CH-11 A positive theory of accounting policy and disclosure – Accounting Theory : Book Guide

Chapter 11: A positive theory of accounting policy and disclosure THEORY IN ACTION Theory in Action 11.1 Objections to crackdown What are the likely components of a chief executive officer’s (CEO) management compensation package that might be affected by the proposed changes? It is most likely that the cash component of CEO compensation packages would be increased if ‘caps’ (upper restrictions) were to be placed on other components (such as share bonuses and options) of the packages. The article also suggests that total salary may have to be increased. How is the introduction of a ‘cap’ (upper limit) on termination payments likely to affect CEO’s remuneration if firms make no adjustments to the compensation packages? Other components consisting of bonuses and equity-based compensation (such as shares or options to acquire shares) on top of base salary is likely to increase, particularly in the period leading up to termination of employment. To provide an incentive to the CEO to outperform the market in the pre-termination period non-salary components of the compensation package may be added to the remuneration package. The instructor might mention at this point the tie in with agency theory: According to agency theory, agents (managers/executives) are utility maximisers and there is no reason to believe that they will necessarily act in the best interest of principals (shareholders) unless the principals’ and agents’ interests are aligned. For example, managers have incentives to increase perquisite consumption at the principal’s expense. In order to solve this agency problem, shareholders need to align managers’ remuneration with their performance in maximising the firm’s value. By including non-salary components in the CEO’s remuneration package, firms will provide incentives to CEOs to act in a manner that will increase firm value. How could researchers evaluate the general impact of a ‘termination pay cap’ on the structure of management compensation packages? This question is aimed at starting the students to think empirically (positive) about consequences. Suggestion: By analysing the components, structure and size of executive compensation packages pre- and post- the imposition of a termination pay cap, and attempt to identify any impact on firm value as measured by market capitalisation or other factors. This analysis might need to consider lagged share prices as the new compensation packages might have behavioural impacts that might not have an immediate impact on the firm’s market value. What sort of key performance indicators are likely to be included in CEOs’ compensation packages? What role might accounting numbers play in these indicators? The most likely key performance indicators would be linked to the financial structure and the market value of the firm. Indicators could include: Percentage and absolute change in share price Percentage and absolute change in debt level Constancy/improvement of earnings Levels/increases in Earnings Per Share (EPS) Also, the firm’s performance could be compared to the relative performance of an index or group of firms that operate in similar sectors. It is possible that the CEOs might choose accounting policies to best suit the achievement of key performance indicators, in which case a key performance indicator could be consistency in accounting policies. Accounting numbers are often used as thresholds or ceilings in setting targets for the incentive components of management remuneration. For example, it is not uncommon for a CEO’s salary package to contain an incentive bonus that is paid only after the firm achieves a certain level of profits that is deemed challenging, but not impossible. From there, the manager achieves a bonus, possibly payable at a particular percentage of the firm’s earnings in excess of that threshold. There might also be a ceiling on the profit that forms the basis for the bonus payment. This recognises that sometimes, profits can only be achieved at the expense of future earnings (e.g. by not maintaining equipment, or not conducting any research and development). As such, the role of accounting numbers in this case is to motivate the manager to achieve higher, sustainable, profits that are challenging, and increase the value of equity. Sometimes, these accounting numbers are set as overall targets for the firm; sometimes they might be set as targets per share, recognising that it is the return to individual shareholders that the manager is to maximise. Students may think of other roles that accounting numbers play in these targets. Consider each on its merits. Theory in Action 11.2 Debt Contracting Explain why the Stella Group’s debt position would have ‘dragged down’ the CVC Asia Pacific organisation’s balance sheet? If debt forms a significant part of a firm’s financial structure, the risk that the firm will not be able to meet its interest obligations increases, as does the chance that it will breach its debt covenants. If debt had been issued under more onerous terms and conditions than are currently available and if the organisation was not able to repay and reissue the debt under more favourable terms, then the existing debt would be burdensome. Generally, shareholders are likely to prefer debt financing to equity in order to (a) obtain tax deductions for the interest on the debt (dividends are not tax deductible to the company); (b) avoid diluting their control over the firm; and/or (c) ensure that future profits in excess of the interest paid on debt accrue to them and are not spread across a broader shareholder base. Note that, in relation to the above: Interest is tax deductible for companies; their own dividend payments are not. Debt has little or no impact on control of the firm. Debt holders do not share ownership of the firm, and therefore they cannot have influence in managing the firm. Shareholders, on the other hand, share ownership of the firm through the possession of their shares. Consequently they share control of the firm and may influence its management by imposing some restrictions to protect their interests. Note that the level of control for an individual shareholder is generally very small unless the firm is small or the shareholder is extremely large. In terms of firm profits, debt holders cannot share the firm’s profits, whereas shareholders will share the firm’s profits through dividend payments. From a lender’s perspective, what are the costs associated with high leverage? How can these costs be mitigated? There are some agency costs associated with high leverage from a lender’s perspective. When leverage increases, managers (acting for shareholders) will have incentives to transfer wealth away from debt holders to shareholders. This can be done through different ways such as excessive dividend payments, asset substitution, underinvestment, and claim dilution. These costs can be mitigated by establishing a debt covenant, in which the lender specifies terms and conditions that restrict the activities of management or require management to take certain actions upon receiving the borrowings. For example, the lender might require the firm to not pay beyond a certain level of dividend, have its accounts audited by an industry specialist audit firm, or to not borrow money from any other lenders without approval from the current lender, or to covenant that it will not allow leverage to exceed a certain ratio, etc. From a shareholder’s perspective, what are the costs of high leverage? How can these costs be mitigated? From a shareholder’s perspective, high leverage may impair the firm’s credit rating since the firm appears risky, and may affect the firm’s ability to raise money in the future. If the firm’s ability to raise money in the future decreases due to excessive current borrowings, the firm may not be able to obtain sufficient funds needed for its expansion and growth. This is the cost that shareholders will bear, as inability to grow will prevent shareholders from maximising their wealth in the firm. In addition, a high leverage firm may also be considered as a risky and unsafe investment by the market. This will cause the share price to fall, which reduces the value of shareholders’ investment in the firm. These costs can be mitigated by aligning management’s interest to shareholders’ interest, and thus preventing management from borrowing excessively at the shareholders’ expense. One way to align management’s interest with shareholders’ is through equity-based remuneration, whereby manager’s remuneration is tied to the firm’s share price. By doing so, management will be more cautious in making decision that can damage the firm’s share price, such as excessive borrowings. Students may raise other ways in which shareholders’ and lenders’ interests are aligned to reduce the likelihood that high leverage will reduce the value of equity. What are some incentives that might explain why CVC chose to restructure the Stella Group by contributing further equity (by buying Octaviar’s 35 per cent stake)? The contribution of further equity would have resulted in a restructuring of the financial position of the group. If the debt/equity ratio was high and approaching the level of any existing debt covenants, the equity injection would have mitigated this unfavourable situation by reducing the level of debt relative to the level of equity. This alone would provide a significant incentive for the equity contribution. A further reason for increasing the level of equity is to ensure that it had greater influence or to secure control, over the group. This could provide it with the ability to determine the future financial policies and actions of the group including the flow of dividends. What are the potential ‘covenants’ and ‘ending terms’ that are likely to have been overhauled in the Stella Group’s financial restructure? The financial covenants that are likely to have been overhauled could include: Links between level of debt and equity, revenue, profit, dividends (and potentially a range of other accounting number) Links between debt and financial statistics such as EPS, Diluted EPS, Dividend ratio (to profit) Lending terms that are likely to have been changed could include: Interest rate Repayment schedule including final repayment date(s) Events likely to crystallise (trigger repayment) the outstanding debt Theory in Action 11.3 What do profits signal? Navitas’s announcement of soaring profit is a strong signal of the firm’s earnings prospects. Other comments in the article reinforce that signal. What could Navitas do in relation to its profits to strengthen the signal even further? Explain your answer. To strengthen its signal even further, Navitas could announce a dividend policy. As firms normally smooth their dividend payments, an increase of dividends in the future would give a signal that Navitas is expecting its business operations and outcomes to improve and be sufficient to support the higher level of dividends. What factors might increase or decrease the credibility of the signal provided by Navitas’s announcements and press attention? Some factors that might increase the credibility of the signal provided by Navitas are: upward trend in global demands for its product/service as a result of the global financial crisis the fact that Navitas has low debt and good cash flow in a period when other firms are struggling to raise debt and are facing diminishing cash flows positive press releases by Navitas positive forecasts and buy recommendations by analysts. Some factors that might decrease the credibility of the signal provided by Navitas are: increased competition from other education providers uncertainty about the length and depth of the global financial crisis changing regulations in the education export sector negative analysts’ forecasts, or ‘sell’ recommendations increased exchange rate which increases the relative cost of Australian education unfavourable press about overseas student experiences in Australia. What do you expect will be the impact of the ‘soaring’ profits on management compensation contracts of Navitas? As top management compensation is often partially based on accounting profits as a proxy for management performance, record earnings produced by Navitas would probably increase the amount of remuneration received by management. In addition, management remuneration is often tied with the company’s share price to align management’s interest with shareholders’ and minimise agency costs. Assuming Navitas’s share price increases after the announcement of its record earnings, its management would also receive even higher remuneration. Theory in Action 11.4 The politics of promoting products What is the potential impact of the increased fines on the content of the accounting reports of firms in the pharmaceutical industry, particularly in relation to accounting information? It is likely that the increased fines would result in a decrease in profits of firms in the pharmaceutical industry as a direct consequence of the increased fines. This would be offset by reduced corporate taxes however the net impact would be a reduction in profit. Future accounting policies chosen by firms in the pharmaceutical industry could address the profit reduction, perhaps through the capitalisation of research and development expenditure that had previously been written off as incurred, or adjustments to depreciation and/or impairment adjustments. Or, the accounting policies could be selected in order to further reduce profits and thus diminish the political profile of the firm. These accounting policies might be chosen on the basis that they defer profits to future periods. How does the article demonstrate political processes? In your answer, explain what, if anything, firms in the pharmaceutical industry can do to manage political costs. The political process is a competition for wealth transfers. The likely wealth transfer is away from firms in the pharmaceutical industry, to other sectors most notably, to government in the form of increased fines. The pharmaceutical industry also faces a wealth transfer in the form of increased compliance costs it must bear. It is likely that firms in this sector will choose accounting policies that will reduce profits, defer profits, or otherwise reduce the public profile of the firm. What do you expect will be the impact of the increased fines in the (1) earnings and (2) management compensation contracts, of firms in the pharmaceuticals industry? If fines are imposed it is likely that the earnings of the firms will reduce. If so, management contracts are likely to be adjusted to counter the impact of performance indicators that are based on profit/earnings measures, so that the compensation of management is not adversely impacted by the effect of the fines on profit. QUESTIONS 1. What is the difference between normative and positive accounting theory? Give examples of each. Positive accounting theory (PAT) is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historical cost accounting system. Examples of PAT include: explaining why firms select specific accounting policies predicting which firms will oppose new or revised accounting rules explaining share price reactions associated with accounting information releases. This approach can be compared with normative accounting theories that dismiss conventional historical cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’ systems of accounting (usually) based on inflation adjustments. Examples of normative theories include: specification of the preferred measurement system theories as to the objective of general purpose financial reporting defining elements of financial statements. 2. What were some of the factors that led to the development of positive accounting theories of accounting policy choice? In the 1970s, positive accounting theory gained dominance in accounting research, mostly through the publication of capital market research, as it became clear that researchers could not prescribe how to prepare financial statements until they knew whether and/ or how investors used financial statements in their decision-making. However, the early positive accounting research relied on perfect market assumptions where, for example, information is available freely, there are no transaction costs, taxes, and monopolistic control. These assumptions imply that capital market researchers could not explain why share prices did not respond immediately to reflect accounting information as predicted. It then became apparent to the researchers that they needed a theory to explain why accounting reports were prepared, before they could explain capital market reactions to accounting information. In investigating market reactions to firms’ accounting practices and earning releases, researchers observed some factors that led to the development of positive accounting theories of accounting policy choice such as: There should be benefits in preparing financial reports as many firms voluntarily incurred the costs of preparing financial reports even prior to any regulation requiring them to do so. Companies lobbied in relation to proposed accounting standards, which is a costly activity that would be only conducted by rational managers if the benefits outweighed the costs. Firms made consistent patterns of accounting policy choice that were related to the economic and governance characteristics of the firms. Firms tended to choose accounting methods that offered conservative measures of profit, assets, and equity. Neither normative theories nor capital markets theories could explain these observations. Positive accounting theory developed as a means of doing so. 3. Why might managers choose accounting methods that increase current period reported earnings? Managers might choose accounting methods that increase current period reported earnings in order to increase their remuneration. Normally managers’ remuneration is tied with accounting numbers, such as profits, as a benchmark in determining how shareholders compensate them for their performance. Therefore, managers tend to choose accounting methods that result in increased profits so that they can maximise their remuneration. In addition, increased current period reported earnings usually will give positive signal to the market. If the investors believe the signal, the firm’s share price will increase and both shareholders and managers will benefit as well (the purpose of managers is to maximise shareholders’ wealth). Shareholders will benefit from capital gains, whereas managers will get more remuneration as some components of their remuneration are determined by the firm’s share price. Why might managers choose accounting methods that reduce current period reported earnings? Managers might choose accounting methods that reduce current period reported earnings in order to avoid political costs. For example, high reported earnings can be seen by employees as the results of exploiting their labour, and consequently they might lobby for increased salary through labour unions. Alternatively, managers might reduce current period reported earnings if high earnings are considered to be an indication of a mature industry, and the government might then remove tariff or subsidies that protect the industry. Other reasons why managers might choose accounting methods that reduce current period reporting include: to smooth income trends in a high profit year (saving this period to boost the next periods’ reported earnings) to ‘take a bath’ by reducing profits this year in order to have higher profits next year, when earnings might be sufficiently high to earn a performance-based bonus for the manager to signal to shareholders that there are reduced earnings in the future (rather than have future profits suddenly slump, the signal might be gentler to shareholders) to warn of bad news early so that management mitigates the likelihood that shareholders or others will litigate against them for misleading their investment or other decisions with high reported earnings. What does it mean when researchers claim that for a signal to be credible, it must be ‘costly’ to replicate? Consider an example where accounting information is used for signalling purposes. Is the signal credible? What are the potential costs of replicating that accounting signal? For a signal to be credible, that signal must not be easily and costlessly replicated by other firms. A good example of credible signalling is when BHP Billiton announced their record profit of US$6.4 billion in 2005, which is a strong signal of the firm’s future earning prospects (see Theory in Action 10.3). Billiton’s earnings were the biggest profit in Australian corporate history at the time they were reported, which is very difficult (if not impossible) for other Australian firms to replicate. If the profit announcement was followed by an increase in divided payments, that would make the signal even more credible. Dividend payments are costly as they involve cash payments to shareholders. Moreover, as firms normally smooth their dividends over the years, if BHP Billiton increased its dividends this would indicate that the firm would be able to maintain its high earnings in the future to support the higher level of dividends. The potential costs of replicating BHP Billiton’s accounting signal could involve cash payments if other firms also tried to increase their dividends to signal good news to the market. Alternatively, if other firms tried to give similar earnings signals to the market, the costs can include the long-term loss of credibility if actual future performance did not match the level that was signalled. What is the debt hypothesis? Explain the logic (theory) underpinning it. The debt hypothesis predicts that as a firm’s leverage (that is, proportion of debt relative to the firm’s assets) increases, managers will select accounting procedures that shift reported profits from future periods to the present period. The theory underpinning the debt hypothesis comes from agency theory where managers (acting on behalf of shareholders) have incentives to transfer wealth away from debt holders to shareholders. In other words, they have incentives to decrease the value of debt so that residual equity increases in value. Recognising this incentive, debt contracts often include covenants whereby firms covenant to not allow their debt to exceed a certain percentage of total assets or total tangible assets. This is intended to ensure that there is sufficient equity to buffer the value of debt if assets lose value and/or the firm makes future losses. As the firm’s leverage increases and the firm gets closer to breaching its debt covenants, managers have incentives to ensure that the firm does not violate its debt covenants. Therefore, managers would choose accounting methods that increase assets or decrease liabilities in order to reduce the reported leverage. Why might managers’ interests differ from those of shareholders? What can shareholders do to ensure that they do not suffer financially because managers’ interests differ from their own? Managers’ interests might differ from shareholders’ interests due to the separation of ownership and control. As managers generally have zero or a small ownership in the firm, they do not bear the costs of any dysfunctional behaviour. If the firm suffers from any loss due to their action, the shareholders would bear the loss, while managers still receive their salaries. To ensure that shareholders do not suffer financially because managers’ interests differ from their own, shareholders can: price-protect against managers’ dysfunctional behaviours Price protection is the way the principals protect themselves against bearing agency costs by paying management compensation according to the level of monitoring costs expected. That is, the principal initially will incur monitoring costs to monitor agents’ behaviours, but then adjust the agents’ remuneration accordingly so the agents ultimately will bear the costs. align managers’ interests with their interests This can be done by remunerating managers on the basis of share-price movements, or using share-based compensation to increase managers’ ownership of the firm. As managers’ ownership increases, the more likely it is that their interests will align with shareholders’ interests. Why might politicians choose, rationally, not to be fully informed about issues they are charged to resolve? In the political market, there is low marginal benefit for individuals to demand information because it is harder to capture benefits from the production of information. Moreover, in the political environment, there is small probability that individuals’ actions will affect their wealth as there are many individuals in the political arena and many decisions being made at any time. Consequently, to be fully informed on all issues is unlikely to be cost-beneficial given the low probability that the individuals will affect the political outcome. For this reason, politicians might choose rationally not to be fully informed about issues they are charged to resolve, because it is costly to gather the information to be fully informed, and at the same time there is low probability that the decision they make based on the information will affect their wealth (costs outweigh benefits). What are debt covenants, and why are they used? Debt covenants are terms and conditions written into debt contracts that restrict the activities of management or require management to take certain actions. As specified by agency theory, managers acting on behalf of shareholders do not always act in the best interest of debt holders. In other words, managers tend to transfer wealth from debt holders to shareholders via excessive dividend payments, asset substitution, underinvestment, or claim dilution. Therefore, debt covenants are used to protect the interests of debt holders thereby reducing agency problems. For example, a debt covenant might require management to maintain the firm’s gearing below a certain level to ensure there is a buffer for debt if the firm generates negative earnings. What are the costs of breaching a debt covenant? How significant do you think these costs might be? As debt covenants normally stipulate the responsibilities and rights of both parties, breach of debt covenants constitutes technical default on the contracts and provides debt holders with rights to institute agreed-upon action such as the seizure of collateral. More importantly, breaching a debt covenant would send negative signals to the market through the reduction of the firm’s debt rating, which is likely to be followed by loss of reputation and a fall in the share price and a rise in the cost of debt. Hence, the costs of breaching a debt covenant does not only include material costs (i.e. seizure of collateral), but also includes the loss of reputation and credibility in the market, with consequences for the cost of capital. The latter cost is much more significant, and could have long-term impact on the firm. Therefore, managers have incentives to ensure that the terms of debt covenants are not violated. Agency relationships give rise to agency costs that are borne, at least initially, by different parties. Briefly explain how agency relationships arise and give rise to agency costs. Agency theory is based on the more general contracting theory that the most cost-effective form of organising economic activity is through a firm-based structure. Using this structure and assuming that contracting is a costly activity, then a firm-based structure leads to a reduction in the number of contracts written (factor suppliers and consumers only contract with the firm rather than directly). The firm thus becomes a nexus of contracts between suppliers of factors of production and consumers of their productive efforts. In agency theory attention is concentrated on the specific contracts involving agency relationships. The main agency relationships are between shareholders/managers and shareholders/debtholders. In agency theory, agents have incentives to not always act in the best interest of the principal. The principal is aware of the possibility of such aberrant behaviour and therefore introduces constraints into the principal–agent contract to modify such behaviour. The costs of such controls are called agency costs. Explain the three types of agency costs and their relationships to each other in the context of: (a) debt contracts (b) equity contracts. The three types of agency costs are: monitoring costs bonding costs residual loss. Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the principal (e.g. shareholders, debtholders) to monitor the agent (that is, the manager). For example, shareholders or lenders could appoint an outside accounting firm to investigate the manager’s performance in managing the financial affairs of the firm. Being rational, the shareholders or lenders would reduce the remuneration to the agent by an amount that increases as monitoring costs increase. In the case of a shareholder–manager agency relationship, the manager’s remuneration will be reduced by the monitoring costs incurred by the shareholders. In the case of a lending contract, the lender (principal) will impose higher costs on the agent (management acting on behalf of shareholders) by demanding lower interest rates or other lending terms that are favourable to the lender. Either way, costs are incurred initially by the principal, but are then passed on to the agent. The agent, as an insider who has access to information about his or her performance, is deemed to be a wealth-maximiser. Therefore, they are likely to bond their actions to align them with the interests of the manager. The agent will incur bonding costs (for example, the costs of providing audited financial statements and voluntarily providing financial information to lenders) to the limit whereby the marginal cost of bonding equals the marginal cost of monitoring that is imposed by the principal. As such, bonding costs are incurred by the agent. Generally it is not possible to eliminate all agent behaviour that is inconsistent with principals’ interests. The cost of this remaining behaviour is known as residual loss. The residual loss is borne by the principal in the first instance. However, if the principal anticipates the level of residual loss that eventuates, the residual loss will be priced into the agency contract. For example, the residual loss could be ‘charged back’ via reductions in the amount of management remuneration or the interest rate on debt in the case of shareholder–manager contracts and lending contracts respectively. The extent to which the principal or the agent bears the residual loss depends on the completeness of the ‘pricing’ in ex post settling up or ex ante price protection Although managers have incentives to transfer wealth from shareholders to themselves or from lenders to shareholders, there are various factors that can limit the wealth transfers. What are those factors, and how do they work to constrain the wealth transfers? Opportunistic behaviour by management can be constrained by: monitoring costs bonding informed and efficient markets. Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the shareholders to monitor managers. For example, shareholders could appoint an outside accounting firm to investigate the manager’s performance in managing the financial affairs of the firm. Being rational, the shareholders would reduce the remuneration to the manager by an amount that increases as the monitoring costs increase. The manager’s remuneration will therefore be reduced, relative to what it would be in the absence of the need for monitoring, by the full amount of the monitoring costs incurred by the shareholders. The monitoring costs are incurred initially by the principal, but are then passed on to the agent. The greater the shareholders’ expectations that managers will opportunistically transfer wealth from the shareholders, the greater the monitoring costs are likely to be. Since monitoring costs are ultimately borne by management, management has less incentive to behave opportunistically the higher the monitoring costs. Managers, as insiders who have access to information about their performance, are deemed to be wealth-maximisers. Therefore, they are likely to bond their actions to align them with the interests of managers if that reduces monitoring costs. Managers will incur bonding costs (for example, the costs of providing audited financial statements) to the limit whereby the marginal cost of bonding equals the marginal cost of monitoring that is imposed by the shareholders. As such, bonding is initiated by managers, and is designed to reduce the potential for them to opportunistically transfer wealth from shareholders. If markets are informed and strongly efficient then the market has full information regarding the incentives and opportunities for managers to act in a manner that is contrary to the interests of shareholders, and the managerial labour market will impound that information into the agent’s price of remuneration. As such, if managers behave opportunistically, this will be known to the internal and external labour markets, and the potential remuneration for the managers will be reduced accordingly. Hence, managers have incentives to protect their reputations by not engaging in wealth transfers from shareholders. If we relax the assumption of strong form efficiency then there will be incentives for the joint sharing of agency costs, and this will differ according to the degree of efficiency and the respective costs and the specificity of the relationship. Because of ex post settling up and price protection, much opportunistic behaviour is prevented or compensated for. What is price protection, and how does it reduce the cost of opportunistic behaviour? Price protection occurs when markets are efficient and impound all relevant information into the agent’s price of remuneration (for example, management salary, rate of interest on debt). Thus, the agent bears the cost of the principals’ expectations regarding the agent’s behaviour. The principals are protected because the value of the expected dysfunctional behaviour of managers is built into reducing the salary that the principals pay to the agent. The agent bears the costs of agency. Therefore, the agent has incentives to behave in a manner that is aligned to principals’ interests because this will reduce principals’ expectations of opportunism, and will impose a lower cost of price protection on the agent. Complete price protection is only achieved when markets are fully (information) efficient. Where markets are less than fully efficient then we will observe some price protection and a sharing of costs between principals and agents (this seems to be more descriptive of reality). Who bears agency costs? In a perfectly efficient market, agency costs are borne by agents either through price protection mechanisms implemented by principals and/or ex post settling up. In a market that is not perfectly efficient, agents perceive that they will not be fully penalised for dysfunctional behaviour. The incomplete price protection and ex post settling up results in the residual loss being partially borne by the principal. Bonus plans are used to reduce the agency costs of equity. Describe the agency relationship giving rise to the agency cost of equity and explain how bonus plans can reduce particular types of agency problems. The separation of ownership and control means that managers can act in their own interests, which may be contrary to the interests of shareholders. This can be broken down into a number of specific difficulties: Risk aversion problem. Managers prefer less risk than shareholders because their human capital is tied to the firm. They prefer to diversify their own risk rather than maximising the value of the firm through higher risk projects. Dividend retention problem. Managers prefer to pay out less of the firm’s earnings in dividends in order to pay for their own perquisites. Horizon problem. Managers are only interested in cash flows affecting their remuneration for the period they remain with the firm, whereas shareholders have a long-term interest in the firm’s cash flows because share prices equal the present value of shareholders’ expectations of all future cash flows. Bonus schemes can reduce these problems by tying the manager’s remuneration to an index of the firm’s performance that has a high correlation with the value of the firm (for example, share prices, earnings). This aligns managers’ and shareholders’ interests by tying managerial compensation to performance ex ante without the need to rely on ex post mechanisms, such as renegotiating salary. Remuneration can also be tied to dividend payout ratios or to options or share bonus schemes. It is likely that a bonus plan will reward managers only after they have achieved an ‘expected’ level of firm profits for a period — then the remuneration will increase as profitability increases, thereby providing incentives for managers to increase their bonuses by increasing firm profitability. There may also be a ceiling on the amount of bonus paid to managers, to reflect the fact that profits can sometimes be increased to artificially high levels by actions that are not in the shareholders’ long-term interests (for example, by reducing repairs and maintenance, not undertaking research and development). Explain the role, if any, played by accounting numbers in specifying the contractual terms of bonus plans designed to reduce agency problems. The major role that accounting numbers play is to provide a measure of the firm’s performance and to provide input to shareholders’ expectations of future cash flows. As different accounting policies and estimates yield different accounting profits, and accounting numbers are used in the determination of bonuses, managers have incentives to manage reported earnings through accounting practices. Explain the main agency costs of debt, and how debt contracts can be designed to reduce those costs. In particular, explain how accounting specifications within the contracts can be used to reduce the agency problems. The main agency problems involved in debtholder–shareholder relationships are: Excessive dividend payments. This lowers the value of debt because it reduces available funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders. Claim dilution. When further debt is issued, this makes the original debt riskier and lowers its value to the original debtholders. Asset substitution. When debt is issued that reflects (and subsequently projects) a particular risk, a higher risk is undertaken. Underinvestment. This occurs when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders. Debt covenants can be structured to restrict conflicts by bonding managers and shareholders to act in the interest of creditors, such as: covenants to restrict the production-investment opportunities of the firm (asset substitution and underinvestment) covenants restricting dividend policy to a function of net income covenants restraining financing policy, usually expressed as gearing ratios bonding covenants — such as increased financial reporting. Accounting would play a primary role if the above covenants were expressed in terms of accounting numbers. Whittred and Zimmer (1986) and Stokes and Tay (1988) found that debt covenants in Australia were mainly expressed in the form of accounting numbers. When Kezza Ltd approached Steffs Banking Corporation Ltd for an unsecured loan of $100 million, Kezza Ltd had a good credit rating. However, the economy was depressed and Steffs Banking Corporation Ltd was concerned about lending such a large sum. You have been asked by Steffs Banking Corporation Ltd to provide a short report to the finance manager, Mike Hanshe, explaining how debt agreements and restrictive covenants can be used to safeguard debt in general. Mike wants the report to explain which agency costs of debt are controlled by specific covenants. Furthermore, he is interested to know how accounting numbers can be used in the debt covenants to help control any opportunistic behaviour on the part of Kezza Ltd. Students should provide an appropriately formatted report in answer to this question. The following are points that should be covered in such a report: Shareholder–debtholder agency problems, discussed in detail in the text, can be categorised as relating to: excessive dividend payments — this lowers the value of debt because it reduces available funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders. claim dilution — when further debt is issued this makes the original debt riskier and lowers its value to the original debtholders asset substitution — when debt is issued which reflects a particular risk a higher risk is undertaken. underinvestment — when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders. In general, a default covenant allowing debtholders to insist on immediate repayment of the debt or renegotiation of the terms of the loan (including interest rates) can be implemented. Some possible ways in which debt agreements and restrictive covenants can be used to safeguard debt include: the dividend problem may be controlled by tiering dividend payments to net income where the income calculation is stipulated, or by restricting dividends to a function of the debt–equity ratio the claim dilution problem may be controlled by restricting the amount of debt that is allowed to be issued with priority over the existing debt, by controlling the debt to equity ratio, or by controlling the times–interest-earned ratio the asset substitution problem can be controlled by restricting the ability of management to undertake high-risk projects (for example, not allowing merger or takeover activity without the explicit approval of the lenders), or by having as a condition of the debt agreement that the interest may be altered with the changing risk profile of the firm the underinvestment problem can be controlled by tying management compensation packages to a risk-adjusted measure of performance, or by using covenants that restrict or control the production-investment activities. Constraints on dividend distributions ensure that funds are retained within the firm, thereby encouraging managers to invest in positive NPV projects rather than leaving cash idle. The underinvestment problem is the most difficult agency problem to control since underinvestment is unobservable Overall, bondholders can be protected by making debt rank higher than other repayments in the event of winding up. Regular financial reporting using pre-specified accounting methods can be used to control opportunism by managers. Furthermore, most of the covenants should be more effective if they are tied to accounting numbers. See also the empirical evidence in Whittred & Zimmer (1986), Stokes and Tay (1988), Stokes and Whincop (1990), Williamson (1988) and Begley (1990). In the context of positive accounting theory, political costs can reduce the value of firms significantly. (a) Give examples of how firms can be exposed to political costs. (b) Give examples of how a firm’s exposure to political costs can influence the nature and/or content of the firm’s annual report, particularly in relation to its accounting information. Political costs arise because a firm has a high public profile and is deemed to be an appropriate ‘target’ for political action that transfers wealth away from the firm. The ‘politician’ who initiates actions to transfer wealth from the firm to another group in society does so because he or she is rewarded with votes. Votes may be interpreted liberally to mean political votes or financial reward, depending upon the circumstances. Examples of how firms can be exposed to political costs: high sustained profits that indicate, over time, that they are earning non-competitive monopoly rents at the expense of consumers volatile profits whose peaks draw attention and public concerns about excessive profits — again, at the expense of consumers operating in publicly sensitive industries such as tobacco growing/manufacturing or highly polluting industries use of a militant labour force that campaigns actively to increase labour’s remuneration or to improve working conditions dealings with governments of countries engaging in politically sensitive activities such as war, human rights violations, trade sanctions, etc. (b) The political process is assumed to be a less efficient market than capital markets. Accounting is a source of information in these markets. Therefore, there is greater opportunity for wealth transfers in political markets due to the use or misuse of accounting information. Politically sensitive firms tend to understate income in order to avoid or reduce political costs — for example, higher cost regulation by politicians, public demands for price or rate decreases, union pressure for wage increases. Also, they tend to smooth reported income to ensure that, as a long-term strategy, they draw less attention than they would with volatile earnings and high earnings peaks. Examples of how a firm’s exposure to political costs can influence the nature and/or content of the firm’s annual report include: High tariff or quota-protected firms have political cost incentives to reduce reported earnings or smooth reported income at a low level so that their industry appears in need of protection. Firms that have a high degree of unionisation of the workforce also have incentives to reduce reported income or smooth reported earnings at a low level in order to avoid attracting attention to high profits that might be deemed to be earned through the exploitation of labour. Government business enterprises that have monopolies on services are expected to employ accounting techniques to reduce reported income to ensure that they are not deemed to be exploitative, and in need of competition from other entities. Firms in politically sensitive areas (for example, banks in high interest rate years) are more likely to employ income-reducing accounting techniques. Positive accounting theory has been criticised by many. Outline the criticisms and comment on their validity. Statistical criticisms: explanatory variables in a number of studies are insignificant and not of the predicted sign established R2s of the models are low colinearity among explanatory variables cross-sectional models not well specified the use of crude proxies (for example, firm size as a proxy for political costs) are not well defined in a theoretical or measurement sense. However, when the evidence is aggregated (Holthausen and Leftwich, 1983; Watts and Zimmerman, 1990; Christie, 1990) there are six variables that have statistical validity, namely: managerial compensation interest coverage leverage size dividend constraints risk. Theoretical and measurement criticisms: Leftwich (1990) points out that positive theory is driven by contracting and monitoring costs but until the mid 1990s there was no real attempt to operationalise or measure these costs (such as the costs caused by covenant defaults). This leads to two risks — high correlation of significant variables and the risk of rejection because of the use of poor proxies (even if the theory is correct). Single versus portfolio accounting policy choices: Zmijewski and Hagerman (1981) were the first to formally recognise that accounting policy choices may relate to portfolios rather than single policies in efforts to affect total income rather than components. Philosophical criticisms: positive research is value laden — the topics chosen, methodology, methods and assumptions are value laden (Merino and Neimark) positive theory is a sociology of accounting rather than a semantic or measurement approach (Christenson) the logical positive philosophy is outdated and inappropriate as a philosophy of science (Christenson) positive theory is constrained to analyse ‘what is’ rather than what ‘could be’ — doesn’t encourage change or improvement. Other criticisms: little or no analysis of anomalies testing positive theories against competing theories dismissing other theories (such as normative) out of hand, and giving the impression of a biased presentation of arguments and evidence assumptions of positive theory should be more rigorously tested and established. Validity of criticisms: This is something that should be debated in class. Researchers clearly have their own views, largely conditioned on their own research interests and exposures. Statistical criticisms are valid. Research is continuing to refine statistical specifications. Philosophical criticisms are more subjective. It appears that all research in science is value laden and myopic to varying degrees. (See Watts and Zimmerman (1990) for some counter views.) The criticism of the validity of assumptions in our view is also valid. Research is being undertaken in this area. Positive theory has sometimes rejected competing theories out of hand when they have a role. Some prefer to be more eclectic in their approach. A key role for positive theory is as the basis of normative theoretical debate. Normative debate should be informed by an understanding of how, and why, particular accounting practices occur. The increasing empirical evidence points to positive theory as a fundamental hypothesis of accounting, and at the moment it is our view that competing theories do not have superior explanatory or predictive power. Positive accounting theory does not prescribe how accounting reports should be prepared. How, then, can it make any contribution to the advancement of accounting as an information system? Do you think that positive accounting theory has played any role in the development of accounting practices or regulation? The contributions made to accounting theory by the positive approach can be categorised along the lines of chapters 9 and 10 as follows: Capital market research (chapter 9): Historical cost income figures have information content for capital markets. Capital markets use a continuous information set (accounting is only one source of information). There are few opportunities for abnormal results in markets after the release of accounting reports. Many issues about ‘proper’ income measurement are relatively unimportant to capital markets. There is no compelling evidence to suggest that markets are mechanistic (or fooled by cosmetic accounting numbers). This research played a major role in testing a number of assumptions made by normative theorists and led to a greater understanding of the relationship between accounting numbers and pricing in capital markets. Later positive research (chapter 10): The major contribution made by this research is to offer a market based explanation as to why we have ended up with the historical cost accounting system as practised by accountants: Agency theory provides an explanation of the role of accounting in agency contracts. The contention is that other markets (such as political markets) are relatively less efficient than capital markets and will lead to attempts to maximise wealth by manipulation of accounting figures through those markets. An understanding of these forces enables positive theorists to offer explanatory and predictive theories to accountants about the role of accounting numbers in market places. Probably, the overall contribution made by positive research has been to lead to a greater questioning of the incentives and effects of prescriptive (normative) theories. The call for more empirical research before implementing changes to accounting methods, which have been derived in a market environment, has led to more analytic and empirical argument about accounting standards. A major role of positive accounting research should be to inform normative debate. By providing an understanding of the effects of alternative accounting practice, positive accounting research has the capacity to contribute to the development of appropriate regulations in the area. Positive research has been used in this capacity, and in the development of regulation — the AARF has examined some of the relevant positive accounting research in relation to key issues. However, regulation is essentially a political process itself (see chapter 12), and the benefits of positive research are not always evident in regulatory pronouncements. Are the contracting and information perspectives of positive accounting theory different in any significant ways? If so, how and why? Which of the two perspectives is more consistent with the efficient market hypothesis, and why? According to the information perspective of positive accounting theory, accounting information is produced to enable investors to make ‘good’ investment decisions. That is, accounting information helps investors, amongst others, to ascertain likely cash flows and wealth transfers accruing to them as a result of their investment. According to contracting theory, accounting is a way in which the various claims on an entity’s resources are affected. Contracts are struck between various parties, and some terms of the contracts are specified in accounting numbers (for example, management bonuses paid as a percentage of reported earnings before interest and tax (EBIT) if EBIT exceeds a given level). Accounting is a mechanism by which contracted wealth transfers are affected between the various parties who have an ‘interest’ in the entity. The above two functions are not mutually exclusive — the parties with claims on an entity’s resources, such as shareholders and lenders, use accounting information not only to monitor wealth transfers but also to provide information about the effects of accounting choices on their welfare. That is, accounting information has a role for providing information in both the capital and political marketplaces. The information function of accounting sits more easily with the efficient market hypothesis (EMH) because this paradigm views accounting numbers as providing information regarding future capitalisation of cash flows to investors, rather than viewing accounting as contributing directly to monitoring and bonding activities. That is, the EMH sees accounting numbers as having information content that assists in making investment decisions, rather than viewing accounting numbers as fulfilling a wider function of explaining why accounting reports are prepared. The EMH, in its strongest form, relies solely on accounting reports being prepared to fulfil the information function. However, many observations regarding the preparation and use of accounting reports and accounting policy choices could not be explained by the EMH’s view that accounting served the information needs of investors. What is unconditional and conditional accounting conservatism? How would an unbiased (neutral) approach to recognition of all gains and losses reduce the stewardship (monitoring) role of accounting? Ball and Shivakumar (2005) note two distinct concepts of conservatism. Unconditional conservatism results in a downward bias on reported net worth so as to offset managers’ tendencies to bias net worth upwards – this is normally associated with the conservatism principle in accounting – recognize expenses early and delay recognition of revenue, etc. Conditional conservatism commits managers to recognising bad news in a timely manner. Ball and Shivakumar (2005) specify that conditional conservatism improves contracting efficiency. This form curbs negative net present value (NPV) projects, thereby improving the efficiency of equity contracting, and quickly triggers debt covenant violations, thereby enhancing the efficiency of debt contracting. Unconditional conservatism, which lowers equity book value and earnings as well, can also curb negative NPV projects and quickly trigger debt covenant violations. Under neutral non-conservative accounting, negative NPV projects are not curbed. However, Basu (2005) notes that this form does not utilize new information, and Ball and Shivakumar (2005) argue that this form adds noise to payoffs to contracting parties and thus could reduce contracting efficiency. Furthermore, contracting parties are expected to be able to readily contract around bias. Thus, efficiency of contracting is expected to improve through the conditional form only (Qiang, 2007; Guay, 2008). The role of financial accounting is to provide information for making economic decisions to buy and sell shares. Evaluate this argument from a contracting perspective. According to the information perspective of positive accounting theory, accounting information is produced to enable investors to make ‘good’ investment decisions. That is, accounting information helps investors, amongst others, to ascertain likely cash flows and wealth transfers accruing to them as a result of their investment. According to contracting theory, accounting is a way in which the various claims upon an entity’s resources are affected. Contracts are struck between various parties, and some terms of the contracts are specified in accounting numbers (e.g., management bonuses paid as a percentage of reported earnings before interest and tax (EBIT) if EBIT exceeds a given level). Accounting is a mechanism by which contracted wealth transfers are effected between the various parties who have an ‘interest’ in the entity. The above two functions are not mutually exclusive in that the parties with claims upon an entity’s resources, such as shareholders and lenders, use accounting information not only to monitor wealth transfers but also to provide information about the effects of accounting choices upon their welfare. That is, accounting information has a role for providing information in both the capital and political market places. The information function of accounting sits more easily with the EMH since this paradigm views accounting numbers as providing information regarding future capitalisation of cash flows to investors, rather than viewing accounting as contributing directly to monitoring and bonding activities. That is, the EMH sees accounting numbers as having information content which assists in making investment decisions, rather than viewing accounting numbers as fulfilling a wider function of explaining why accounting reports are prepared. The EMH, in its strongest form, relies solely upon accounting reports being prepared to fulfil the information function. However, many observations regarding the preparation and use of accounting reports and accounting policy choices could not be explained by the EMH’s view that accounting served the information needs of investors. Explain the role of auditing in agency theory and the information perspective. Auditing costs are an example of monitoring costs. They are borne in the first instance by the principal then passed to the agent through price protection. Auditing provides assurance about the accounting numbers used in management compensation and debt contracts. They can also provide assurance to investors who are purchasing shares in a company with a majority shareholder that agency conflicts between the two groups of shareholders will be minimised (see Fan and Wong). The information perspective emphasises the signalling role of auditing. Datar, Feltham and Hughes explain how a promoter of a new company uses a high quality auditor to signal to the new investors that the company is of high quality. It is difficult for new investors to judge the quality of a new company because information about the company has not been publicly available through financial statements. The promoter can retain a large holding of shares to convince the new shareholders (i.e. place their own money on the line) or use a high quality auditor. In both cases, the signal is credible because it is costly. It is costly to hire a high quality auditor, and it is costly to retain some shares in a newly floated company. CASE STUDIES Case Study 11.1 Further concessions sought on share plans This article describes certain components of executive remuneration. What are those components? The components of executive remuneration described in this article are equity based compensation (shares, options) arrangements. To the extent that earnings of a firm affect share prices, share-based compensation is also affected by reported earnings. This article reports on proposals by government to tax employee share arrangements and on the political pressures to mitigate those proposals. Why would an employee’s remuneration package contain non-cash components? The purpose of incorporating non-cash components (such as equity based compensation and other incentives) in a remuneration package is to align managers’ interests with shorter and longer term shareholders’ interests. Changes in stock price can be viewed as a short term relation, option incentives as longer term (because share price has to meet the exercise price), and profits can be either short term or long term. Profit is commonly used as a benchmark because profits indicate increases in shareholder wealth — obviously something that is in the interests of shareholders. By remunerating managers based on profit, managers have at least one of the same interests as shareholders, which is to maximise profit. Hence, managers should theoretically cease dysfunctional behaviour that might affect profit adversely. Incorporating non-salary components is also one way for shareholders to monitor managers’ behaviours. However, this depends on how it is measured. If it is measured using fair value it approaches the short term share market more closely. If historical costs are used then this more conservative approach means that changes in prices leak into profits at a slower rate. Hence giving a longer term perspective. Shareholders seek to incorporate this portfolio of non-cash components in management compensation to inter-temporally align managers’ interests with theirs. Managers are prepared to accept this ‘at-risk’ compensation because it demonstrates that they are prepared to act in the interests of shareholders, and should lead to a reduction in the costs of shareholders monitoring their performance, thus increasing their overall remuneration. What sort of benchmarks and hurdles are likely to be included in a ‘sound’ remuneration package? A sound remuneration package that contains non-cash components including equity-based compensation arrangements will also contain hurdles that are realistic and that increase the value of the firm. Examples include percentage increases in share price linked to the movements in appropriate share-indexes; increases in earnings per share (EPS) and perhaps progress towards achieving desired debt/equity levels, cash balances, or other critical accounting measures of success or improvement in firm performance. Finally, a portfolio approach that combines short, medium and long term incentives should be borne in mind. Why do you think unions reacted negatively to the government’s proposal to tax employee share schemes up-front? Many unions have successfully negotiated equity-based compensation components for their members, Although these compensation arrangements tend not to be in the same order of magnitude as they are for CEOs, unions are reluctant to see the benefits diminished as would occur if taxation arrangements were altered. Case Study 11.2 Results blamed on accounting How does this article and the underlying profit decrease demonstrate signalling theory? In your answer, explain what, if anything, is costly to replicate and therefore gives the signal credibility. Signalling theory proposes that managers use the accounts to signal expectations and intentions regarding the future of firms. By announcing the fund’s performance compared favourably to the All Ordinaries Accumulation index, Argo Investments management is giving a positive signal to the market that the firm is expected to perform well in the future. To be considered credible by the market, the signal must be costly to replicate by other firms. In Argo Investment’s case, the signal is costly to replicate in it has outperformed the index. This is something which is difficult to replicate by other firms. In particular, the market will punish firms if investors believe that inappropriate means have been used to alter reported earnings (e.g. earnings management through changes in accounting policies or deferral of maintenance and other expenditure that affects the long-term viability of an entity but reduces profits in the periods of the expenditure). In Argo’s case the earnings deterioration, it argued, was not caused by poor operations, rather, it was the result of an enforced change in regulations (accounting standards). Apply the theories described in this chapter to explain the decrease in reported earnings from the information perspective. Under this approach, managers provide accounting information to investors to assist in their decision making. The accounting information is used to indicate how the value of the firm and claims against it will change. In Argo Investment’s case, management provides information to the market by announcing its annual reported earnings for the current year. This information will help the market, particularly investors, to make economic decisions. For example, after Argo announces its earnings some potential investors might decide to sell Argo shares due to its possible unprofitable future prospects. How is the application of Accounting Standard 139 likely to have affected Argo Investment’s approach to the structuring of CEOs’ remuneration packages? If the earnings of a firm are likely to have been adversely affected by the introduction of the new accounting standard, we may expect to see adjustments to the remuneration packages of CEOs’ as firms move to alter the structure according to the anticipated impact. The imposition of new accounting standards is beyond the control of CEOs and as such compensation committees are likely to have protocols/processes in place that facilitate restructuring under such conditions. Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152