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In his article "The Impact of Accounting Regulation on the Stock Market: The Case of Oil
and Gas Companies," Lev (1979) examined the daily returns on a portfolio of oil and gas
companies' common shares affected by the exposure draft of SFAS 19. This standard
required firms to use the successful efforts method of accounting for the costs of oil and gas
exploration. Under successful efforts, costs of drilling unsuccessful wells are written off
when the well is determined to be unsuccessful. An alternative policy is full cost accounting,
under which the costs of unsuccessful wells are capitalized into the costs of successful wells.
For firms with an active exploration policy, successful efforts reports lower net income than
full cost, and also increases earnings volatility. Under the proposed standard, firms that were
using the full cost method would be required to switch to the successful efforts method. The
new standard became effective in December 1977 SFAS 19 was objected to particularly
strongly by small oil and gas firms, especially if were actively exploring, who argued that
successful efforts accounting would reduce ty to raise capital, with consequent effects on oil
and gas exploration and on the their abili level of competition in the industry Lev found that
there was an average decline of 4.5 % in the share prices of firms th have to switch to the
successful efforts method, during a three-day period foll ease of the exposure draft (july 18,
1977). This study is one of the few that have securities market reaction to an accounting
policy change that would have no direct impact on cash flows.
Required
a. Why did Lev examine share returns around the date of the exposure draft (July 18, 1977)
rather than the date SFAS 19 was issued (December 5, 1977)?
b. Use contract theory and efficient securities market theory to explain why the stock market
reacted as it did to the exposure draft of SFAS 19
c. Suppose that, pursuant to the theory and evidence described in Section 6.2, securi- ties
markets are not efficient. What reaction to SFAS 19 would you then expect? Explain
5. A new accounting standard requires a firm to accrue major new liabilities for employee
pensions and benefits. As a result, its debt-equity ratio rises to the point where technical
violation of covenants in its borrowing agreements is threatened. Management knows that
renegotiation of these covenants would be difficult and costly.
Suggest some accounting policy choices that could reduce the likelihood of technical
violation. Ideally, any changes in policies should not violate GAAP, not affect the firm's real
operations, and not reduce cash flows. Justify your suggestions.
6. Use contract theory to explain how conditionally conservative accounting can contribute to
efficient contracting Consider both debt and managenal compensation contracts.
Required
a. Why would firms with large ESO plans buy back their stock? Explain
b. Normally, companies that buy back their shares do so over time, to avoid the increased
demand bidding up share price, thus raising the cost of buying them back. As the shares are
bought back, the company then records the reduction in outstanding shares and the cash
payment. However, according to an article in The Globe and Mail (Uanuary 31, 2006, p.
B13), "Watch out for the loophole: buybacks have hidden costs" (reproduced from The Wall
Street Journa), many companies have engaged in accelerated share repurchase. Under this
tactic, firms recorded their total planned buyback all at once at their shares' current market
price, even though they had not yet bought back the shares. This maximized the increase in
current earnin Would you, as a potential investor in firms using this tactic, be concerned?
Why or why not?