Making Financial Reporting Decisions Modules 3, 4 & 5 deal with theoretical frameworks related to making financial reporting decisions How do I make financial reporting decisions?

Financial Reporting Decisions You are here Unregulated Financial Reporting Decisions Regulated Financial Reporting Decisions Making Financial Reporting Decisions Contracting Determinants of Financial Reporting Social Determinants Of Financial Reporting The Impact of Financial Reporting Decisions Critique of PAT

Lecture 4 Contracting Determinants of Financial Reporting

Lecture Overview u Review u Financial reporting decisions u Moral hazard and the stewardship role of accounting u Incentives for managers to supply financial info. u Overview of positive accounting theory (section 3.1) u Agency theory, contracts, and accounting (3.2) u Opportunistic and efficiency perspectives (3.3.1) u Owner/manager contracting (section 3.3.2)

Review Financial Reporting Decisions u Financial reporting decisions relate to the application of the accruals process (financial accounting) and the disclosure of other relevant information u Important to understand determinants of financial reporting decisions and expected impacts on decisions of stakeholders

Review Financial Reporting Decisions u Unregulated financial reporting decisions can be guided by theoretical frameworks and research results u Five types of financial reporting decisions u Expensing versus Capitalisation of Costs u Accounting Methods u Accounting Estimates u Disclosure versus Recognition u Disclosure Policy

Review Moral hazard u Arises when some parties cannot observe all the actions of the other parties to the transaction u Accounting to monitor the behaviour of managers u Stewardship role of accounting

Review Stewardship Role of Accounting u Key Issue: motivating manager effort u difficult for owners to observe mgmt behaviour u manager can shirk on effort or over consume perks of the job u Solution: net income can be determined and utilised as an indicator of management performance u Emphasis on reliability of financial reporting

Review Incentives for managers to supply financial information u Capital markets u Markets for managers, corporate takeovers, and lemons u Threat of litigation u Contractual incentives

Overview of Positive Accounting Theory ( 3.1)

Positive vs. normative theory u Positive theories seek to explain and predict particular phenomena u Positive theories help us to understand what we see u Positive theories provide explanations for what we see u Normative theories provide prescriptions u Tell us what we ‘should’ do u Provides an ‘ideal’ or ‘norm’ for practice to strive for u Not always fully accepted in practice, eg. conceptual framework, current cost accounting

Positive Accounting Theory (PAT) u PAT is one particular positive theory of accounting u There are other positive theories of accounting – for example, stakeholder and legitimacy theories covered in module 4 u PAT seeks to explain and predict accounting practice, involves more than just describing practice

What Positive Accounting Theory (PAT) aims to do u Explain why firms prepare accounting reports and have them audited u Explain why companies lobby proposed accounting standards u Explain how accountants choose accounting methods u Explain why accountants might change accounting methods

Relevance to accounting regulation and practice u Accounting regulators need to understand accounting practice u For assessing social and economic implications of proposed regulations u Practicing accountants can also benefit from an understanding of positive accounting theories u Helpful when making financial reporting decisions u Helpful when advising clients and managers about making financial reporting decisions u Helpful when auditing the decisions of others

Positive Accounting Theory How do I make financial reporting decisions?

Underlying Assumption and Economic Focus u Central economics-based assumption u All individuals’ action is driven by self-interest u Individuals will act in an opportunistic manner to the extent that the actions will increase their wealth (over short or long term) u Notions of loyalty and morality are ignored u Theory has an economic focus u Focus on the firm and individuals involved u Focus on costs and benefits - basis of all decision making

Underlying Theory u Positive accounting theory builds on agency theory u We need to learn about agency theory first, and then extend this theory to financial reporting

Agency Theory, Contracts and Accounting (3.2)

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

Agency Theory u Positive accounting theory focuses on the costs of contracting in situations where there is an agency relationship u An agency relationship arises where there is a contract under which one party (the principal) engages another party (the agent) to perform some service on the principal's behalf u For example, an agency relationship arises where there is a separation of management and control. Managers have remuneration contracts

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

Monitoring Costs u The rational principal will monitor the agent u Monitoring costs u costs of measuring, observing and controlling the agent's behaviour u eg prepare financial statements (stewardship role of accounting), audit the accounts, set budgets, establish mgmt compensation schemes etc.

Price Protection & Ex Post Settling Up u The rational principal will pass these costs onto the agent via reduced remuneration u Price Protection (Ex ante - up front) u The principal reduces the remuneration paid to the agent in anticipation of agency costs u Ex post settling up (Ex post - after the fact eg. at the end of each year) u The principal reduces the remuneration paid to the agent based on observed agent performance (reduced bonus or reduced salary for the following year)

Impact of price protection u Agents pay for the principals’ expectations of their opportunistic behaviour u Agent will seek to ‘bond’ with the principal ie. establish contracts to limit their ability to undertake opportunistic behaviour u The agent, not the principal has the incentive to contract for monitoring

Bonding Costs u The costs of bonding the agent's interests to the principals u Give undertakings to act in the interests of the principals, usually in the terms of a contract

Residual Loss u Rational agent will only incur ‘bonding costs’ to the point where it is equal to the reduced ‘monitoring costs’ imposed on him/her u It will not be possible to eliminate all conflicts of interest u Residual loss u costs attributable to any remaining divergence of interest between principal and agent

Impact of market forces u Market forces provide additional incentives for managers to work in the interests of the owners u Market for managers (reputation effects) u Market for corporate control

The Role of Financial Reporting u Financial reporting can be used to reduce conflicts within the firm u Financial statements are used to monitor manager performance and contract terms u Auditing of financial statements provides and extra layer of monitoring

Implications for financial reporting (*important) 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

Impact of Self Interest on Financial Reporting u Managers have incentives to present financial statements in a way that ensures the best outcome under the firm’s contracts u Managers may act in their own best interests when making financial reporting decisions, rather than in the best interests of the firm

PAT Research u PAT is the ‘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

Opportunistic and Efficiency Perspectives (3.3.1)

Opportunistic and efficient contracting perspectives u There are two perspectives on positive accounting theory: u opportunistic (ex post) u ex post - after the contracts are finalised u managers transfer wealth from principals u efficient (ex ante) u ex ante - before the contracts are finalised u managers do not act opportunistically, as they believe price protection and ex post settling up are complete

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

Opportunistic perspective u managers have incentives to choose accounting methods ex post which will give them the greatest economic benefits u managers act opportunistically by manipulating the accounting numbers u accounting policy choices can be explained by examining the incentives for managers to behave opportunistically

Efficient Contracting Perspective u Managers choose accounting policies that will maximise overall firm value u Firm value is maximised through reduced agency costs - most efficient use of contracts (bonding) and accounting (monitoring) u Managers choose those accounting methods that facilitate efficient monitoring rather than those that transfer wealth to themselves u Such behaviour is due to concerns about ‘reputation’ and ex post settling up

Efficient Contracting Perspective u Firm contracts (eg debt and remuneration contracts) are related to the types of assets held by each firm u Each firm has a set of contracts which is optimal (most efficient) u Accounting methods are related to the types of assets held by each firm u Each firm has a set of accounting methods which is optimal (most efficient)

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)

Owner/manager contracting

Monitoring & Bonding activities – owner/manager contracting u Financial statements were originally provided by managers to bond their interests to those of shareholders (pre-regulation) u Shareholders use audited financial statements to monitor management behaviour (stewardship role)

Monitoring & Bonding activities – owner/manager contracting u Management compensation schemes are often used to bond manager and shareholder interests u Financial statements are used to determine manager compensation under accounting based bonus schemes

Manager Compensation u Managers may be rewarded: u On a fixed basis (set salary); u On the basis of results achieved; or u A combination of the two

Problems associated with fixed salary compensation: u Limited incentive to increase value of firm through investment in risky projects u Known as the ‘risk-aversion’ problem u Reduced incentive to pay dividends or take on optimal levels of debt u Known as the ‘dividend retention’ problem

Typical Bonus Schemes u Bonuses and /or shares / share options are offered to give managers an incentive to act in the interests of shareholders u Bonuses can be tied to u accounting numbers (such as net income, sales, return on assets); or u share price (market based performance measure) u 21% of Australian managers hold shares in their firm

Typical Bonus Schemes u The type of incentive used depends on u the type of firm involved u Accounting profits are not the best indicator of performance for some firms (eg.com firms) u the level of manager u 35% of Australian senior managers hold shares

Problems associated with accounting based bonus schemes u Managers have incentives to manipulate the accounts to maximise the amount of bonuses paid (opportunistic perspective) u known as the ‘bonus plan’ hypothesis u Managers may adopt a short-term focus, especially for managers approaching retirement u Known as the ‘horizon problem’

Problems associated with market based bonus schemes u Share prices are affected by factors not under the control of managers (eg. Market wide impacts on prices) u A ‘noisy’ measure of performance u Only very senior managers have the opportunity to affect share prices

To be continued u Next week we will cover u Details of debt contracts u Other economic determinants of financial reporting decisions u Conclusions and implications from the research results

For Tutorials u Required reading u Text chapter 7, pp. 201 – 226 (skim 205 – 210) u Self assessment questions u Questions 1 – 8 and 12 & 13 from module 3 u Answers in tutorials