Prepared by Arabella VolkovUniversity 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 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

Where to get more information

• Other courses• List books• Articles• Electronic sources