Making Financial Reporting Decisions

1
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?
2
Financial Reporting Decisions
Regulated Financial Reporting Decisions
Unregulated Financial Reporting Decisions
Making Financial Reporting Decisions
You are here
The Impact of Financial Reporting Decisions
Social Determinants Of Financial Reporting
Contracting Determinants of Financial Reporting
Critique of PAT
3
Lecture 4Contracting Determinants of Financial
Reporting
4
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)

5
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

6
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

7
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

8
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

9
ReviewIncentives for managers to supply
financial information

• Capital markets
• Markets for managers, corporate takeovers, and
  lemons
• Threat of litigation
• Contractual incentives

10
Overview of Positive Accounting Theory ( 3.1)
11
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 theories provide prescriptions
• Tell 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

12
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

13
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

14
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

15
Positive Accounting Theory
How do I make financial reporting decisions?
16
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 has an economic focus
• Focus on the firm and individuals involved
• Focus on costs and benefits - basis of all
  decision making

17
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

18
Agency Theory, Contracts and Accounting (3.2)
19
Firms and Contracts

• Firms can be characterised as a nexus of
  contracts
• between consumers of products and the suppliers
  of factors of production
• Firms exist because they reduce contracting
  costs,
• firms provide an efficient means of organising
  economic activity
• Contracts include all types of agreements between
  two or more parties

20
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

21
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

22
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.

23
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)

24
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

25
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

26
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

27
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

28
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

29
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 agents
  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

30
Impact of Self Interest on Financial Reporting

• Managers have incentives to present financial
  statements in a way that ensures the best outcome
  under the firms contracts
• Managers may act in their own best interests when
  making financial reporting decisions, rather than
  in the best interests of the firm

31
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

32
Opportunistic and Efficiency Perspectives (3.3.1)
33
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

34
Opportunistic and efficient contracting
perspectives

• opportunistic - self interest objective
• efficient - maximisation of firm value objective

35
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

36
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

37
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)

38
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)

39
Owner/manager contracting
40
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)

41
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

42
Manager Compensation

• Managers may be rewarded
• On a fixed basis (set salary)
• On the basis of results achieved or
• A combination of the two

43
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

44
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

45
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

46
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

47
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

48
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

49
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