Issues in Accounting Theory M

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Issues in Accounting Theory M

• Topic 3 Accounting Policy Choice Research (APCR)

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CONTRACTING THEORY

• 1.0 Introduction
• Why voluntary audited financial reports?
• Why do particular firms adopt certain accounting
  policies?
• Why do managers lobby standard setters?
• If managers cant fool investors , why manipulate
  accounting policies?

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CONTRACTING THEORY

• 2.1 The firm as a nexus/focal points/central
  points of contracts (combine labour capital)
  in order to reduce contracting costs.
• Large firms are explained by their greater
  efficiency in producing goods/services . Not the
  case for individuals since this would involve
  them entering huge number of contracts.
• 2 types of contracts (called as agency
  contracts)
• - management contracts and
• - debt contracts.

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2.2 Agency Theory in which a principal
(shareholders/debt holders) delegate decision
making authority to an agent (managers).

• The principal/agent relationship
• (lenders/SHs)
• (managers)
• Delegation of decision making
• Moral hazard

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2.2 Agency Theory

• Example
• No answer on deals at Walker Corp
• Property development company
• 1994 1995 directors bought properties from the
  company at less than market value
• Then floated the company (issued shares)
• In a position to resell at great profit so S/Hs
  lose

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2.2 Agency Theory

• Agency Costs
• Monitoring (costs incurred initially by
  principals to observe and control the behaviour
  of managers) by passing these costs to managers
  price protection). Reducing managers
  remuneration, requiring higher interest rates,
  reducing the loaned funds or paying lower prices
  for shares that managers wishing to raise capital
  may have an offer.
• Bonding (costs incurred by managers in
  attempting to reassure principals that they will
  act in the interests of principals or compensate
  principals if they do damage their interests).
  Examples to have audited fs prepared and to
  refrain from certain activities that benefit the
  agent but damage the principal.
• Residual Loss (not all opportunistic behaviour
  will be removed, managers have some residual
  capacity to reduce the value of the firm and so
  damage principals). Example taking large
  perquisites such as unnecessarily expensive
  business trips.

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2.2 Agency Theory

• Agency Costs
• It is the managers who have the incentives to
  enter into bonding contracts in order to
• - reduce agency costs that will be passed on to
  them
• - avoid adjustments to their salaries, after a
  principal observes managerial opportunistic
  behaviour.

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2.2 Agency Theory

• Price Protection (the ability of principals to
  transfer the bearing of agency costs to the
  agent).
• (offer less for a used car)
• Role of accounting reports
• (like a used car warranty)

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3.0 Manager/shareholder relationships

• 3.1 Price Protection Example 1
• 1. Manager owns 100 capital
• 2. Market value of equity V 90k
• 3. Manager floats 30 of equity
• for 27k (90k x .30)
• 4. No debt

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3.1 Price Protection Example 1 (cont)

• Manager sells company property to self for
  10k less than market value.
• PV of company market value of
• equity falls to 80k (90k - 10K).

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3.1 Price protection Example 1 (cont)

• Who bears the cost of fall in equity?
• Shareholders .30 x 10k 3k
• Manager (1 - .30) x 10k 7k

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3.1 Price Protection Example 1 (cont)

• 3k increase in managers overall wealth.
• Cash from sale of equity 27k
• Value of equity (.70 x 80k) 56k
• Profit on property 10k
• 
  93

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3.1 Price Protection Example 1 (cont)

• Ex ante price protection
• Assume
• Market efficiency rational expectations
• Principals price protect

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3.1 Price protection Example 1 (cont)

• Ex ante price protection (p.271 of the text and
  p.46 of SG) it assumes that firms select
  accounting practices for efficiency reasons ie.
  accounting policies are put in place ex ante to
  reduce the cost of contracting between the firm
  and its claimholders.
• Principals pay only (.30 x 80k) 24k

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3.1 Price protection Example 1 (cont)

• Managers overall wealth constant.
• Cash from sale of equity 24k
• Value of equity (.70 x 80k) 56k
• Profit on property 10k
• 
  90k

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3.2 Role of Contracting

• Manager has incentive to enter into bonding
  and monitoring contracts. Why does price
  protection not eliminate all opportunistic
  behaviour?
• Price protection and 'ex post settling up'
  (after the event making adjustments that ensure
  managers bear the costs of opportunistic
  behaviour) are means by which principals pass on
  agency costs to agents. However, price protection
  will only be taken to the point where the
  marginal cost of protection equals the marginal
  benefit. Therefore, not all opportunistic
  behaviour will be eliminated.
• In perfectly efficient capital markets agents
  will bear the full cost of any opportunistic
  behaviour. However, if some inefficiency exists,
  an agent still has scope to act opportunistically
  so that the costs are not fully passed on to the
  agent.

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3.2 Role of Contracting

• Role of financial reporting
• Efficient Contracting

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3.3 Manager/Shareholder Relationships

• 3.3 Agency Problems (ex ante) reasons for
  differences in shareholders managers incentives
  regarding firm policies represent a number of
  specific problems, these problems include
• Risk Aversion (means that managers prefer less
  risk than do shareholders).
• Dividend Retention (occurs when managers prefer
  to pay out less of the companys profit in
  dividends than shareholders prefer so that
  managers can retain money in the business for
  their own salaries and benefits.
• Horizon (a difference in the time horizon
  interests of shareholders and managers with
  respect to the firm). Shareholders are
  theoretically interested in the cash flows of the
  firm for an infinite number of periods into the
  future, since the value of the shares is the
  discounted PV of future CFs. On the other hand,
  managers are interested in the CFs of the firm
  only for as long as they intend to stay in the
  firm.

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• Ex Ante Economic Opportunistic Behavior by
  Managers
• Contracting Occurs
• Role for Financial Reports
• (Contracting and Monitoring)
• Ex Post Opportunistic Accounting Policy Choice

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3.4 Bonus Plan Hypothesis

• When managerial remuneration is related to
  reported earnings via a bonus plan, managers will
  select accounting policies that shift reported
  earnings from future periods to current periods.

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4.0 Shareholder/Debtholder Relationships

• 4.1 Assumptions
• Manager acts in the interests of shareholders

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4.0 Shareholder/Debtholder Relationships

• 4.2 Agency Problems
• Excessive Dividends
• Loan Covenants
• minimum dividend cover
• maximum debt/total tangible assets

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4.0 Shareholder/Debtholder Relationships

• 4.2 Agency Problems
• Claim Dilution (where a firm enters into a debt
  agreement that has a higher degree/priority that
  debt that has already been issued).
• Loan Covenants
• maximum debt/total tangible assets
• minimum interest cover
• negative pledge

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4.0 Shareholder/Debtholder Relationships

• 4.2 Agency Problems
• Asset Substitution/Increasing Business Risk
• Loan Covenants
• restricting acquisitions and mergers
• maximum debt ratio

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4.0 Shareholder/Debtholder Relationships

• 4.2 Agency Problems
• Underinvestment
• Loan Covenants
• min. level of net tangible assets
• maximum debt ratio

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4.0 Shareholder/Debtholder Relationships

• 4.3 Price Protection

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• Ex Ante Economic Opportunistic Behavior by
  Managers
• Contracting Occurs
• Role for Financial Reports
• (Contracting and Monitoring)
• Ex Post Opportunistic Accounting Policy Choice

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4.0 Shareholder/Debtholder Relationships

• 4.4 Debt-Equity Hypothesis or Debt-Leverage
  Hypothesis
• As a firms leverage increases (debt/total
  tangible assets) a manager selects accounting
  policies that shift reported earnings from future
  periods to present periods.

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4.4 Debt - equity hypothesis

• Required D/TTA 1/3
• D/TTA before 20X2 profit 100/300
• No Manip. With manip.
• 20X2 Profit 120 210
• Addit. debt capacity 40 70
• D/TTA 1/3 140/420 170/510
  

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5.1 Ex post opportunism

• Accounting policy choices to avoid breaching
  covenants.
• How possible?

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5.2 Ex Ante Efficient Contracting

• Reducing agency costs by agreeing to covenants
  and accounting principles when making contracts.

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6.0 Political Processes

• Political visibility and regulatory costs

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6.0 Political processes

• Political costs hypothesis
• Politically visible firms have incentives to
  adopt, or lobby for, accounting policies that
  reduce reported income.

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8.0 Tests of agency theory

• Political costs - W Z
• GPLA - general price level accounting

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8.0 Tests of agency theory

• Z H Ex post opportunism political costs
• Portfolio of accounting policies
• Income increasing or decreasing

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8.0 Tests of agency theory

• Z H Ex post opportunism political costs
• Claim consistency with
• bonus plan
• debt-equity
• political costs

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8.0 Tests of agency theory

• Z H Ex post opportunism political costs
• Regression coefficients
• positive policies choices income
  increasing
• significant not due to chance

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9.0 Tests of efficient contracting- ex ante

• Voluntary consolidation
• Consolidation accounting - better information for
  lenders

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10.0 Evaluation

• Tinker et al
• Sociology of accounting
• Logical positivism