Changes to accounting policies that are implemented by regulatory bodies result in reactions by managers and investors. In the case of SFAS 19, the SEC required that oil and gas companies use the successful-efforts method of accounting for the costs of oil and gas exploration. Although some firms already used this method, many companies would be switching from the full-cost method. The difference between these methods is that the successful-efforts method requires that costs associated to unsuccessful exploration be charged to current expenses. Under the full cost method these costs can be spread over future periods (with some limitations).
Managements' reactions to the accounting policy change can be explained by using the positive accounting theory. Positive accounting theory tells us that managers act rationally and make positive decisions wither for their own benefit or for the benefit of the firm. Under the full cost accounting method, managers were able to spread out costs to future periods thereby making net income and retained earnings for current periods higher. Under the new requirements management would be required to expense unsuccessful exploration costs in the current period, reducing net income, and adversely affecting the firms borrowing power. There may also be affects on the managers’ willingness to continue to explore and expand if there is an increased risk that possible incentives could be affected by the decrease in net income, or the reduction in borrowing power based on their debt covenants that are related to debt/equity ratio. The key in this situation is that the managers would have chosen to adopt the new accounting policy had it been beneficial to himself or the firm. Instead, the accounting policy is being required by mandate of the SEC.
For investor behavior, we can use the efficient securities market theory. Investors typically react in a predictable, rational manner to public information affecting...
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