Prepared by Arabella Volkov University of Southern Queensland

References Text – Chapter 10 A positive theory of accounting discretion

Learning Objectives At the conclusion of this lecture, you should have an appreciation of: Why the firm can be described as a ‘nexus of contracts’ How accounting is used in contractual specifications to reduce the agency costs of equity and debt

Learning Objectives At the conclusion of this lecture, you should have an appreciation of: How managers’ ex post accounting decisions can transfer wealth from shareholders to managers How price protection and ex post settling up by shareholders and lenders constrain opportunistic reporting by managers

Learning Objectives At the conclusion of this lecture, you should have an appreciation of: How managers’ ex post accounting decisions can transfer wealth from lenders to equityholders The difference between ex post opportunism, efficient contracting and the information perspectives of accounting, and how signalling theory relates to each perspective

Learning Objectives At the conclusion of this lecture, you should have an appreciation of: How accounting can be used to signal information about the firm How accounting can be used to reduce the political costs faced by the firm Key criticisms of positive theories of accounting choice, and their validity

Background: Early Demand for Theory Capital markets research inconclusive Observations of accounting policy choice –Why do managers prepare financial reports? –How are accounting policy choices made? Information hypothesis could not explain all observations

Contracting Theory The firm as a legal ‘nexus’ of contractual relationships Organising economic activity to reduce contracting costs –management contracts –debt contracts

Agency Theory Jensen & Meckling (1976) Contract where one party (the principal) engages another (the agent) to act on their behalf –e.g. where there is a separation of management and control. Managers have remuneration contracts Utility maximisation by both parties –Agent may act on her/his own behalf (self-interest)

Agency Theory Firms can be characterised as a nexus of contracts –Between consumers of products and the suppliers of factors of production Firms exist because they reduce contracting costs, –Firms provide an efficient means of organising economic activity Contracts include all types of agreements between two or more parties

Agency Theory Agency costs –Due to self interest, the agent might act in his/her own interest rather than that of the principal (moral hazard) –Agents may undertake certain Divergent Behaviours –This agency problem gives rise to Agency Costs (monitoring, bonding and residual loss)

Agency Theory Agency costs can be categorised into: 1.Monitoring Costs – the cost of observing the agent’s behaviour Auditing costs 2.Bonding Costs – Costs borne by the agent (e.g. manager) as a result of aligning their interests with the principal (e.g. owners) Manager has to prepare financial reports (a cost to the manager in terms of time and effort)

Agency Theory Agency costs can be categorised into (continued): 3.Residual Loss – loss associated with not being able to fully align the interests of the principal with the agent

Agency Theory Price Protection (ex ante – up front) The principal reduces the remuneration paid to the agent in anticipation of agency costs Cost of dysfunctional behaviour built into remuneration Ex post settling up (ex post – after the fact e.g. at the end of each year) The principal reduces the remuneration paid to the agent Remuneration based on observed agent performance

Manager-Shareholder Agency Relationships Managers as agents of owners can act in own interest The smaller the manager ownership in the firm the more likely divergent behaviours Manager has incentive to contract with firm to reduce divergent behaviours to reduce price protection Manager bear cost of owner monitoring

Manager-Shareholder Agency Relationships Agency Costs of Equity Risk-Aversion – limited incentive to increase value of firm through investment in risky projects Dividend Retention – reduced incentive to pay dividends or take on optimal levels of debt Horizon Problem – short term focus on performance of firm Over-consumption of Perquisites

Manager-Shareholder Agency Relationships Reducing the agency costs of equity Bonuses are usually tied to firm performance in some way to motivate managers to act in the owners’ interest Bonuses can be paid in cash and/or shares/share options Bonuses can be tied to: 1.Accounting numbers(such as net income, sales, return on assets) 2.Share price (market based performance measure)

Shareholder-Debtholder Agency Relationships Agency costs of debt 1.Excessive dividend payments-reducing debtholder’s security 2.Asset substitution-firm invests in higher risk projects (no benefit to debtholder) 3.Under investment-where no incentive to invest in positive NPV projects 4.Claim dilution-issuing higher priority debt

Shareholder-Debtholder Agency Relationships Debt-holders can Price Protect via increased interest charges or reduced amounts provided The interests of shareholders can be bonded to those of debtholders via restrictions in lending agreements (Loan Covenants) Covenants often rely on numbers contained in financial statements Covenants usually restrict the behaviour of managers acting on behalf of owners

Ex post Opportunism versus Ex ante Efficient Contracting Contracts provide incentives for agents to act against principals interest Opportunistic perspective –ex post (after contracts finalised) –incomplete contracts –bonus plan hypothesis –debt-equity hypothesis Efficient contracting perspective

Ex post Opportunism versus Ex ante Efficient Contracting Efficient contracting perspective Efficient contracts align interests of agent with principal Actions that benefit agent also benefit firm Ex ante – before contracts are finalised

Information Perspective and Signalling Holthausen Derived from signalling theory Managers provide information to investors to assist in their decision making Similar to efficient contracting Accounting information precedes cash flows

Information Perspective and Signalling Aligned with the information hypothesis Managers use the accounts to signal expectations and intentions regarding the future Incentives to signal good, neutral and bad news

Political Processes The firm and parties interested in the firm Political market v. capital market –Less demand for information in political market –Less benefit from information gathering –Heterogeneity of interests

Political Processes Political costs – wealth transfers –Size hypothesis Implications for firm behaviour –e.g. banking sector in Australia

Empirical Tests Testing the opportunistic and political cost hypothesis –Watts & Zimmerman –Zmijewski & Hagerman –provided little insight

Empirical Tests Empirical tests – tests using contract details (Healy) Figure 10.1: Allocation of funds to the bonus pool, based on accounting profit

Empirical Tests Figure 10.2: Accounting accruals as a function of bonus plan specifications Empirical tests – tests using contract details (Healy)

Empirical Tests Refining the specification of political costs –Liberty & Zimmerman –Godfrey & Jones –DeAngelo –Wong –Lemke & Page –Panchapakesan & McKinnon –Ali & Kumar

Empirical Tests Tests of efficient contracting hypotheses –interest capitalisation –voluntary consolidated financial reporting –changes in CEO –other studies

Evaluation of the Theory Methodological and statistical criticisms –empirical evidence weak and inconclusive –McKee, Bell & Boatsman –Christie –Leftwich

Evaluation of the Theory Philosophical criticisms –Tinker, Merino and Neimark –Christenson –Watts and Zimmerman

Summary Positive accounting theory has been a major force in accounting research for 20 years Researchers argue they have tried to develop a theory that has an information role Positive accounting theory continues to develop

Key Terms and Concepts Positive theory Accounting choice Empirical and theoretical Hypotheses Methodological Contracting theory Agency theory

Where to get more information Other courses List books Articles Electronic sources