AGENCY THEORY Class Announcements       Assignment #7 due March 6th; available on-line Research Paper Part #3 due March 13th Reading in Chapter 9 (Agency Theory) – skip examples and calculation type discussions Midterm returned in-class Monday’s class (March 10th) is at 5:00-7:00pm in SCHW 110 (Movie) Business Banquet - April 2nd – 5:45-8pm, Catering Gabrieau's Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia Research Paper Part #3  Discuss the current academic research on your topic area A brief synthesis by topic not by paper  Three (3) academic references required (excluding text and CPA/CICA Handbook)     Due: March 13th (5:00pm) Worth: 2.5% Length: Cover page, One page submission (double spaced), reference page with Parts #1 & #2, Marking Keys #1& #2attached to the back. Part #2 – Average 1.86/2.5 (74%) Class Objectives 1. 2. 3. 4. 5. Agency is a theory of contracts Contracts as a means to manage the expectations and relationship between principals and agents Types of agency contracts Contracts as a means to manage the expectations and relationship between principals and agents Corporate Governance addresses agency issue Agency Theory  Positive accounting theory envisions firms as a nexus of contracts.  (e.g.    compensation agreements, debenture contracts Agency theory envisions firms as necessary structures to maintain contracts; firms logically arise because of the need for a control system to mitigate a sort of destructive opportunism called “shirking” Two parties with conflicting interests to a contract 1) agent 2) principal Party’s actions are motivated by the contract itself Agency Theory: Rational Agents     In agency theory, people are assumed to be rational profit maximizing individuals who will promote self interest. Separation between ownership and management Agents:  Self Interested  Choose actions that maximize own expected utility (adverse selection)  Have alternative opportunities of use of their time  Effort-adverse (moral hazard)  Tendency to shirk (moral hazard)  Risk –adverse See P9-8 (p. 370) http://www.cbc.ca/player/News/TV%20Shows/The%20National /ID/2437757413/ Agency Theory: Definition   “Agency theory is branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agent’s interest would otherwise conflict with those of the principal.” (p. 340) Agents (manager) have an information advantage (i.e. information asymmetry) Agency Theory: Contracts    Accounting information (e.g. net income) has a role to play in motivating and monitoring manager performance (p. 369) Accounting information competes with other sources of information Contractual agreements have accounting implications Precise –payoff and value of performance measure  Sensitivity –effort and value of performance measure   Types of contractual obligations Employment contracts  Lending contract  Agency Theory: Employment Contract  Modeled as: a principal who owns some productive resource  an agent to whom work or decision making is delegated (contract motivates effort; incentive compatible)     Separation of ownership and control The running of an organization is a complex and specialized task for which the owner may not have the required skills. A compensation scheme is struck in advance that will reward the agent for his efforts leaving something for the principal Agency Theory: Employment Contract  The tendency of an agent to shirk is an example of moral hazard (information asymmetry)  A) Principal could run the business himself (direct monitoring)  B) Costless observation of manager’s efforts and provision of salary (indirect monitoring)  C) Fixed contract (i.e. rental contract) (internalizing)  D) Profit sharing (performance measure) Agency Theory: Lending Contract     Contacts exist between a lender (principal) and a firm (agent) Manager (agent) tries to find an effective contractual arrangement that would lower the interest rate Rational lenders will anticipate moral hazard (shirking) and will raise the interest rates for their loans Lender (principal) imposes covenants Limit dividends if interest coverage ratio is below some level  Limit additional borrowing if shareholders’ equity is below a specific level  Agency Theory: Accounting Implications    Profit sharing contract is most attractive contract (especially employment contract) Base compensation on performance measures Net income   is most often used performance measure other than share price is informative about managerial effort but not fully informative      Poor governance Recognition lag Adverse selection GAAP allows flexibility to avid rigidity Accounting information needs to be:  Precise - Performance & Payoff  Sensitive – Performance & Effort Corporations: Corporate Governance   Private and Public Corporations  Separation of Ownership (Shareholders) and Management Corporate Governance is the relationship between:  Shareholders (owners)  Board of Directors  Corporate Officers Owners / Shareholders Board of Directors Corporate Officers Middle and Lower Management Corporate Governance: Conflict    Separation of ownership and management Manager and shareholder interests alignment Information asymmetry  Incentives to conceal bad news (agency theory adverse selection)  Incentives to shirk (agency theory – moral hazard)  Agency Theory – attempt to modify behavior Corporate Governance: Defined    Corporate Governance is the relationship between shareholder, the board of directors and other top managers in the corporation Corporate governance processes attempt to ensure proper functioning of management Corporate governance is implemented and evaluated through various processes within the organization  Board of Directors – internal and external directors    Audit Committee – meet with auditor and review audited financial statements Compensation Committee – set corporate officers compensation Nominating Committee – nomination of qualified members Securities Exchanges (e.g. OSC, SEC)  Reporting in Annual Report  Corporate Governance: Importance  Why is corporate governance important?  Owners can not easily observe the corporate officers who are managing the owners’ investment  Companies lack oversight by investors  Board of Directors have failed to provide proper checks and balances  Markets have stirred distrust instead of building confidence (e.g. Enron)  Rules for Board of Directors make accountability explicit Corporate Governance: Need       94% of investors say corporate governance is important 83.5% believed new regulations should be put in place to strengthen investor confidence in global markets Regulatory requirement  US – SOX (2002)  Canada – National Policy 58-201(2005)  Globalization of world capital markets Internally imposed obligation Ownership responsibility Competitive advantage Corporate Governance: Issues      1. Better Boards  Independence, skill, accountability 2. Executive Compensation  Link pay to performance, disclose metrics and links, executive overcompensation (US & Canada) 3. Financial reporting  Improved disclosure in financial statements 4. CEO Performance 5. Cost compliance/time Corporate Governance: Proposed Solutions  Better Boards  Director independence: How many? Who is independent?  Independent and financially literate audit committee; to whom external auditors would report directly  Independent compensation committee  Only one management representative on board of directors  Continuing education  Truly independent directors Corporate Governance: Proposed Solutions  Financial Reporting  Management attest to financial statements and to the presence of reasonable internal controls  Codes of conduct/ethics  Transparency Corporate Governance: Proposed Solutions   Audit Committees  Charter  Qualifications (financial literacy) Auditors  Participate in public oversight program established by CPAB  Reduce concerns over loss of client  Reduce commodification of audit by reducing cost pressure  Increase oversight with firm review Corporate Governance: National Instrument 58-101 National Instrument 58-101 - Disclosure of Corporate Governance Practices: 1. Board of Directors 2. Board Mandate 3. Position Descriptions 4. Orientation and Continuing Education 5. Ethical Business Conduct 6. Nomination of Directors 7. Compensation 8. Other Board Committees 9. Assessments Corporate Governance: Multilateral Instrument 58-110 Multilateral Instrument 58-110 - Disclosure of Corporate Governance Practices: 1. Audit Committee Charter 2. Composition of the Audit Committee 3. Relevant Education and Experience 4. Reliance on Certain Exemptions 5. Reliance on Exemption in 3.3(2) or 3.6 6. Reliance on Section 3.8 7. Audit Committee Oversight 8. Pre-approval Policies and Procedures 9. External Auditor Service Fees (by Category) Class Objectives - Revisited 1. 2. 3. 4. 5. Agency is a theory of contracts Contracts as a means to manage the expectations and relationship between principals and agents Types of agency contracts Contracts as a means to manage the expectations and relationship between principals and agents Corporate Governance addresses agency issue Midterm Results     Average: 47.79/65 (74%) Hi: 74/65 Lo: 13.5/65 Comments:  Did not answer question(s)  Insufficient knowledge of basic concepts  Insufficient information about basic concepts  Provide evidence or discussion for your opinions/conclusions; do not assume  Quality of the argument is important (no dumping)