contrinue Flashcards
What is the owner-manager agency problem?
A situation where the manager (agent) may not act in the best interest of the owner (principal) due to conflicting incentives.
What happens if a manager is paid a fixed salary without monitoring?
The manager will shirk, resulting in agency costs.
What is a first-best solution in agency theory?
A scenario where the owner can perfectly monitor the manager, eliminating agency costs.
What is a second-best solution in agency theory?
Compensation based on performance measures like net income, aligning incentives but not eliminating agency cost.
How can indirect monitoring work in agency theory?
By linking manager pay to observable outcomes indirectly related to effort, like performance thresholds.
What are the risks of renting the firm to the manager?
Reduces agency cost but increases inefficiency as the risk-averse manager bears all the risk.
What is the effect of tying pay to net income with noise?
It reduces agency costs compared to firm rental, but some inefficiency remains.
What happens when the manager can manage earnings?
They might report consistently high net income to increase compensation, leading to higher agency cost.
What is the implication of adding share price as a second performance measure?
It may better align incentives by combining sensitivity (share price) and precision (net income).
Why use both share price and net income in compensation?
To balance sensitivity and precision in evaluating managerial performance.
What are desirable properties of performance measures?
Sensitivity (effort affects the measure) and precision (measure predicts payoff).
When is share price preferred in executive compensation?
For long-term goals like R&D, due to high sensitivity to future performance.
When is net income preferred in executive compensation?
For short-term goals like cost-cutting, due to high precision in reflecting cash flow.
What is the worst outcome in agency theory?
When a manager always reports managed earnings and shirks, increasing agency costs beyond rental case.
What does earnings management imply in contracts?
The potential for performance-based contracts to backfire if managers distort reported metrics.
What is earnings management?
The use of accounting techniques to produce financial reports that present an overly positive view of a company’s financial position.
What are the three main patterns of earnings management?
Big Bath, Income Smoothing, Income Maximization.
What is Real Activities Management (RAM)?
Manipulating operational decisions, like overproduction or cutting R&D, to meet earnings targets.
What are some RAM tactics?
Offering discounts, delaying R&D, overproducing to spread fixed costs.
Why do managers manage earnings?
To hit compensation targets, avoid covenant violations, or reduce political costs.
How can accountants help curb earnings management?
Through full disclosure of revenue policies and special items.
What is the role of net income in executive compensation?
It serves as a performance measure but may be manipulated.
What does the Burgstahler & Dichev (1997) study suggest?
Earnings distributions show signs of manipulation, as they deviate from expected normal distribution.
