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Chapter 5: Theories in accounting Contemporary issue 5.1 News Corp reduces agency problems through executive remuneration plans Questions Both the horizon problem and risk aversion are agency problems that relate specifically to the relationship between owners and managers and which contracting can assist in overcoming. Explain these two problems. News Corp Ltd has recently introduced a new pay scheme to link executive pay to a range of performance measures, including share performance through ‘total shareholder return’. How does linking bonuses to share performance reduce the horizon problem and risk aversion? Why is it important to link executive bonuses to a range of entity performance measures rather than one, as was previously the case with News Corp? 1. Managers and owners have differing time horizons in relation to the entity. This is known as the horizon problem. Owners are interested in the long-term growth and value of the entity as the share value today reflects the present value of the expected future cash flows. As such, shareholders want managers to make decisions that enhance these future cash flows over the long term. Managers, on the other hand, are interested in the cash flow potential only as long as they expect to be employed by the entity. This is particularly an issue for managers who are approaching retirement. Managers who are seeking to move to another entity within the short term are also more likely to want to demonstrate the short-term profitability of the entity as evidence of effective management. Managers generally prefer less risk than shareholders. This is known as the risk aversion problem. Shareholders are not likely to hold all their resources as shares in one entity. They are able to diversity their risk through investing across multiple entities, cash or property investments. Shareholders may also receive regular income from other sources such as a personal salary from employment. As such, shareholders have ‘hedged’ or minimized the risk of one of these investments losing value. In addition, the liability of owners is limited to the amount they are required to pay for their shares. Managers, on the other hand, have more capital invested in the entity than shareholders through their ‘human capital’ or managerial expertise. It is likely that their remuneration is their primary source of income. As such, losing their job or being paid less can substantially impact on their personal wealth. Given higher risk has the potential to generate higher returns shareholders prefer managers to invest in higher risk projects. Conversely, managers wish to take less risk when deciding on projects for the entity because they have more to lose – they are more risk averse than owners. 2. Linking managerial bonuses to share performance by using a measure such as ‘total shareholder return’ encourages managers to focus on long-term performance because it is likely to affect their own wealth. Tying a greater proportion of managerial pay to share price movements as the manager approaches retirement is also likely to encourage managers to maximise long-term performance and to more closely align managerial time horizon with that of owners. Paying managers a cash bonus based on measures of share performance encourages managers to invest in potentially more risky projects that are likely to maximise the performance of the entity into the future. 3. Linking executive bonuses to a range of entity performance measures plays two main roles. First, it encourages managers to consider different aspects of the entity’s performance – both short and long term – that will lead to an overall strengthening of the entity, and be more likely to lead to longer-term increases in firm and shareholder value. If managerial pay is tied to only one measure, such as profits, it will encourage managers to take a short-term focus and to engage in activities that might benefit the organization in the current year, but are less likely to be beneficial over the longer term. It might also encourage managers to use accounting methods, such as accruals management, to maximise profits in the current year rather than future periods. Second, given managers bear a large amount of risk, through their human capital investment in the organization, and it is likely to be their main source of income, it is more beneficial for managers to have their pay linked to a range of performance measures. If the company performs poorly on one measure in a year and managers do not meet targets for that performance target, for example profit, they are still likely to receive a bonus based on other measures of performance where targets were met. Contemporary issue 5.2 Power and duty: is the social contract in medicine still relevant? Questions What is a ‘social contract’? The article discusses some of the implied terms of the social contract between doctors and patients. Articulate what these are and discuss how they are currently under threat. The term ‘social contract’ has often been used to describe how business interacts with society. It relates to the explicit and implicit expectations society has about how entities should act to ensure they survive into the future. A social contract is not necessarily a written agreement, but is what we understand society expects of entities. Some expectations could be explicit (legislation relating to pollution or employee health and safety are examples), while others are implicit. Evidence of implicit terms of the social contract can be gained from communications and writing of a society at a point in time. Media attention to high executive bonus payments when share prices are declining could be an example of the degree of public importance placed on these issues, and therefore an implied component of a social contract. Training doctors requires significant public investment, including through publicly funded universities and medical facilities. It was proposed in 2008 that the cost of training one doctor was approximately $1 million. As a result of this public investment, doctors are expected to serve the health needs of the community with ‘competent, ethical and professional care’. There are a number of ways this social contract appears to be under threat. The corporatisation of healthcare, with a move towards private medical facilities operated for profit. This does not align with the ‘social contract’ view of a commitment to universally accessible publicly available funded health care. In addition there is the view that medical benefits scheme funding is often misused, which undermines public trust in doctors. This means that both the medical profession and doctors could be placing self-interest and financial concerns above the ‘common good’. Review questions 5.1 What is the underlying assumption of positive accounting theory, and how can it be used to understand the problems that exist between owners and managers? Positive accounting theory examines a range of relationships, or contracts, in place between the entity and suppliers of equity capital (owners), managerial labour (management) and debt capital (lenders or debt holders). It is based on an underlying economic assumption called the ‘rational economic person’ assumption, which assumes that all individuals act to maximise their own utility. The theory takes the view that maximising utility relates to maximising financial wealth, with non‐ financial aspects of utility effectively ignored. When examining the problems that exist between owners and managers this assumption, proposing that all parties are effectively going to act in their own self-interest, helps us to consider the differences in utility that might exist between shareholders (owners) and managers; and between lenders and managers. From there we can look to alternative mechanisms to reduce these problems that might meet the utility needs of both parties. 5.2 Explain what an agency relationship is, and explain the following costs: monitoring costs, bonding costs, residual loss. An agency relationship is one where a person, or group of persons, known as the principal, employs the services of another – referred to as the agent – to perform some activity on their behalf. In doing so the principal delegates the decision making authority to the agent. Monitoring costs are incurred by the principal, and relate to measuring, observing and controlling the agent’s behaviour. They could include audit of financial reports, putting in place rules, or costs incurred to set up a management compensation plan. Bonding costs are costs incurred by managers in an attempt to provide some assurance that they are making decisions in the best interest of principals. Residual loss refers to the additional divergence between agents and principals that can’t be contracted for, or cannot be monitored in its entirety. It is likely to be too costly to guarantee an agent will make decisions optimal to the principal at all times and in all circumstances. 5.3 Why would managers’ interests differ from those of shareholders? What can shareholders do to ensure that they do not suffer financially because of this difference in interests? Managers’ interests might differ from owners for a number of reasons, given both managers (agents) and owners (principals) are assumed to act in their own interest, and these actions might not necessarily align. Agency theory points to three main problems which highlight differences between interests of managers and owners: the horizon problem (managers and owners have differing time horizons in relation to the entity); risk aversion (managers generally prefer less risk than shareholders); and dividend retention (managers prefer to maintain a greater level of funds within the entity, and pay less of the firm’s earnings to shareholders as dividends). Shareholders, through the board of directors, can insist on a contract which financially rewards managers in ways that align with their interests. For example: linking managerial remuneration to the longer-term performance of the firm, through bonuses that don’t vest until such time as financial hurdles are met. Options or performance rights can also serve to encourage a longer-term view. 5.4 Explain the three agency problems that exist in the relationship between owners and managers. The three main agency problems that exist in the relationship between owners and managers are: the horizon problem; risk aversion; and dividend retention. The horizon problem exists because managers and owners have differing time horizons in relation to the entity. Shareholders have an interest in the long-term growth and value of the entity as the share value of the entity today reflects the present value of the expected future cash flows over the long-term. Managers, on the other hand, are interested in the cash flow potential only as long as they expect to be employed by the entity. Risk aversion refers to the fact that managers generally prefer less risk than shareholders. Owners diversify their risk through investing across multiple entities, and are also likely to receive income from other sources. Managers have a large amount of ‘human capital’ tied up in the entity and rely on the entity as their main source of income. As such they are likely to be more risk averse than owners, and are less likely to want to invest in risky projects. Managers prefer to maintain a greater level of funds within the entity, and pay less of the firm’s earnings to shareholders as dividends. This is referred to as dividend retention. Managers wish to expand the business they control, whereas shareholders wish to maximize the return on their investment in the entity through increased dividends. 5.5 Explain the four agency problems that exist in the relationship between lenders and managers. The four agency problems that exist in the relationship between lenders and managers are: excessive dividend payments; underinvestment; asset substitution; and claim dilution. When lending funds, lenders price debt to take account of an assumed level of dividend payout. Excessive dividend payments, while good for shareholders, could lead to a reduced asset base securing the debt or leave insufficient funds in the entity to service the debt. Underinvestment arises when managers, on behalf of owners, have incentives not to undertake positive NPV projects if the projects could lead to increased funds being available to lenders. This might particularly be the case when the entity is in financial difficulty. Given creditors rank above owners in order of payments in the event of liquidation, any funds from these projects would go towards debt rather than equity. Managers have incentives to use debt finance to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns to shareholders. This is referred to as asset substitution. Lenders bear the risk of this strategy as they are subject to the ‘downside’ risk of this strategy but do not share in any ‘upside’ returns. When entities take on debt of a higher priority than that on issue it is referred to a claim dilution. While taking on additional debt increased funds available to the entity, it decreases security to lenders, making lending more risky. 5.6. What is a debt covenant and, from an agency theory perspective, why is it used in lending agreements? A debt covenant is a restriction or a term included in a debt contract that is designed to protect the interests of lenders. They could include things such as a dividend payout ratio, working capital ratio, leverage ratios, or the restriction of the borrowing of higher priority debt. Debt covenants are used in lending agreements to ensure managers, acting on behalf of the firm, do not make decisions that would be detrimental to lenders, that is, a debt covenant aligns the interests of the firm and lenders. 5.7 Why would managers agree to enter into lending agreements that incorporate covenants? As a result of agreeing to the terms of debt covenants managers are able to borrow funds at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods of time. 5.8 What are the costs of breaching a debt covenant? If a firm breaches a debt covenant, this can be extremely costly. The manager, on behalf of the firm could be required to repay the borrowings immediately (therefore forcing the firm into financial distress or potentially insolvency). The loan might also have to be refinanced at a higher cost (interest rate) or for a shorter period of time. A breach of a lending agreement could also limit the availability of funds from this lender and others. 5.9 What role does accounting play in reducing agency problems? Accounting plays two roles in reducing agency problems. The first is where the terms of managerial compensation or lending agreements are written in terms of accounting; and the second is where accounting is used to determine performance against the terms of the contracts. 5.10 How can shareholders mitigate the risk that managers will transfer wealth from shareholders to themselves? Provide specific examples and explain how they work to limit these wealth transfers. Shareholders can mitigate the risk that managers will transfer wealth from shareholders to themselves by including in the managerial compensation contract a range of performance targets or hurdles. Managers can be paid a range of pay – fixed salary, short term bonus and long-term bonus, shares and options. This will encourage managers to act in the long term (shares and options); as well as maximise short term performance (to gain a short-term bonus). 5.11 How might institutional theory explain accounting disclosures? Institutional theory is used to understand the influences of organizational structures such as rules, norms and guidelines. Accounting disclosures are likely to be a way of demonstrating corporate legitimacy by disclosing how the organization is meeting the expectations of these rules, norms and guidelines. 5.12 Using institutional theory, evaluate the factors that might lead a country to adopt international financial reporting standards, rather than its local standards. The decision to adopt international financial reporting standards (IFRS) at the national level can be influenced by a range of factors across three levels. At the highest level, decisions of other nations with which the country does business, and international bodies such as the World Bank, can influence a decision to adopt (IFRS) if this will align with reporting needs. At the organisational level, the accounting profession may lobby for changes in reporting standards. Finally, organisations themselves might attempt to influence the adoption of IFRS if it increases access to international funding mechanisms etc. These influences can be coercive (e.g. the World Bank to support national funding); mimetic (e.g. copying decisions in nations with close ties); and normative (resulting from changing norms across countries in the region). 5.13 What is a social contract and how does it relate to organisational legitimacy? A social contract is used to describe how business interacts with society. It relates to the explicit and implicit expectations society has about how businesses should act to ensure they survive into the future. A social contract is not necessarily a written agreement, but is what we understand society expects. While the relationship between society and business is explained by the social contract, organizational legitimacy describes the state in which an organization has met the terms of the social contract. It explains the process by which the terms of a social contract is gained or maintained. 5-14 How can corporate disclosure policy be used to maintain or regain organisational legitimacy? Four ways an organization can obtain or maintain legitimacy have been identified in the academic literature: Seek to educate and inform society about actual changes in the organisation’s performance and activities Seek to change the perceptions of society, but not actually change behaviour Seek to manipulate perception by deflecting attention from the issue of concern to other related issues Seek to change expectations of its performance Disclosure can be used as a technique in each of these strategies. An entity might provide information to offset negative news that may be publicly available. They could also use disclosure to draw attention to strengths or to down play information about negative activities. Disclosure can also be used to advertise actual changes in performance or activities. 5.15 Why would managers decide to voluntarily disclose environmental performance information in an annual report? Public reporting of information that is not mandated, such as details of environmental performance is a powerful tool in showing an organization is meeting the expectations of society, and therefore maintaining organizational legitimacy. This can be used to draw attention to the company’s strengths, and to play down any weaknesses. 5.16 How does the idea of value creation under stakeholder theory differ from that under positive accounting theory? Stakeholder theory considers creation of value for all stakeholders, considering how operations affect all stakeholders, not concentrating solely on shareholders and profits. Managers should consider balance across all stakeholders. Positive accounting theory, on the other hand, considers value creation only from the perspective of owners and managers. 5.17 Stakeholder theory proposes that it is important to harmonise or balance stakeholders’ needs and expectations. Choose two stakeholder groups and evaluate how a company can balance the views of these shareholders in its dealing with them. Any two of the following organizational stakeholders can be identified and discussed: Investors/owners – Investors and particularly institutional investors have power through the provision of equity funds, and their role in appointing the board of directors. A company will need to balance the needs of larger or institutional shareholders with minority shareholders to ensure they are both considered in decisions. Political groups – these groups can incorporate community groups, lobby groups and shareholder associations amongst others. Different groups have varying ability to influence the operations of the organization with respect to their area of influence. For instance, environmental lobby groups can influence public opinion about an entity’s environmental performance, so the entity needs to ensure they manage this relationship. The company will need to carefully balance the needs and expectations of all these groups in decision making. Customers – these are major providers of cash funds to the entity. In many industries meeting consumer needs is the driving force behind the organization, and it will find it difficult to operate successfully without the source of customers. Meeting the needs of customers is important, and it is necessary for companies to balance this against the needs of shareholders and employees in particular. Communities – some companies have a major impact on local communities. A specific example is the mining sector where towns and the communities which live there are significantly impacted by the organization, and the entity is reliant on local communities for support including labour, services and other resources. In these circumstances community groups can be seen as powerful parties, as it is important for entities to ensure a close working relationship. It is particularly important to balance the needs of community groups against the demands of shareholders. Employees – as the suppliers of one major resource to companies – labour – employees are important to the smooth operation of the entity. Issues with employee conditions can significantly affect this supply of labour and therefore the continuous operation of the entity. This needs to be balanced against the needs and demands of other suppliers – of capital, raw materials etc. Governments – government at all levels have a significant amount of influence over the operations of entities through legislation that impacts on operations. This can relate to corporations legislation, legislation that dictates taxes, fees, tariffs and allowances the entity receives, and that dealing with how entities need to treat employees, the surrounding environment and consumers, as just some examples. These all have the potential to incur financial costs on the entity in terms of compliance, and need to be carefully considered against other demands from employees, suppliers and shareholders in particular. Suppliers – raw materials are also a major cost to the entity, so any demands from suppliers for information, performance expectations etc. are likely to significantly impact on the entity. Decisions not to supply to an entity can also be costly as it requires the entity to seek out alternative sources. 5-18 What are the factors a manager might consider in making various expensing–capitalising choices? Agency theory would propose that where a manager has discretion about the timing and the nature of activities, they are likely to choose to expense or capitalise in order to maximize profits, which would lead to increased bonuses to managers. It is also likely to ensure the entity is not close to breaching any debt covenant that might be in place. 5.19 How can positive accounting theory explain corporate social and environmental reporting? Positive accounting theory highlights the importance of minimising information asymmetry between owners and managers. Managers need to be mindful of presenting both good and bad news about the entity as it impacts on reputation and future share values. As such they are likely to provide information about social and environmental performance to ‘bond’ themselves to shareholder expectations regarding sustainability performance, and to reduce information asymmetry, thus leading to a reduction in the cost of capital. Application questions 5.20 Making managerial pay contingent on measures of managerial and/or firm performance motivates them to deliver good performance for shareholders. However, it also burdens them with greater risks than they may like. How do organisations balance these two considerations when choosing managerial pay and performance measures? The board of directors will choose a range of measures, both accounting and non-accounting to use as performance target for managers. This will ensure managers work towards improving firm performance on a number of levels – both short and long term, which is in the best interest of owners. It also serves to reduce the risk to managers. If managerial pay is only linked to one measure of performance, and it is not met, managers arguably receive no bonus. With a range of performance measures, if the managerial team meets performance on some measures but not others it means they will not lose all bonus. 5.21 Obtain the remuneration report for a publicly listed company. Examine the compensation contract for the chief executive officer (CEO). Prepare a report which summarises your findings relating to the following issues: What amount is short-term in nature (salary and cash bonus) and what is based on long-term firm or managerial performance? What proportion of the CEO’s pay is performance based, and what proportion is not? What measures of accounting performance are used to determine the CEO’s bonus? Given the accounting firm performance measures in the contract, what accounting decisions could the CEO might make in order to maximise their bonus? Can agency theory provide an explanation for the various remuneration components? Justify your answer. The responses to each of the above questions will depend upon which company students choose. All the information in parts (a) to (c) is required to be disclosed in the Remuneration Report. The answer to (d) will depend upon the accounting performance measures disclosed in the report. It is likely that they are all short term measures such as return on assets (ROA) and profitability. These will lead to managers taking a short term approach to performance, perhaps decreasing expenses and capitalizing costs where possible. In answering (e) students should refer to the use of remuneration contracts to limit the following agency problems: horizon problem, dividend retention, risk aversion. 5-22 Bonus plans are used to reduce agency problems that exist between managers and shareholders. Discuss two (2) of these problems specific to the relationship between shareholders and managers and identify how bonus plans can be used to reduce the agency problems you have identified. In your answer you should provide examples of specific components that should be added to a bonus contract to address the issues identified. There are three agency problems: the horizon problem, dividend retention and risk aversion. Bonus plans will be used in different ways to reduce each of these problems. To reduce the horizon problem, long-term bonuses such as shares or options are useful, as it encourages managers to improve long-term performance, and take a longer-term focus. Tying a greater proportion of managerial pay to share price movements, using ratios such as total shareholder return, particularly as the manager approaches retirement is also likely to encourage managers to maximize long-term performance. Linking bonuses to ratios such as a dividend payout ratio will likely encourage managers to enhance dividend payouts to shareholders. Similarly, linking bonuses to profits will also encourage managers to seek additional profits, which in turn are going to be available for dividends, thus alleviating the dividend retention problem. Including incentives to encourage managers to invest in more risky projects can reduce the risk aversion problem. For instance, linking a bonus partly to profits can encourage managers to consider more risky projects that have the potential to increase profits. Limiting the share-based compensation as a manager’s ownership in the company increases is also likely to encourage managers to invest in more risky opportunities as it increases a manager’s ability to diversify their own risk. 5.23 You have recently been appointed as a lending officer in the commercial division of a major bank. The bank is concerned about lending in the current economic environment, where there has been an economic downturn. You have been asked by your supervisor to provide a report indicating how you can safeguard the bank against the risks of lending. In your report you should outline how covenants in debt agreements can be used to reduce the risks, what agency problems the bank should be concerned with, and how accounting information can be used to assist in this process. Debt covenants are designed to protect the interests of lenders. They also bond managers, representing the firm, and allow managers to borrow funds at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods. The bank should be concerned about the following agency problems: Excessive dividend payments: if managers issue a higher level of dividends than the payout ratio assumed in the calculation of a lending agreement this can lead to a reduction in the asset base securing debt, and potentially leave insufficient funds within an entity to service the debt. A restriction on dividend policy, or including a maximum dividend payout ratio, can reduce this problem. Underinvestment: arises when managers have incentives not to undertake positive NPV projects if the projects would lead to increased funds being available to lenders. Covenants that restrict the investment opportunities of the entity, or working capital ratios can reduce the problem. Asset substitution: managers have incentives to use debt finance to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns to shareholders. Debt covenants can restrict investment opportunities, including merger activity. Including clauses that secure the debt against specific assets, or including a leverage ratio in the covenant can also reduce the risk of asset substitution. Claim dilution: entities take on debt of a higher priority than that on issue. Debt covenants could restrict the borrowing of higher priority debt, or debt with an earlier maturity date. Accounting information can play two roles in this process. (1) it can be used as part of the covenants in debt contracts, and (2) can be used to assess performance against these covenants. The bank can require lenders to provide audited financial statements half-yearly or annually so it can ensure restrictions in debt contracts are not being breached. 5.24 A clothing manufacturer has decided to close its factory in a regional Australian town and move its operations offshore to another country where they are going to be able to employ workers at a substantially reduced cost. Closing the factory will result in the loss of 400 jobs in the town. Outline the issues the company might face with regards to its implied social contract. You should identify what groups or people are likely to be concerned or affected by the decision and whether the decision is likely to be seen as advantageous or disadvantageous to these groups. You should also discuss actions the company could take to reduce any potential negative reaction to the decision. In a regional town a clothing factory that employs 400 workers is likely to be responsible for employing a major proportion of the community; in fact it may be the major employer in the region. This means closure will have a significant effect through increased unemployment. This will have a flow-on effect to other businesses in the area which are supported by the clothing factory employees (e.g. retail stores, housing, medical services, child care services etc.). Because of this close association with the community it has an implied social contract with the local community to communicate with employees and the broader community with regards to its intentions. Many employees may have moved themselves and their families to the area to seek employment. The company is likely to face opposition and lobbying by employees themselves, other businesses in the area, local government and employer associations. The decision is likely to be disadvantageous to all these groups. Shareholders of the company are also likely to be affected by the decision, and are likely to be supportive, given reduced costs are likely to lead to increase profits. Customers of the company are also going to be affected, and may make a decision to boycott the company’s products if they are not supportive of the company’s move offshore. This is likely to lead to adverse publicity, which may also be seen by shareholders as negative. The company can take a number of actions to reduce the potential negative reaction to the decision. They should communicate with all interest groups, both in the local community and externally, to explain fully their decision. They need to highlight the advantages to the Australian economy, and to interest groups. They should also seek ways to reduce the impact on employees and the local community by seeking alternative employment opportunities for employees etc. 5.25 You work for a mining entity which is about to commence exploration in a remote area of the Northern Territory. You have been asked to assist the mining entity to manage its stakeholders to ensure the exploration permit is approved and there is no negative publicity associated with the operation. You are to identify the various stakeholders the mining entity needs to consider, and identify the issues each might be concerned with. In your answer you should identify whether these issues are potentially costs or benefits to the organisation. There is a range of stakeholders who will be concerned with the operation. Some of these include: Shareholders: As one of the major financial supporters of the company shareholders have an interest in future operations as it is likely to affect future shareholder value. Shareholders expect the company to keep them informed on any issues regarding the venture – likelihood of success, issues it faces of a legal nature and issues that are likely to impact on the future successful operation of the venture. It is anticipated that shareholders will be supportive of the venture, if there is no negative publicity and the permit is approved. If not, shareholders might see the negative publicity as a potential to impact negatively on firm value so may look to sell shares. Government: the government will be responsible for issuing any permit. This will be related to the location, indigenous ownership issues, environmental impacts and the potential for national income. It is important the company communicate with a range of government departments, as the success of the venture, and the granting of the exploration permit will rest upon government decisions. Indigenous landowners: It is important that the company consider any land rights issues and the possibility that the exploration might impact on indigenous sacred sites. The company needs to communicate with local elders to manage these issues to ensure the success of the project. Employees and potential employees: the successful exploration could increase employment prospects within the area and the company generally, which would be a benefit to current and future employees. It is important that the company communicate with employees about benefits and costs of working in a remote location. Local communities: If the exploration is successful then local communities are going to be affected by an influx of company employees. This could put a strain on existing infrastructure so the company needs to consider this and manage the provision of additional infrastructure to support the mine, employees and families, as well as contributing to the community. Lenders: costs of exploration and development need to be managed through the provision of financial resources. The company needs to manage its relationship with lenders to ensure their financial support of the project. Borrowings and their cost are likely to be affected by the probability of success so it is important that lenders are kept informed of developments, including successful application for exploration permits, and environmental impacts. 5.26 In an article published in the Australian Financial Review it was revealed that across the top‐100 companies, boards are increasingly paying chief executives larger annual cash bonuses to avoid investor backlash. It was proposed that fixed pay had doubled over a 5‐year period to an average of $1.8 million. It was suggested that boards were paying higher cash salaries to placate executives unhappy with having to meet demanding performance hurdles to access options. The article highlighted the lack of any downside risk for executives with this compensation strategy. Proxy advisors were also concerned about long‐term performance hurdles in some firms being less demanding than would be expected. Shareholders of Australian entities have the ability to vote to show either their support or dissatisfaction with companies’ remuneration reports. While this is non‐binding on the board, they are obliged to take note of shareholders’ views. From 2011 if the remuneration report receives greater than 25% of shareholder votes against it, the board of directors will be spilled and subject to re‐election. Why might shareholders choose to vote against reports with a large proportion of executive pay as salary and short‐term cash bonuses? Critically evaluate what impact a vote against the remuneration report greater than 25% might have on the following years’ remuneration report. Shareholders might choose to vote against remuneration reports with a large proportion of executive pay as salary and short-term cash bonuses because they perceive this type of remuneration does not encourage executives to perform in a way that aligns with investors. A vote of greater than 25% against the remuneration report may have a number of different impacts. It may result in no change if the directors choose not to take on board shareholder concerns. Alternatively, directors may improve communication with respect to the remuneration of directors so shareholders understand more fully the relationship between executive remuneration and shareholder performance expectations. Finally, it may have a significant impact on the remuneration report as the board of directors responds to shareholder concerns by amending the remuneration of managers to more closely align with shareholder expectations. 5-27 In April 2013 the crowded Rana Plaza garment factory on the outskirts of Dhaka, the capital of Bangladesh, collapsed, killing more than 1000 people. Following this, an Accord on Fire and Building Safety in Bangladesh has been signed by more than 150 global brands. The Accord allows staff to stop work if their safety is under threat. Some notable Australian firms have yet to sign this accord. In addition, the International Labor Organization, an agency of the UN, set up the Rana Plaza Donors Trust Fund, which aimed to raise US$30 million to provide compensation to any affected by the factory collapse. All garment companies that source goods from Bangladesh, and in particular those using the Rana Plaza factory were invited to donate to the fund, in accordance with their ability to pay, the size of their relationship with Bangladesh and their relationship with Rana Plaza. You have been appointed as a consultant to a clothing retailer which, while it sources clothing from factories in Bangladesh, did not have clothing manufactured by the company operating the Rana Plaza garment factory. The retailer has asked you to evaluate the appropriateness, pros and cons of signing the Accord on Fire and Building Safety, and of donating funds to the Rana Plaza Donors Trust Fund. They would also like some advice on the extent to which the entity should disclose their involvement in garment manufacturing in Bangladesh. In providing a response to the firm, use appropriate theories explored in this chapter to support your review and recommendations. A range of issues could be discussed in a response to the company. From the perspective of positive accounting theory’s information asymmetry, not providing any information about how the company is addressing these issues may be detrimental to reputation because it might be seen that the company has something to hide. Under positive accounting theory the company would consider the financial costs and benefits of supporting the accord and/or making a donation. From a stakeholder perspective, customers, employees and suppliers, through the supply chain are all going to be influenced by any decision the company makes. The company needs to balance its relationships with each. 5.28 Pick an organisation you are familiar with. List three important classes of participants in this organisation. Identify the resources that each contributes to and receives from the organisation. Explain the relationship of each of these classes of participants from both an agency theory and a stakeholder theory perspective. Different organisations will have different participants. Non-profit organisations will have different participants than profit-seeking organisations. The type of organisation will therefore affect the range of classes of participants you choose. Whether the organisation is a multi-national or domestic company will also affect the range of participants, as multi-nationals will need to consider government in different countries. The participants you might consider would include: shareholders or other owners; employees; employees; creditors and other lenders; suppliers of raw materials; community groups. 5.29 When accounting for non‐current assets accounting standards allow the application of a cost or a revaluation method. Evaluate the impact of the choice on common debt covenants, including interest cover and leverage ratios. Cost or revaluation will affect debt covenants differently, depending on their numerator or denominator. Two examples will be illustrated: Interest cover and debt to assets. Interest cover: calculated as earnings before interest and tax / interest expense. Often depreciation is also not included in the calculation of earnings before interest and tax. Therefore using cost or the revaluation method (which would affect asset values, depreciation and other comprehensive income does not have an impact on either the numerator or denominator. Debt to assets: calculated as total debt / total assets. The value of assets will be affected by the decision to use the cost or revaluation method. A greater asset base, following revaluation will mean a smaller debt to assets ratio. Case study questions Case study 5.1 AusGroup breaches debt covenants Questions Debt covenants or restrictions are commonly used in Australian lending agreements. Discuss how they are used to reduce agency problems that exist in the relationship between entities and lenders. Why would a company choose to enter into a lending agreement which contains a covenant that puts a restriction on the maximum debt to assets (leverage) that a company can take on? Evaluate the costs to AusGroup from breaching the conditions of its debt contract. How can the company reduce these costs? 1. Excessive dividend payments: A restriction on dividend policy, or including a maximum dividend payout ratio, can reduce this problem. Underinvestment: Covenants that restrict the investment opportunities of the entity, or working capital ratios can reduce the problem. Asset substitution: Debt covenants can restrict investment opportunities, including merger activity. Including clauses that secure the debt against specific assets, or including a leverage ratio in the covenant can also reduce the risk of asset substitution. Claim dilution: Debt covenants could restrict the borrowing of higher priority debt, or debt with an earlier maturity date. 2. As a result of agreeing to the terms of debt covenants managers are able to borrow funds at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods of time 3. There are likely to be a range of costs, many of which are not able to be readily quantified. Firstly, would be the financial costs of appointing an advisor – KPMG. Second, AusGroup may need to find the funds to repay the debt, or to refinance at a higher interest rate. Thirdly would be the reputation effects that result from the breach. AusGroup could look to reduce some costs by seeking alternative sources of finance, or working closely with their current lender. Rather than refinancing, they could look to extend the current time period for commitments instead. Case study 5.2 $10M CEO bonuses encourage short-term decisions Questions One of the problems in the shareholder/manager agency relationship that pay contracts are designed to overcome is the horizon problem. Outline what the problem is and how the contract between managers and shareholders can be designed to reduce the horizon problem. The article highlights the excessive use of bonuses to encourage shore‐term decisions. From an agency perspective, why would managers prefer short‐term cash bonuses instead of long‐term equity bonuses? What problems does this approach lead to for the board of directors and shareholders? In presenting your answer you should refer to relevant information in the above article to support your view. Why would managers prefer short‐term cash over long‐term equity bonuses? Why does this not align with shareholder interests? Explain your answer. 1. The horizon problem exists because managers and owners have differing time horizons in relation to the entity. Shareholders have an interest in the long-term growth and value of the entity as the share value of the entity today reflects the present value of the expected future cash flows over the long-term. Managers, on the other hand, are interested in the cash flow potential only as long as they expect to be employed by the entity. The contract between managers and owners is a compensation contract. As part of that contract there should be an equity component because this encourages managers to take a longer-term focus and maximise future performance. Tying a greater proportion of managerial compensation to share price movements, using total shareholder return as a performance hurdle for example, is also likely to encourage managers to maximise long-term performance. 2. In answering this question it is important to discuss agency theory, and the agency costs that exist between the owners and managers. These might include the horizon problem, risk aversion, dividend retention. These should be explained in the student’s answer (I will not go into the detail of each here for brevity). The main issue relevant to this article is risk aversion and the horizon problem, and discussion should reflect this. For example: Paying the CEO a cash bonus would imply that it is based on short-term performance measures, which does not align with shareholders’ long-term horizon (horizon problem). It will also not encourage management to engage in risky project which could possibly provide larger returns in the long-term (risk aversion). Issues from the article, to support the students’ response could include: It encourages CEOs to pursue strategies where the outcomes are relatively easy to measure, allowing the board to hide behind performance measures that don’t allow deep understanding of what the CEO is doing. Doesn’t reflect or pursuit of the right strategies. short term decisions are likely to be more important than working closely with the board and in the best interest of shareholders. Encourages companies to be ‘transactional focused’ rather than ‘build capability and innovate’. 3. Managers would prefer short-term bonuses because these allow the managers to receive their return early, and be able to invest this in whatever way they wish. This does not align with shareholders wishes because it encourages a focus on short term performance only. Case study 5.3 Supply chain – using child labour or paying unfair rates can destroy a brand Questions The above article discusses investors’ call for more transparency in regard to human rights and employment issues through companies’ supply chains. Many companies discuss this information in their sustainability report. What is sustainability? Provide three examples of activities that are considered to have an impact on the sustainability performance of a company. Corporate decisions to voluntarily disclose information about policies and practices relating to human rights and employment can be explained using a number of theories addressed in this chapter. Discuss one of these theories, and explain, from a theoretical viewpoint, why firms would choose to provide this information when they are not formally required to do so. How does a company’s supply chain relate to determining sustainability of an organisation’s operations? Explain your answer, supporting your view with examples from the article. 1. Sustainability refers to the ability to meet the needs of the present generation without compromising the ability of future generations to meet their own needs. There are a range of activities that could affect a company’s sustainability performance. These might include its impact on the environment, relationship with employees and the community, human rights issues and other aspects of social performance. 2. One popular theory that could be used to explain voluntary disclosure of human rights and employment issues might be legitimacy theory. In this case organisations might be providing this additional information to ensure they align with an implied social contract. It could also be a way to maintain or regain corporate legitimacy. 3. A company’s supply chain is an important aspect of its operations, and investors and consumers are increasingly concerned about the source of goods and services, and the human rights and therefore sustainability issues surrounding the source of these goods. There are a number of points made in the particle to support this perspective including: investors are concerned about the conditions faced by textile and footwear manufacturing in Asia; the Rana Plaza fire in Bangladesh has put this at the forefront of investor’s minds. Solution Manual for Contemporary Issues in Accounting Michaela Rankin, Kimberly Ferlauto, Susan McGowan, Patricia McGowan 9780730343530
