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Making Financial Making Financial Reporting DecisionsReporting DecisionsModules 3, 4 & 5 deal with
theoretical frameworks related to making financial
reporting decisions
How do I make financial reporting
decisions?
Financial Reporting Decisions
You arehere
Unregulated Financial Reporting Decisions
Regulated FinancialReportingDecisions
Making Financial Reporting Decisions
ContractingDeterminants of Financial Reporting
Social Determinants Of FinancialReporting
The Impact ofFinancialReportingDecisions
Critique of PAT
Lecture Lecture 44Contracting Determinants Contracting Determinants
of Financial Reportingof Financial Reporting
Lecture OverviewLecture 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 Review Financial Reporting Financial Reporting DecisionsDecisions
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 Review Financial Reporting Financial Reporting DecisionsDecisions
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 Review Moral Moral hazardhazard
Review Review Moral Moral hazardhazard
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 Review Stewardship Role of Stewardship Role of AccountingAccounting
Review Review Stewardship Role of Stewardship Role of AccountingAccounting
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
ReviewReviewIncentives for managers Incentives for managers to supply financial to supply financial informationinformation
Capital markets Markets for managers, corporate
takeovers, and lemons Threat of litigation Contractual incentives
Overview of Positive Overview of Positive Accounting Theory ( 3.1)Accounting Theory ( 3.1)
Positive vs. normative Positive vs. normative theorytheory
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
Positive Accounting Positive Accounting Theory (PAT)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 What PPositive ositive AAccounting ccounting TTheoryheory (PAT) (PAT) aims to doaims 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 Relevance to accounting regulation accounting regulation and practiceand 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 Positive Accounting TheoryTheory
How do I make financial reporting decisions?
Underlying Assumption Underlying Assumption and Economic Focusand 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
Underlying TheoryUnderlying 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 Agency Theory, Contracts and Accounting (3.2)and Accounting (3.2)
Firms and ContractsFirms 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
Agency TheoryAgency 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 CostsAgency 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 CostsMonitoring 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 Price Protection & Ex Post Settling UpPost 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 Impact of price protectionprotection
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 CostsBonding 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 LossResidual 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 forcesImpact 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 The Role of Financial ReportingReporting
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 Implications for financial reporting (*important)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 Impact of Self Interest on Financial Reportingon 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 ResearchPAT 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 Opportunistic and Efficiency Perspectives Efficiency Perspectives
(3.3.1)(3.3.1)
Opportunistic and Opportunistic and efficient contracting efficient contracting perspectivesperspectives
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 Opportunistic and efficient contracting efficient contracting perspectivesperspectives
opportunistic - self interest objective
efficient - maximisation of firm value objective
Opportunistic Opportunistic perspectiveperspective
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 Efficient Contracting Contracting PerspectivePerspective
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 Efficient Contracting Contracting PerspectivePerspective
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 contractsTwo 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 Owner/manager contractingcontracting
Monitoring & Bonding Monitoring & Bonding activities – activities – owner/manager owner/manager contractingcontracting 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 Monitoring & Bonding activities – activities – owner/manager owner/manager contractingcontracting
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 CompensationManager Compensation
Managers may be rewarded: On a fixed basis (set salary); On the basis of results achieved; or A combination of the two
Problems associated Problems associated with fixed salary with fixed salary compensation: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 SchemesTypical 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 SchemesTypical 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 Problems associated with accounting based with accounting based bonus schemesbonus 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 Problems associated with market based with market based bonus schemesbonus 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 continuedTo 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 TutorialsFor 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