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 ObjectivesAt 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 tosignal 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 TheoryAgency 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
remunerationEx 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 debt1. Excessive dividend payments-reducing
debtholder’s security2. Asset substitution-firm invests in higher
risk projects (no benefit to debtholder)3. Under investment-where no incentive to
invest in positive NPV projects4. 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 versusEx 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 versusEx 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 TestsEmpirical 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 ofbonus 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