Market Value and Change in Accounting Policy - Essay Example

Market Value and Change in Accounting Policy Introduction The main purpose of this study is to determine how the choice of accounting policy, a firm makes in the market, can affect its market value or earning management. In 1979, there was an average decrease of 4.5% in the share price of oil and gas firms that would have changed their accounting policy, for the exploration cost, from the “full cost” method to “successful efforts”. This case forms the basis for carrying out research on whether accounting policy may influence the value of a firm. Any organization in the market has to ensure that it chooses the correct accounting policy in order to attract more investors. The investors usually have interest in studying the financial situation of the company to allow them make an effective marketing decision. Insightfully, this means that the choice the company makes will affect the reflection and recording of financial statement to the investors. Consequently, the earning management by a company highly depends on the accounting policy that a firm uses in showing its financial position. Discussion The switch between FC and SE, as accounting methodologies, depend on the reasoning that one capitalizes while another expenses the cost. Successful Efforts refers to the methodology where the unsuccessful exploration cost is expensed and usually integrated as part of the income statement. However, Full Cost involves capitalizing the unsuccessful exploration cost meaning that this cost is not part of the income statement in this case. The choosing of the two alternative methods relies on their effectiveness in achieving transparency related to the accounting information about oil and gas company’s earnings and cash flows. Based on the Successful Cost method, the objective of an oil and gas company is to produce oil or gas from its reserves hence the view that only the costs related to successful efforts are capitalized. On the other hand, the cost incurred is usually expensed, because successful results rely on the change of productive assets. Conversely, FC method holds that the main objective of the oil and gas companies is to explore and develop oil and gas reserves. This implies that the costs incurred in the process of exploration and development should be capitalized followed by writing them off as the operation cycle continues. However, the regulatory approval from Financial Accounting Standards Board (FASB), which looks over the establishment of the governing GAAP, required the oil and gas companies to adopt the SE method. In rejecting the change from FC to SE method, the users argued that this could substantially depress reported earnings and equity figures; and increase the volatility of earnings over time. This means that a change from FC to SE will reduce the capabilities of the firm to raise capital in the stock market thereby leading to vulnerability to competition. The increased volatility of earnings implicates a limitation in the ability of the firms to carry out new explorations in the industry. In order, to support its view on the potential effect coming with adopting FASB Exposure draft, the journal presents statistics showing that 70 out of 109 FC firms would have their average earnings reduced by at least 5%; and 86% of these companies will also witness at least 5% decrease in their owner’s equity (Lev, 1979, p. 487). Impact of the change on cash flow The shift in the accounting method, from FC to SE had no impact to the cash flow albeit the decrease in the market value. A no-effect theory as stated by HOLTHAUSEN, argues that there is no effect on the stock price associated with the change in accounting policy (Holthausen & Leftwich, 1998, p. 114). The accounting methods are just a façade for the accounting numbers, available for the investors. The writer notes that the firms, adopting policy change can unravel the accounting numbers, without spending any dollar, implying that the choice of accounting methods do not affect the wealth of the company. In the case of a firm changing its accounting policy, the users are in a position of applying costless compensating changes in their algorithm (Al-Jabr & Spear, 2004, p.20). Further, in the event of changing rule used in manipulating the accounting numbers, the users are able to renegotiate earlier contacts at no cost. These instances illustrate the change in policy as costless contracting and monitoring which cannot have influence on the cash flows. However, the presence of other factors such as LIFO-FIFO switches bear impact on the cash flow. These two aspects describe the technique followed by a given firm in selling its goods. LIFO (last in, first out) illustrates a situation where a company sells the last items purchased prior to other whilel FIFO (First in, First out) assumes that the first items purchased are the first to sell. The LIFO-FIFO switches normally have impact because of their influence on the taxable income. In a period when there is increasing inflation, LIFO results to reduction in the taxes paid due to the associated increase in cost of sales (Jabr et al, 2009, p.57). However, the opposite occurs when the prices reduce in the market resulting to increase in the taxable income. For FIFO, periods of rising inflation results lower value of goods and hence the associated lower cost of sales due to the increase in the taxes paid. In periods of falling prices, FIFO results to higher value of goods and higher cost of goods sold as the result of decrease in the tax paid. Reasons for market value decrease Considering the above discussion, it is important to be aware of the reasons behind the decrease in market value for the FC stock during the announcement period. The following are some of the most probable reasons for the decrease: The proposed accounting policy change for the FC firms impeded the ability to work alongside the debt covenants especially the debt/equity ratio (Lev, 1979, p. 500). The felt effect occurred as the result of the arising need for reducing investment write-off, when adopting the successful effort method. Investment serves as an important aspect in increasing the equity of any firm hence reduction in the associated investment write-off meant that the firms’ equity was also to decrease. Intuitively, the decrease in the equity implied an increase in the debt/equity ratio indicating that the firms found difficulty in settling for their debts in the market (Collins et al, 1982, p. 8). This served in upholding a bad image for these firms to the investors; hence illustrating the associated decrease in the market value. The associated decrease in the market value may have also been influenced by the resulting impact on the dividend policy. As stated by the FC users, a change to SE would result to higher volatility of earnings, thereby triggering the need for proper strategies to settle for any unexpected changes in performance. In this case, most of the firms’ management sorts for decreasing the payout ratio, during the change, to avoid the decreasing consequences during poor performance. The companies expected that during losses from exploration, they would still maintain their investors, because of the prior decrease (Iyengar, 1999, p.39). However, this served in increasing the market value of these companies, since the nature of investors does not allow them to buy stocks with low payout dividends. Further, expensing all cost of unsuccessful exploration, as required by the FASB exposure form (for SE method) might also have had an upper hand in decreasing the cash and the consequent market value for the firms. Due to this (expensing all cost of unsuccessful exploration), the managers had to decrease their involvement in high-risk exploration because this would have implied an increase in the expense as compared to the obtained revenue. High-risk exploration forms an integral part of management initiative, especially if the involved firm expects to realize profitability. Consequently, the step taken by some FC firms to reduce their involvement in high-risk exploration, served in reducing the associate cash. The associated adverse effect of the proposed accounting change on the net income may have triggered some managers to change their direction of operation. The FC users argued that adoption of SE method would reduce their net income, consequently paralyzing their operations in the market. The only way that these firms would have escaped from this scenario is through adopting proper strategies for the compensation of the expected losses. Some of these managers had to shift their operational decisions, to adopting “drilling activity” as a compensation reduction in net income associated. This change in the operational decisions served as a major setback on the economic conditions of these firms, consequently, resulting to the decreased in the market value. Further research Recent research done on the relationship between earnings management and accounting policy also shows that the two have a direct correlation. In their journal, Transformation in Accounting Policies Impact on Earning Management of Pakistan International Airlines – PIA, Saleem supports the direct correlation between the two. The company had adopted International Accounting Standard 19, which served in disorienting its earning management. Revision made to IAS 19. The policy change occurred as the result of revision done on IAS 19. The writer asserts, “Though, the Corporation was accounting for the compensated absences on the payment basis but it was inadequate to depart from the revised International Accounting Standard 19” (Saleem, 2006, p. 60). This shows that the compensated expenses, accounted by the company were not compatible to the policy change consequently leading to the losses. Consequently, it is true that a change in accounting policy will affect the earning management of a given company. Bibliography Holthausen R., & Leftwich, R. (1998). The Economic Consequences of Accounting Choice: Implication of Costly Contractin Monitoring. Journal of accounting and Economics 5, North Holland. Lev, B 1979, 'The Impact of Accounting Regulation on the Stock Market: The Case of Oil and Gas Companies', Accounting Review, 54, 3, p. 485, Business Source Complete, EBSCOhost, viewed 7 December 2013. Collins, D, Rozeff, M, & Salatka, W 1982, 'The SEC's Rejection of SFAS No. 19: Tests of Market Price Reversal', Accounting Review, 57, 1, p. 1, Business Source Complete, EBSCOhost, viewed 7 December 2013. Jabr, Y.A. & Spear, N. 2009, "ASSET IMPAIRMENT AND ACCOUNTING CONSERVATISM: EVIDENCE FROM THE OIL AND GAS INDUSTRY", Petroleum Accounting and Financial Management Journal, vol. 27, no. 3, pp. 37-60. Iyengar, R.J. 1999, "Simultaneity of accounting choice and exploration expenditures in the oil and gas industry", Petroleum Accounting and Financial Management Journal, vol. 18, no. 1, pp. 32-48. Al-Jabr, Y. & Spear, N. 2004, "OIL AND GAS ASSET IMPAIRMENT BY FULL COST AND SUCCESSFUL EFFORTS FIRMS", Petroleum Accounting and Financial Management Journal, vol. 23, no. 3, pp. 1-25. Saleem, Ahmed. Transformation in Accounting Policies Impact on Earning Management of Pakistan International Airlines - PIA (December 2006). Available at SSRN: http://ssrn.com/abstract=995810 or http://dx.doi.org/10.2139/ssrn.995810 Read More