Lecture 5 Contracting and Other Economic Determinants of Financial Reporting

Lecture Overview u Economic determinants of financial reporting (module 3 continued) u Review of last lecture u Debt contracting (3.3.3) u Other economic determinants of financial reporting (3.3.4) u Empirical research results (3.4)

Review - positive accounting theory (PAT) u Major focus is on stewardship role of accounting u Looks at reasons underlying financial reporting decisions u Emphasis on relationship between financial reporting decisions and contracts, particularly management compensation contracts and loan agreements (debt contracts) u Based on ‘agency theory’

Review - Agency Theory u Conflicts of interest give rise to agency costs u Contracts are used to reduce these conflicts of interest (bonding) - contract terms sometimes rely on accounting information u Firms prepare audited accounting reports to facilitate monitoring of these contracts (stewardship role of accounting)

Review - Agency Costs u Due to self interest, the agent might act in his/her own interest rather than that of the principal (moral hazard) u This agency problem gives rise to agency costs u Agency costs can be categorised into u monitoring costs u bonding costs u residual loss

Review - Opportunistic and efficient contracting perspectives u opportunistic - self interest objective u efficient - maximisation of firm value objective

Review - Implications for financial reporting decisions u Because contracts are used to bond the agent to the principal, and financial statement information is often used to monitor the agent’s compliance with these contracts u Agents have incentives to present the financial statements in a way that ensures the best outcome under the contracts u Therefore, contracts need to be considered when making financial reporting decisions

Two important contracts u Two contracts that tend to be monitored using accounting information are: u management compensation (remuneration) contracts u debt contracts (bank loan agreements or debenture trust deeds)

Review - Management Compensation Contracts

Debt Contracting

Nature of the relationship u Debtholders are the principal u The manager, acting on behalf of shareholders, is the agent u Shareholders can opportunistically transfer wealth away from debtholders u firm value is the sum of debt and equity u equity claimholders can be made better off by u increasing the value of the firm (equity is the residual claim), or u by transferring wealth away from debtholders

Divergence of interests between shareholders and debtholders u Divergence of interests gives rise to agency costs (four agency costs of debt) u excessive dividend payments u asset substitution u underinvestment u claim dilution

Monitoring and Bonding activities - the debt claimholder problem u Debtholders can price protect via increased interest charges u The interests of shareholders can be bonded to those of debtholders via restrictions in lending agreements (covenants) u Covenants often rely on numbers contained in financial statements u Breach of a covenant can result in higher interest charges, seizure of secured assets, refinancing of debt

Typical debt covenants u Bonding covenants u provision of financial statements, audit reports etc. u Restrictions on financing and dividend policy u leverage limits, interest coverage and working capital provisions u Reading 3.1 gives details of typical Australian bank loan agreement covenants

Ex Post Financial Reporting Incentives - under debt contracts u Managers have incentives to ensure that the terms of the covenants are not violated u breaching a debt covenant is costly u As the firm approaches a leverage restriction, managers have incentives to adopt asset and/or earnings increasing, or liability decreasing accounting policies u the ‘debt-to-equity’ hypothesis

Summary of Agency Theory u Conflicts of interest give rise to agency costs u Contracts are used to reduce these conflicts of interest (bonding) - contract terms sometimes rely on accounting information u Firms prepare audited financial statements to facilitate monitoring of these contracts (stewardship role of accounting) u Existence of these contracts gives managers an incentive to present the financial statements in a way that ensures the best outcome under the contracts

Other economic determinants of financial reporting

Provision of information to investors u Accounting has an information role as well as a stewardship role u Managers have incentives to provide relevant information for user decision making u This incentive may impact on manager’s choice of accounting methods (and other financial reporting decisions)

Information and Efficient Contracting Perspectives u Difficult to distinguish information and efficiency perspectives u Information perspective u managers select accounting policies to signal how the future cashflows, and hence, the value of the firm (and claims against it) will change u Efficient contracting perspective u managers select accounting policies that best reflect economic events, transactions and cashflows that have already occurred

Stewardship and Information Roles of Financial Reporting u The stewardship role of accounting relates to both the opportunistic and efficient contracting perspectives u contract terms tend to relate to financial statement numbers rather than unrecognised disclosures u The information role of accounting relates to the information perspective u incorporates both financial statement numbers and unrecognised disclosures

Costs of the political process u Involves the relationship between the firm and other parties interested in the firm u government u trade unions u community groups u Interested parties monitor firm's profits to ensure that they are not excessive u seek opportunities to transfer wealth away from firms

Political costs u Profits which are considered to be excessive can be redistributed in society via u extra taxes, increased wages, removal of subsidies u ‘Political costs’ are the costs of these wealth transfers out of the firm u Highly profitable (and otherwise politically sensitive) firms have incentives to reduce reported earnings u Known as the ‘size’ hypothesis

Political costs must be assessed against incentives related to debt and compensation contracts when making financial reporting decisions

Summary of PAT u A theory of accounting based on agency theory (a ‘story’) u Empirical research is used to test the story u 3 early research hypotheses (predictions): u Bonus plan hypothesis u Debt/equity hypothesis u Political cost hypothesis u These hypotheses assume that managers act opportunistically u Empirical research has been used to test these hypotheses as well as ‘efficiency’ and ‘information’ based hypotheses

Empirical Research Results

Research results - Opportunistic perspective u Overall there is support for debt contract terms impacting on accounting policy choices u Managers of firms that are close to default on debt covenants tend to choose asset/income increasing accounting policies u The results in relation to the impact of management bonus plans are mixed u researchers need to focus on specific contract attributes, these are difficult to obtain

Implications of Results for Accounting Regulation u Regulation of accounting practice can reduce the ability of managers to choose accounting methods opportunistically u The cost of regulation is often less than the cost of controlling opportunistic behaviour within each firm

Implications of Results for Financial Reporting Decisions u Consider how the decision will impact payoffs under contracts u will management compensation be increased or decreased? u will debt covenants be violated? u Auditors should be aware of the potential for managers to choose accounting policies opportunistically

Research results - Efficient contracting perspective u The efficiency perspective is supported u Different types of firms have different contract terms and use different accounting policies u Difficult to distinguish empirically between u opportunistic perspective u efficiency perspective and u the information perspective

Implications of Results for Accounting Regulation u Uniformity in accounting methods between firms is not necessarily desirable u Firms’ investments in assets vary and give rise to unique agency / contracting problems u Regulations which prescribe the use of one method for all firms impose costs on firms for which the prescribed method is not optimal

Implications of Results for Financial Reporting Decisions u The assets held by each firm, as well the terms of its contracts, must be considered when making financial reporting decisions

Research Results - Political Costs u The evidence indicates that managers consider potential political costs when making financial reporting decisions u Managers of politically sensitive firms (including large firms) tend to choose income decreasing accounting methods

Implications of Results for Financial Reporting Decisions u The political sensitivity of the firm should be considered when making financial reporting decisions u Auditors should be aware of the potential impact of political costs on financial reporting decisions

Summary - Factors to consider when making financial reporting decisions u Contracts of the firm u Assets of the firm u Provision of relevant information u Potential political costs u Social/legitimacy considerations (module 4) u Expected impacts on financial statement users (modules 6 & 7)

For Tutorials u Required reading u Text chapter 7, pp. 227 – 235 u Self assessment questions u Remainder of questions from module 3 u Answers in tutorials