %,- )other post.employment benefits+ ?sually options issued at current market value Managers want to ma$ compensation )Salary/ bonus/ stock $ecutive compensation @@ #ompany options+ e$pense )e.g./ Michael isner=s tenure as 0r #ash %,,, 0isney # 3+ #r Share #ap %,, If get option at higher e$ercise price& already #r additional paid up cap 1,, gain/ hence managers less incentive to give their To issue stock option best as already get the profit 2hen issue share/ no impact on IS Then& Manipulation of a stock whose price has been 3ld rule& as long as e$ercise price and market price are the rising In %11%/ ?S Senate threatened toe$pense/ get involvedH via option backdating ABero same/ there is no e$pense so/ in %11'/ "AS4 resumed reconsideration of A:4 4ut managers are getting compensation as they e$ercise '; 5ow have to find out the e$pense for the options that are "AS4 met consultants/ held board * task.force granted 6 to recogni7e compensation as e$pense #ompensation e$pense now is the fair market value of the meetings April F/ %11( "AS4 voted for e$pense * equity option !ence stock option increase tremendously for the more high recognition Eune (,/ %11( "AS4 issued an I $posure 0raftJ tech firms Cater #riticism )KKK+ 6 business/ auditors/ >#s/ industry As a result/ 5I was overstated by a lot steps in S3 accounting 3ld rule& no compensation e$pense groups 3ver the ne$t decade or more& 5ew rule& there is some compensation e$pense 0ramatic increase in )fi$ed+ employee stock Management to change transaction to minimi7e impact options 3ne is stock option e$pense 3ption pricing models )4lack D Scholes E: If co give mgmt compensation/ it should be in form of e$pense %19(+ 4ut if compensation is e$pensed/ the 5I will increase den will >ery sharp criticism of A:4 '; )e.g./ look into it/ then will reali7e why paying them so much inconsistency+ compensation but they not doing well 0uring %1FG.%1FF "AS4 reconsidered A:4 '; Share& if there is no outflow of resources/ why should it be an "AS4 was unanimous about the debit/ but not e$pense8 the credit )this led to a broader study of R!S In stock option e$pense there is no e$pense that is being used of 4alance Sheet+ up incentives "AS4 researched various option pricing S3 Since there is no asset used up/ no cash given/ then why is models )big issue of reliably estimating 2hile stock.based compensation <solves= that an e$pense one agency problem/ it arguably #ause there is an opportunity cost to company 6 cos they can <creates= another sell the options outside and profit from it 2hile it incents managers to care If do not give option then will give some kind of bonus )cash+ about stock price hence will be an e$pense It may incent them to care too conomic consequence !ence they want t treat it as an e$pense in the IS much 0echow/ !utton/ Sloan )EAR %11-+ 5ow restricted stock is taking over as Many companies submitted criticism the compensation choice letters. 2hy8 5o evidence of increase in cost.of.capital from lower 5I )inconsistent with <threat to competitiveness= argument+ 5o association with company leverage or si7e )inconsistent& debt covenant and political costs hypotheses+ Strong association with options to compensate e$ecutives )consistent& bonus plan hypothesis+/ Iopposition to e$pensing stock options arose

Chapter 8: Economic consequences and positive accounting theory

>aluing options Standard 4lack Scholes overstates cost mployees e$ercise early 2hy not use e$pected time to e$ercise This varies over time and across firms This also depends on in the moneyness of the option and risk aversion of # 3 3ptions need to vest 6 vesting uncertain 0ifficult to value option e$pense 6 unreliable If e$ercise early/ then 4S no applicable 6 IS not reliable/ If e$ercise early/ 4S overstate value/ option e$pense is too high/ income is low 4ut can put the e$pected time for e$ercise 5ot so indicative of future !ow to know e$pected time& look at previous years ) the average e$ercise time, Then take the number and put into 4S formula :ut an estimated period where employees e$ercise their option for a more accurate 4S value ( !ypothesis of positive theory accounting Let a distribution of when employees e$ercise %. The bonus plan hypothesis )e.g./ If there is too much variation/ the e$pected e$ercise time will be 0echow et al. EAR %11-+ a bad measure '. The debt covenant hypothesis )e.g./ 5eed to be constant over time for the same firm for it to be a Mittelstaedt et al. TAR %11;+ good measure (. The political cost hypothesis )e.g./ Eones If company is reasonably new/ and too short period to find out EAR %11% 6 p. '1%.'1(+ when will they e$ercise If can get bonus/ will manipulate upwards - 0o not have much history to predict If no change/ will not manipulate - M look at similar firms/ whether is it constant If can save for future then will manipulate - 4ut found out that it varies for different firms downwards - M difficult to figure out a good estimate of e$ercise 2. Debt covenant hypothesis - M decrease reliability of the value calculated from 4S 2ill try to manipulate leverage downwards $pected time to e$ercise depends on 0ebt*equity or debt*total assets !ow deep in the money )how much money they make+ #an reduce debt 6 payback or move some And the risk aversion of the managers )if risk neutral or risk debt off books and into off 4S items )capital adverse+ lease+ conomic conseq . restatements !ence difficult to figure out the value of option Increase the assets 6 revaluation/ increase S! fendi/ Srivastava/ Swanson )E" ',,9+ . associations w equity/ create some fake assets/ restatements %. 0ebt covant violation. Interest coverage & how much 5I can If firm close to violating/ it will manipulate the cover the interest. 2ant to show higher interest coverage number so violations will not happen (. :olitical cost hypothesis ratio so can continue borrowing and dnt hav to incur loss for "irm does not want political cost )people in renegotiation '. Raise capital& reduce cost of capital/ show is profitable firm/the govt/ regulators/ some agencies+ can get lower interest rate and sell capital at higher price 0o not want anything bad happen if not (. If #L is not very good& # 3 and his friends on the board/ people will scrutini7e g. SMRT will not want to show high profits as directors are not independentH do 3r when # 3 is chariman of the board 6 duality )one person not want to draw attention to yourself and incur high political cost holds ' position+/ if do both/ very powerful as know the Money lenders incur a lot of political cost as company very well/ can control and can manipulate the they have a lot of money 4oard and firm for their own benefit G. 2hen # 3 .have a lot of in the money option )market value #ompanies will manipulate their numbers conomic conseq 3: 4 such that they will not have high political cost higher than e$ercise price+& incentive of value manager to Accounting change& from cash basis to current )discounted :>+ 6 liability If have high liability in 4S& debt covenant may be violated/ high leverage ration& hence want to cut healthcare to make benefit smaller conomic conseq& cut the benefit for retiring employee If the employees were productive assets Retired employees no longer productive for the company hence can reduce their healthcare 2hy don=t cut benefits to current employees8 They will leave 4ut retired employees cannot do anything/ cannot quit so easy target Mittelstaedt/ 5ichols/ Regier )TAR %11;+ Many companies reduced * terminated 3: 4. 2hy8 2eak association with financial weakness 2eak association with rising health care costs Strong association with the impact of )new+ S"AS %,- liability in terms of how it increases pre.S"AS %,- liabilities

:ositive accounting theory Is concerned with predicting such actions as the choice of accounting policies by firm managers and how these managers will respond to proposed new accounting standards. If you view firms as ne$us of contracts/ this emphasi7es importance of <contracting costs= Trying to design the most <efficient= contracts #osts of moral ha7ard * opportunistic behavior

Chapter 9: Game theory Mathematical models of conflict #ooperative games vs. 5on #ooperative games #ooperative games 6 #artels 5on #ooperative games 6 3ligopolies. "or e$ample& 4etween shareholders and managers )the agency problem+ 4etween debt.holders and shareholders )the agency problem+ 4etween standard.setters and other parties 4etween auditors and clients N quilibriums 5ash quilibrium& A bo$ from which neither party wants to move. #oordination& ?sing a some device to coordinate actions :ure strategies& 2here there is a preferred corner solution Mi$ed strategies& 3ne can go with any of the strategies with some probability Repeated games& :lay the same game with the same player

The agency problem :rincipal )owner+ is risk.neutral/ manager )agent+ is risk. averse )square root utility+. Manager=s reservation utility is (. Managers fi$ed pay is T'; in all states Manager works hard& 3wner gets )%,,P,.-+R);;P,.G+.'; M ;9 Manager shirks& 3wner gets )%,,P,.G+R);;P,.-+.'; M GF 3wner is risk neutral so ? M U If costless monitoring is possible/ pay the manager only if the manager doesn=t shirk. )I"irst.bestJ M ;9 owners pay off+ 3wner prefers manager to work hard :roblem& owner cannot monitor the manager #ostless monitoring& if the manager can be costlessly monitored by the owner %st best solution& owner gets the ma$ payoff 5o agency problem& if owner can monitor the manager very closely - 2hen owner is the manager - "amily owned businesses 6 have much better monitoring - 2hy do you need monitoring and not give a contract 6 giving them bar for net income - Managers will have incentive to manipulate the numbers - Managers giving their own grades by making the books

Auditor=s payoff M O.(PpPqQ R O.;PqP)%.p+Q R )%.q+).(p+ M .(pq .;q R ;pq 6 (p R (pq M .;q R ;pq 6 (p Slope over p M ;q 6 ( )differentiate wrt p+ quating to 7ero/ qM (*; M ,.-, #lerk is committing more fraud and the auditor is committing less fieldwork #lerk commit fraud -,S of the time and auditor verify ;,S of the time there is no one cell that dominates the other cell. Then have to put some weight in each of the cell :utting some weight in every of the cell. 0on=t follow one particular strategy but follow a mi$ed strategy 5ow nobody is buying/ now all the money flow to risk free M no capital investment/ !ence is not a good equilibrium to have To get away from this equilibrium/ distort to honest eqm - Through regulation/ - If manager is getting the money out front/ need to give them punishment - #lawback& if find out that they have lied - So as to induce them to be more honest - If there is any distortion/ investors will sue the managers and get their money back - !ave to make the threat credible )make people believe that they will carry out the threat+ - Through enforcement - If not credible/ then will not have a good equilibrium