Voluntary Accounting Changes (VACs)

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2.2 Voluntary Accounting Changes (VACs)

Accounting changes can be divided into two categories. One class is mandatory accounting changes (MACs), and the second class is voluntary accounting changes (VACs). MACs are that firms should follow the accounting regulations government enact with no reason, while VACs are that firms can make accounting changes voluntarily with certain intention, and the study mainly focuses on the VACs part.

Studies have examined the determinants and consequences of VACs. For example, Pincus and Wasley (1994) report types, frequency, and earnings effects of VACs, and the economic characteristics of firms that make these changes. They examine accounting changes from the perspectives of managerial opportunism (earnings management) and efficient (optimal) contracting. The perspective of managerial opportunism comprises post-contract opportunism to influence wealth redistributions between managers and stockholders or between bondholders and stockholders, and attempts to increase their compensation or reduce the probability of violating provisions of debt covenants and conceal poor operating performance. The perspective of efficient contracting is that changes in the economic environment can lead to changes in firms' optimal contracting technologies. Under this condition, VACs are viewed as rational responses to changing contracting technology, and are made to minimize contraction costs and maximize firm value. However, the latter is supported by limited evidence. That is, they show that VACs are more likely to be made for the intention of earnings management or smoothing reported earnings. Dharan and Lev (1993) also provide descriptive evidence demonstrating that earnings management is a managerial motivation for changing accounting methods.

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Moreover, several researches examine whether debt covenants affect borrowers’

decisions to change accounting methods. Healy and Palepu (1990) show that when firms close to violating their lending covenants and suffering from cash management concern, they may adopt the strategy such as dividend cuts or omission rather than making income-increasing accounting decisions, and Fields et al. (2001) argue that there is inconclusive evidence on whether accounting choices are motivated by debt covenant.

However, Watts and Zimmerman (1986) suggest that debt contracts that make covenant thresholds a function of financial ratios give borrowers a motivation to make accounting changes to avoid costly covenant violations. Beatty and Weber (2003) examines whether the provisions of a firm’s bank debt contracts influence its voluntary accounting choices, and find that firms are more likely to make income-increasing changes rather than income-decreasing changes when bank debt contracts let accounting changes to affect contract calculations. They also find that if firms’ debt contracts include accounting-based performance-pricing or dividend restrictions, borrowers are more likely to make voluntarily income-increasing accounting changes. That is, gaining lower interest rates through performance-pricing or keeping dividend payment flexibility are both the incentives of making VACs.

We can classify the impact of accounting changes related to earnings of firms into income-increasing accounting changes, and income-decreasing accounting changes.

Papers have also focused on the motivation of income-increasing or income-decreasing VACs decisions. Dharan and Lev (1993) suggest that through the five years subsequent to the year of accounting changes, they find that firms originally making

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income-decreasing decision have more abnormal return than the firms with income-increasing decision; the latter have large negative returns over the period. They also indicate that when facing the income-increasing accounting changes, investor’s valuations reflect a concern for the reduced quality of earnings, which reflected by smaller earnings response coefficients and r-squared. It suggests that income-increasing accounting changes may be the first manifest sign of other hidden, fundamental problems in firms that will be exposed in following years. Besides, firms perhaps prefer making income-increasing accounting changes when debt contract is allowed to affect its calculation by accounting changes or include accounting-based performance-pricing (Beatty and Weber 2003). In the perspective of economic factors motivating accounting method decision, which assumed that accounting choices are a function of political costs, manager’s compensation plan, and debt constraints, Cheng and Coulombe (1993) report that, relative to the Compustat population, firms adopting income-increasing changes are related to financial distress.

Bradshaw et al. (2008) state that accounting choices are important since that they will influence contracts, reported performance and stock prices. There are papers discussing about market reaction of VACs. For example, Linck et al. (2007) investigate the relation between VACs and equity prices by examining long-run stock-price performance and research changes in earnings informativeness in years surrounding the VAC event by examining the behavior of earning response coefficients and the relationship between earnings and future cash flows. They suggest that earnings informativeness is not significantly changed by VACs. Their results also show little

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evidence that, within an efficient market, trading strategy based on the earnings effect of a VAC generate abnormal profits, which is different from prior researches. For instance, Dharan and Lev (1993) examine the valuation consequence of accounting changes and find that investors’ seem to largely ignore the accounting changes in the year they are made, whatever income-increasing changes or income-decreasing changes are adopted.

However, their longitudinal test shows that firms making accounting changes experience different long-term returns relative to other firms in the subsequent period after accounting changes.

This study also investigates the consequence of VACs. This research focuses on the relation between VACs and post-earnings announcement drift and further examines the relation between accounting choices heterogeneity before and after VACs and post-earnings announcement drift.

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