Making Financial Making Financial Reporting DecisionsReporting DecisionsModules 3, 4 & 5 deal with

theoretical frameworks related to making financial

reporting decisions

How do I make financial reporting

decisions?

Financial Reporting Decisions

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Unregulated Financial Reporting Decisions

Regulated FinancialReportingDecisions

Making Financial Reporting Decisions

ContractingDeterminants of Financial Reporting

Social Determinants Of FinancialReporting

The Impact ofFinancialReportingDecisions

Critique of PAT

Lecture Lecture 44Contracting Determinants Contracting Determinants

of Financial Reportingof Financial Reporting

Lecture OverviewLecture Overview Review

Financial reporting decisions Moral hazard and the stewardship role of

accounting Incentives for managers to supply financial info.

Overview of positive accounting theory (section 3.1)

Agency theory, contracts, and accounting (3.2)

Opportunistic and efficiency perspectives (3.3.1)

Owner/manager contracting (section 3.3.2)

Review Review Financial Reporting Financial Reporting DecisionsDecisions

Financial reporting decisions relate to the application of the accruals process (financial accounting) and the disclosure of other relevant information

Important to understand determinants of financial reporting decisions and expected impacts on decisions of stakeholders

Review Review Financial Reporting Financial Reporting DecisionsDecisions

Unregulated financial reporting decisions can be guided by theoretical frameworks and research results

Five types of financial reporting decisions Expensing versus Capitalisation of Costs Accounting Methods Accounting Estimates Disclosure versus Recognition Disclosure Policy

Review Review Moral Moral hazardhazard

Review Review Moral Moral hazardhazard

Arises when some parties cannot observe all the actions of the other parties to the transaction

Accounting to monitor the behaviour of managers

Stewardship role of accounting

Review Review Stewardship Role of Stewardship Role of AccountingAccounting

Review Review Stewardship Role of Stewardship Role of AccountingAccounting

Key Issue: motivating manager effort difficult for owners to observe mgmt

behaviour manager can shirk on effort or over

consume perks of the job Solution: net income can be determined

and utilised as an indicator of management performance

Emphasis on reliability of financial reporting

ReviewReviewIncentives for managers Incentives for managers to supply financial to supply financial informationinformation

Capital markets Markets for managers, corporate

takeovers, and lemons Threat of litigation Contractual incentives

Overview of Positive Overview of Positive Accounting Theory ( 3.1)Accounting Theory ( 3.1)

Positive vs. normative Positive vs. normative theorytheory

Positive theories seek to explain and predict particular phenomena Positive theories help us to understand what we

see Positive theories provide explanations for what we

see Normative theories provide prescriptions

Tell us what we ‘should’ do Provides an ‘ideal’ or ‘norm’ for practice to strive

for Not always fully accepted in practice, eg.

conceptual framework, current cost accounting

Positive Accounting Positive Accounting Theory (PAT)Theory (PAT)

PAT is one particular positive theory of accounting

There are other positive theories of accounting – for example, stakeholder and legitimacy theories covered in module 4

PAT seeks to explain and predict accounting practice, involves more than just describing practice

What What PPositive ositive AAccounting ccounting TTheoryheory (PAT) (PAT) aims to doaims to do

Explain why firms prepare accounting reports and have them audited

Explain why companies lobby proposed accounting standards

Explain how accountants choose accounting methods

Explain why accountants might change accounting methods

Relevance to Relevance to accounting regulation accounting regulation and practiceand practice

Accounting regulators need to understand accounting practice For assessing social and economic implications of

proposed regulations Practicing accountants can also benefit from

an understanding of positive accounting theories Helpful when making financial reporting decisions Helpful when advising clients and managers

about making financial reporting decisions Helpful when auditing the decisions of others

Positive Accounting Positive Accounting TheoryTheory

How do I make financial reporting decisions?

Underlying Assumption Underlying Assumption and Economic Focusand Economic Focus

Central economics-based assumption All individuals’ action is driven by self-interest Individuals will act in an opportunistic manner

to the extent that the actions will increase their wealth (over short or long term)

Notions of loyalty and morality are ignored

Theory has an economic focus Focus on the firm and individuals involved Focus on costs and benefits - basis of all

decision making

Underlying TheoryUnderlying Theory

Positive accounting theory builds on agency theory

We need to learn about agency theory first, and then extend this theory to financial reporting

Agency Theory, Contracts Agency Theory, Contracts and Accounting (3.2)and Accounting (3.2)

Firms and ContractsFirms and Contracts

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 Theory Positive accounting theory focuses on the costs of

contracting in situations where there is an agency relationship

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

For example, an agency relationship arises where there is a separation of management and control. Managers have remuneration contracts

Agency CostsAgency Costs

Due to self interest, the agent might act in his/her own interest rather than that of the principal (moral hazard)

This agency problem gives rise to agency costs

Agency costs can be categorised into monitoring costs bonding costs residual loss

Monitoring CostsMonitoring Costs

The rational principal will monitor the agent

Monitoring costs costs of measuring, observing and

controlling the agent's behaviour eg prepare financial statements

(stewardship role of accounting), audit the accounts, set budgets, establish mgmt compensation schemes etc.

Price Protection & Ex Price Protection & Ex Post Settling UpPost Settling Up

The rational principal will pass these costs onto the agent via reduced remuneration

Price Protection (Ex ante - up front) The principal reduces the remuneration paid to the

agent in anticipation of agency costs Ex post settling up (Ex post - after the fact eg.

at the end of each year) 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 Impact of price protectionprotection

Agents pay for the principals’ expectations of their opportunistic behaviour

Agent will seek to ‘bond’ with the principal ie. establish contracts to limit their ability to undertake opportunistic behaviour

The agent, not the principal has the incentive to contract for monitoring

Bonding CostsBonding Costs The costs of bonding the

agent's interests to the principals

Give undertakings to act in the interests of the principals, usually in the terms of a contract

Residual LossResidual Loss Rational agent will only incur

‘bonding costs’ to the point where it is equal to the reduced ‘monitoring costs’ imposed on him/her

It will not be possible to eliminate all conflicts of interest

Residual loss costs attributable to any remaining

divergence of interest between principal and agent

Impact of market forcesImpact of market forces

Market forces provide additional incentives for managers to work in the interests of the owners Market for managers (reputation

effects) Market for corporate control

The Role of Financial The Role of Financial ReportingReporting

Financial reporting can be used to reduce conflicts within the firm

Financial statements are used to monitor manager performance and contract terms

Auditing of financial statements provides and extra layer of monitoring

Implications for financial Implications for financial reporting (*important)reporting (*important)

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

Agents have incentives to present the financial statements in a way that ensures the best outcome under the contracts

Therefore, contracts need to be considered when making financial reporting decisions

Impact of Self Interest Impact of Self Interest on Financial Reportingon Financial Reporting

Managers have incentives to present financial statements in a way that ensures the best outcome under the firm’s contracts

Managers may act in their own best interests when making financial reporting decisions, rather than in the best interests of the firm

PAT ResearchPAT Research

PAT is the ‘story’ Empirical research is used to test the story 3 early research hypotheses (predictions):

Bonus plan hypothesis Debt/equity hypothesis Political cost hypothesis

These hypotheses assume that managers act opportunistically

Opportunistic and Opportunistic and Efficiency Perspectives Efficiency Perspectives

(3.3.1)(3.3.1)

Opportunistic and Opportunistic and efficient contracting efficient contracting perspectivesperspectives

There are two perspectives on positive accounting theory:

opportunistic (ex post) ex post - after the contracts are finalised managers transfer wealth from

principals efficient (ex ante)

ex ante - before the contracts are finalised

managers do not act opportunistically, as they believe price protection and ex post settling up are complete

Opportunistic and Opportunistic and efficient contracting efficient contracting perspectivesperspectives

opportunistic - self interest objective

efficient - maximisation of firm value objective

Opportunistic Opportunistic perspectiveperspective

managers have incentives to choose accounting methods ex post which will give them the greatest economic benefits

managers act opportunistically by manipulating the accounting numbers

accounting policy choices can be explained by examining the incentives for managers to behave opportunistically

Efficient Efficient Contracting Contracting PerspectivePerspective

Managers choose accounting policies that will maximise overall firm value

Firm value is maximised through reduced agency costs - most efficient use of contracts (bonding) and accounting (monitoring)

Managers choose those accounting methods that facilitate efficient monitoring rather than those that transfer wealth to themselves

Such behaviour is due to concerns about ‘reputation’ and ex post settling up

Efficient Efficient Contracting Contracting PerspectivePerspective

Firm contracts (eg debt and remuneration contracts) are related to the types of assets held by each firm

Each firm has a set of contracts which is optimal (most efficient)

Accounting methods are related to the types of assets held by each firm

Each firm has a set of accounting methods which is optimal (most efficient)

Two important contractsTwo important contracts Two contracts that tend to be

monitored using accounting information are:

management compensation (remuneration) contracts

debt contracts (bank loan agreements or debenture trust deeds)

Owner/manager Owner/manager contractingcontracting

Monitoring & Bonding Monitoring & Bonding activities – activities – owner/manager owner/manager contractingcontracting Financial statements were

originally provided by managers to bond their interests to those of shareholders (pre-regulation)

Shareholders use audited financial statements to monitor management behaviour (stewardship role)

Monitoring & Bonding Monitoring & Bonding activities – activities – owner/manager owner/manager contractingcontracting

Management compensation schemes are often used to bond manager and shareholder interests

Financial statements are used to determine manager compensation under accounting based bonus schemes

Manager CompensationManager Compensation

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

Problems associated Problems associated with fixed salary with fixed salary compensation:compensation:

Limited incentive to increase value of firm through investment in risky projects Known as the ‘risk-aversion’ problem

Reduced incentive to pay dividends or take on optimal levels of debt Known as the ‘dividend retention’

problem

Typical Bonus SchemesTypical Bonus Schemes

Bonuses and /or shares / share options are offered to give managers an incentive to act in the interests of shareholders

Bonuses can be tied to accounting numbers (such as net income,

sales, return on assets); or share price (market based performance

measure) 21% of Australian managers hold shares in their firm

Typical Bonus SchemesTypical Bonus Schemes

The type of incentive used depends on the type of firm involved

Accounting profits are not the best indicator of performance for some firms (eg .com firms)

the level of manager 35% of Australian senior managers hold

shares

Problems associated Problems associated with accounting based with accounting based bonus schemesbonus schemes

Managers have incentives to manipulate the accounts to maximise the amount of bonuses paid (opportunistic perspective) known as the ‘bonus plan’ hypothesis

Managers may adopt a short-term focus, especially for managers approaching retirement Known as the ‘horizon problem’

Problems associated Problems associated with market based with market based bonus schemesbonus schemes

Share prices are affected by factors not under the control of managers (eg. Market wide impacts on prices) A ‘noisy’ measure of performance

Only very senior managers have the opportunity to affect share prices

To be continuedTo be continued

Next week we will cover Details of debt contracts Other economic determinants of

financial reporting decisions Conclusions and implications from the

research results

For TutorialsFor Tutorials

Required reading Text chapter 7, pp. 201 – 226

(skim 205 – 210)

Self assessment questions Questions 1 – 8 and 12 & 13

from module 3 Answers in tutorials