Lecture 5 Contracting and Other Economic Determinants of Financial Reporting

Lecture 5
Contracting and Other
Economic Determinants of
Financial Reporting
Lecture Overview
 Economic
determinants of financial
reporting (module 3 continued)
 Review
of last lecture
 Debt contracting (3.3.3)
 Other economic determinants of financial
reporting (3.3.4)
 Empirical research results (3.4)
Review - positive accounting
theory (PAT)
 Major
focus is on stewardship role of
accounting
 Looks at reasons underlying financial
reporting decisions
 Emphasis on relationship between financial
reporting decisions and contracts, particularly
management compensation contracts and
loan agreements (debt contracts)
 Based on ‘agency theory’
Review - Agency Theory
 Conflicts
of interest give rise to
agency costs
 Contracts are used to reduce these
conflicts of interest (bonding) contract terms sometimes rely on
accounting information
 Firms prepare audited accounting
reports to facilitate monitoring of
these contracts (stewardship role of
accounting)
Review - 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
Review - Opportunistic and
efficient contracting perspectives
opportunistic
- self interest objective
efficient - maximisation of firm value
objective
Review - Implications for
financial reporting decisions
 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
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)
Review - Management
Compensation Contracts
Debt Contracting
Nature of the relationship
 Debtholders
are the principal
 The manager, acting on behalf of shareholders, is
the agent
 Shareholders can opportunistically transfer
wealth away from debtholders
 firm
value is the sum of debt and equity
 equity claimholders can be made better off by
 increasing the value of the firm (equity is the
residual claim), or
 by transferring wealth away from debtholders
Divergence of interests
between shareholders and
debtholders
 Divergence
of interests gives
rise to agency costs (four
agency costs of debt)
 excessive dividend payments
 asset substitution
 underinvestment
 claim dilution
Monitoring and Bonding activities
- the debt claimholder problem
 Debtholders
can price protect via increased
interest charges
 The interests of shareholders can be bonded to
those of debtholders via restrictions in lending
agreements (covenants)
 Covenants often rely on numbers contained in
financial statements
 Breach
of a covenant can result in higher interest
charges, seizure of secured assets, refinancing of
debt
Typical debt covenants
 Bonding
covenants
 provision
of financial statements, audit
reports etc.
 Restrictions
policy
on financing and dividend
 leverage
limits, interest coverage and
working capital provisions
 Reading
3.1 gives details of typical
Australian bank loan agreement
covenants
Ex Post Financial Reporting
Incentives - under debt
contracts
 Managers
have incentives to ensure that the
terms of the covenants are not violated
 breaching a debt covenant is costly
 As the firm approaches a leverage restriction,
managers have incentives to adopt asset
and/or earnings increasing, or liability
decreasing accounting policies
 the
‘debt-to-equity’ hypothesis
Summary of Agency Theory
 Conflicts
of interest give rise to agency costs
 Contracts are used to reduce these conflicts of interest
(bonding) - contract terms sometimes rely on
accounting information
 Firms prepare audited financial statements to facilitate
monitoring of these contracts (stewardship role of
accounting)
 Existence of these contracts gives managers an
incentive to present the financial statements in a way
that ensures the best outcome under the contracts
Other economic determinants
of financial reporting
Provision of information to
investors
 Accounting
has an information role
as well as a stewardship role
 Managers have incentives to provide
relevant information for user
decision making
 This incentive may impact on
manager’s choice of accounting
methods (and other financial
reporting decisions)
Information and Efficient
Contracting Perspectives
 Difficult
to distinguish information and
efficiency perspectives
 Information perspective
 managers
select accounting policies to signal how
the future cashflows, and hence, the value of the
firm (and claims against it) will change
 Efficient
contracting perspective
 managers
select accounting policies that best
reflect economic events, transactions and
cashflows that have already occurred
Stewardship and Information
Roles of Financial Reporting
 The
stewardship role of accounting relates to
both the opportunistic and efficient
contracting perspectives
 contract
terms tend to relate to financial statement
numbers rather than unrecognised disclosures
 The
information role of accounting relates to
the information perspective
 incorporates
both financial statement numbers
and unrecognised disclosures
Costs of the
political process
 Involves
the relationship between the firm
and other parties interested in the firm
 government
 trade
unions
 community groups
 Interested
parties monitor firm's profits to
ensure that they are not excessive
 seek
opportunities to transfer wealth away from
firms
Political costs
 Profits
which are considered to be excessive
can be redistributed in society via
 extra
taxes, increased wages, removal of subsidies
 ‘Political
costs’ are the costs of these wealth
transfers out of the firm
 Highly profitable (and otherwise politically
sensitive) firms have incentives to reduce
reported earnings
 Known
as the ‘size’ hypothesis
Political costs must be assessed
against incentives related to debt
and compensation contracts
when making financial reporting
decisions
Summary of PAT
A theory of accounting based on agency
theory (a ‘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
 Empirical research has been used to test these
hypotheses as well as ‘efficiency’ and
‘information’ based hypotheses

Empirical Research Results
Research results Opportunistic perspective
 Overall
there is support for debt contract
terms impacting on accounting policy choices
 Managers
of firms that are close to default on debt
covenants tend to choose asset/income increasing
accounting policies
 The
results in relation to the impact of
management bonus plans are mixed
 researchers
need to focus on specific contract
attributes, these are difficult to obtain
Implications of Results for
Accounting Regulation
 Regulation
of accounting practice can
reduce the ability of managers to choose
accounting methods opportunistically
 The cost of regulation is often less than
the cost of controlling opportunistic
behaviour within each firm
Implications of Results for
Financial Reporting Decisions
 Consider
how the decision will impact
payoffs under contracts
 will
management compensation be
increased or decreased?
 will debt covenants be violated?
 Auditors
should be aware of the
potential for managers to choose
accounting policies opportunistically
Research results - Efficient
contracting perspective
 The
efficiency perspective is supported
 Different types of firms have different
contract terms and use different accounting
policies
 Difficult to distinguish empirically between
 opportunistic
perspective
 efficiency perspective and
 the information perspective
Implications of Results for
Accounting Regulation
 Uniformity
in accounting methods between
firms is not necessarily desirable
 Firms’
investments in assets vary and give rise
to unique agency / contracting problems
 Regulations
which prescribe the use of one
method for all firms impose costs on firms
for which the prescribed method is not
optimal
Implications of Results for
Financial Reporting Decisions
 The
assets held by each firm, as well the
terms of its contracts, must be
considered when making financial
reporting decisions
Research Results Political Costs
 The
evidence indicates that managers
consider potential political costs when
making financial reporting decisions
 Managers of politically sensitive firms
(including large firms) tend to choose
income decreasing accounting methods
Implications of Results for
Financial Reporting Decisions
 The
political sensitivity of the firm
should be considered when making
financial reporting decisions
 Auditors should be aware of the
potential impact of political costs on
financial reporting decisions
Summary - Factors to
consider when making
financial reporting decisions
 Contracts
of the firm
 Assets of the firm
 Provision of relevant information
 Potential political costs
 Social/legitimacy considerations
(module 4)
 Expected impacts on financial statement
users (modules 6 & 7)
For Tutorials
 Required
 Text
 Self
reading
chapter 7, pp. 227 – 235
assessment questions
 Remainder
of questions from module 3
 Answers in tutorials