Transcript Making Financial Reporting Decisions

Making Financial Reporting
Decisions
Modules 3, 4 & 5 deal with
theoretical frameworks related to
making financial reporting
decisions
How do I make
financial reporting
decisions?
Financial Reporting Decisions
Regulated
Financial
Reporting
Decisions
You are
here
Unregulated Financial Reporting Decisions
Making Financial Reporting Decisions
Contracting
Determinants
of Financial
Reporting
Social
Determinants
Of Financial
Reporting
Critique of PAT
The Impact of
Financial
Reporting
Decisions
Lecture 4
Contracting Determinants of
Financial Reporting
Lecture Overview

Review
 Financial
reporting decisions
 Moral hazard and the stewardship role of
accounting
 Incentives for managers to supply financial info.
Overview of positive accounting theory (section
3.1)
 Agency theory, contracts, and accounting (3.2)
 Opportunistic and efficiency perspectives
(3.3.1)
 Owner/manager contracting (section 3.3.2)

Review
Financial Reporting Decisions
 Financial
reporting decisions relate to
the application of the accruals process
(financial accounting) and the
disclosure of other relevant information
 Important to understand determinants
of financial reporting decisions and
expected impacts on decisions of
stakeholders
Review
Financial Reporting Decisions
 Unregulated
financial reporting decisions can
be guided by theoretical frameworks and
research results
 Five types of financial reporting decisions
 Expensing
versus Capitalisation of Costs
 Accounting Methods
 Accounting Estimates
 Disclosure versus Recognition
 Disclosure Policy
Review
Moral hazard
 Arises
when some parties cannot observe
all the actions of the other parties to the
transaction
 Accounting to monitor the behaviour of
managers
 Stewardship role of accounting
Review
Stewardship Role of Accounting
 Key
Issue: motivating manager effort
 difficult
for owners to observe mgmt behaviour
 manager can shirk on effort or over consume
perks of the job
 Solution:
net income can be determined and
utilised as an indicator of management
performance
 Emphasis on reliability of financial reporting
Review
Incentives for managers to
supply financial information
 Capital
markets
 Markets for managers, corporate
takeovers, and lemons
 Threat of litigation
 Contractual incentives
Overview of Positive Accounting
Theory ( 3.1)
Positive vs. normative theory
 Positive
theories seek to explain and predict
particular phenomena
 Positive
theories help us to understand what we
see
 Positive theories provide explanations for what
we see
 Normative
 Tell
theories provide prescriptions
us what we ‘should’ do
 Provides an ‘ideal’ or ‘norm’ for practice to strive
for
 Not always fully accepted in practice, eg.
conceptual framework, current cost accounting
Positive Accounting Theory
(PAT)
 PAT
is one particular positive theory of
accounting
 There are other positive theories of
accounting – for example, stakeholder and
legitimacy theories covered in module 4
 PAT seeks to explain and predict accounting
practice, involves more than just describing
practice
What Positive Accounting
Theory (PAT) aims to do
 Explain
why firms prepare accounting
reports and have them audited
 Explain why companies lobby proposed
accounting standards
 Explain how accountants choose accounting
methods
 Explain why accountants might change
accounting methods
Relevance to accounting
regulation and practice
 Accounting
regulators need to understand
accounting practice
 For
assessing social and economic implications of
proposed regulations
 Practicing
accountants can also benefit from
an understanding of positive accounting
theories
 Helpful
when making financial reporting
decisions
 Helpful when advising clients and managers
about making financial reporting decisions
 Helpful when auditing the decisions of others
Positive Accounting Theory
How do I make
financial reporting
decisions?
Underlying Assumption and
Economic Focus
 Central
economics-based assumption
 All
individuals’ action is driven by self-interest
 Individuals will act in an opportunistic manner to
the extent that the actions will increase their
wealth (over short or long term)
 Notions of loyalty and morality are ignored
 Theory
 Focus
 Focus
has an economic focus
on the firm and individuals involved
on costs and benefits - basis of all decision
making
Underlying Theory
 Positive
accounting theory builds on
agency theory
 We need to learn about agency theory
first, and then extend this theory to
financial reporting
Agency Theory, Contracts and
Accounting (3.2)
Firms and Contracts
 Firms
can be characterised as a nexus of
contracts
 between
consumers of products and the
suppliers of factors of production
 Firms
costs,
exist because they reduce contracting
 firms
provide an efficient means of organising
economic activity
 Contracts
include all types of agreements
between two or more parties
Agency Theory
 Positive
accounting theory focuses on the costs of
contracting in situations where there is an agency
relationship
 An agency relationship arises where there is a
contract under which one party (the principal)
engages another party (the agent) to perform some
service on the principal's behalf
 For example, an agency relationship arises where
there is a separation of management and control.
Managers have remuneration contracts
Agency Costs
 Due
to self interest, the agent might act in
his/her own interest rather than that of the
principal (moral hazard)
 This agency problem gives rise to agency
costs
 Agency costs can be categorised into
 monitoring
costs
 bonding costs
 residual loss
Monitoring Costs
 The
rational principal will monitor
the agent
 Monitoring costs
 costs
of measuring, observing and
controlling the agent's behaviour
 eg prepare financial statements
(stewardship role of accounting),
audit the accounts, set budgets,
establish mgmt compensation
schemes etc.
Price Protection & Ex Post
Settling Up
 The
rational principal will pass these costs onto the
agent via reduced remuneration
 Price Protection (Ex ante - up front)
 The
principal reduces the remuneration paid to the agent
in anticipation of agency costs
 Ex
post settling up (Ex post - after the fact eg. at the
end of each year)
 The
principal reduces the remuneration paid to the agent
based on observed agent performance (reduced bonus or
reduced salary for the following year)
Impact of price protection
 Agents
pay for the principals’ expectations of
their opportunistic behaviour
 Agent will seek to ‘bond’ with the principal
ie. establish contracts to limit their ability to
undertake opportunistic behaviour
 The agent, not the principal has the incentive
to contract for monitoring
Bonding Costs
 The
costs of bonding the agent's
interests to the principals
 Give undertakings to act in the
interests of the principals, usually
in the terms of a contract
Residual Loss
 Rational
agent will only incur
‘bonding costs’ to the point where it
is equal to the reduced ‘monitoring
costs’ imposed on him/her
 It will not be possible to eliminate all
conflicts of interest
 Residual loss
 costs
attributable to any remaining
divergence of interest between principal
and agent
Impact of market forces
 Market
forces provide additional
incentives for managers to work in the
interests of the owners
 Market
for managers (reputation effects)
 Market for corporate control
The Role of Financial Reporting
 Financial
reporting can be used to
reduce conflicts within the firm
 Financial statements are used to
monitor manager performance and
contract terms
 Auditing of financial statements
provides and extra layer of monitoring
Implications for financial
reporting (*important)
 Because
contracts are used to bond the agent to
the principal, and financial statement
information is often used to monitor the agent’s
compliance with these contracts
 Agents have incentives to present the financial
statements in a way that ensures the best
outcome under the contracts
 Therefore, contracts need to be considered
when making financial reporting decisions
Impact of Self Interest on
Financial Reporting
 Managers
have incentives to present
financial statements in a way that
ensures the best outcome under the
firm’s contracts
 Managers may act in their own best
interests when making financial
reporting decisions, rather than in the
best interests of the firm
PAT Research
 PAT
is the ‘story’
 Empirical research is used to test the story
 3 early research hypotheses (predictions):
 Bonus
plan hypothesis
 Debt/equity hypothesis
 Political cost hypothesis
 These
hypotheses assume that managers act
opportunistically
Opportunistic and Efficiency
Perspectives (3.3.1)
Opportunistic and efficient
contracting perspectives
 There
are two perspectives on
positive accounting theory:
 opportunistic (ex post)
 ex
post - after the contracts are finalised
 managers transfer wealth from principals
 efficient (ex ante)
 ex ante - before the contracts are finalised
 managers do not act opportunistically, as
they believe price protection and ex post
settling up are complete
Opportunistic and efficient
contracting perspectives
opportunistic
- self interest objective
efficient - maximisation of firm value
objective
Opportunistic
perspective
managers have incentives to choose
accounting methods ex post which will give
them the greatest economic benefits
 managers act opportunistically by
manipulating the accounting numbers
 accounting policy choices can be explained by
examining the incentives for managers to
behave opportunistically

Efficient Contracting
Perspective
 Managers
choose accounting policies that will
maximise overall firm value
 Firm value is maximised through reduced
agency costs - most efficient use of contracts
(bonding) and accounting (monitoring)
 Managers choose those accounting methods that
facilitate efficient monitoring rather than those
that transfer wealth to themselves
 Such behaviour is due to concerns about
‘reputation’ and ex post settling up
Efficient Contracting
Perspective
 Firm
contracts (eg debt and remuneration
contracts) are related to the types of assets
held by each firm
 Each firm has a set of contracts which is
optimal (most efficient)
 Accounting methods are related to the types
of assets held by each firm
 Each firm has a set of accounting methods
which is optimal (most efficient)
Two important contracts
 Two
contracts that tend to be monitored
using accounting information are:
 management compensation
(remuneration) contracts
 debt contracts (bank loan agreements or
debenture trust deeds)
Owner/manager contracting
Monitoring & Bonding activities
– owner/manager contracting
 Financial
statements were
originally provided by managers to
bond their interests to those of
shareholders (pre-regulation)
 Shareholders use audited financial
statements to monitor management
behaviour (stewardship role)
Monitoring & Bonding activities
– owner/manager contracting
 Management
compensation schemes
are often used to bond manager and
shareholder interests
 Financial statements are used to
determine manager compensation
under accounting based bonus
schemes
Manager Compensation
 Managers
 On
may be rewarded:
a fixed basis (set salary);
 On the basis of results achieved; or
 A combination of the two
Problems associated with fixed
salary compensation:
 Limited
incentive to increase value of
firm through investment in risky
projects
 Known
as the ‘risk-aversion’ problem
 Reduced
incentive to pay dividends or
take on optimal levels of debt
 Known
as the ‘dividend retention’ problem
Typical Bonus Schemes
 Bonuses
and /or shares / share options are
offered to give managers an incentive to act in
the interests of shareholders
 Bonuses can be tied to
 accounting
numbers (such as net income, sales,
return on assets); or
 share price (market based performance measure)

21% of Australian managers hold shares in their firm
Typical Bonus Schemes
 The
type of incentive used depends on
 the
type of firm involved
 Accounting
profits are not the best indicator of
performance for some firms (eg .com firms)
 the
level of manager
 35%
of Australian senior managers hold shares
Problems associated with
accounting based bonus
schemes
 Managers
have incentives to manipulate the
accounts to maximise the amount of bonuses
paid (opportunistic perspective)
 known
as the ‘bonus plan’ hypothesis
 Managers
may adopt a short-term focus,
especially for managers approaching
retirement
 Known
as the ‘horizon problem’
Problems associated with
market based bonus schemes
 Share
prices are affected by factors not
under the control of managers (eg.
Market wide impacts on prices)
A
‘noisy’ measure of performance
 Only
very senior managers have the
opportunity to affect share prices
To be continued
 Next
week we will cover
 Details
of debt contracts
 Other economic determinants of financial
reporting decisions
 Conclusions and implications from the
research results
For Tutorials
 Required
reading
 Text
chapter 7, pp. 201 – 226
(skim 205 – 210)
 Self
assessment questions
 Questions
1 – 8 and 12 & 13 from
module 3
 Answers in tutorials