Earnings management Part 1, agency theory, corporate governance Flashcards
when does the agency theory hold?
When two conditions are met:
* information assymetry: the principal cannot perfectly observe what the ahgent is doing and/or the results they are producing
* misaligned incentives: what is good for the agent is not necessarily what is good for the principal
What is the agency problem regarding CEO’s and shareholders and how is the agency issue minimised?
IA: shareholders cant perfectly observe what the CEO is doing and only the CEO knows the true financial standing of the company and the reasonableness of any accounting estimates
MI: issues:
* CEO’s not working hard
* avoiding taking risks that are in the shareholders best interests
* taking private benefits not in shareholders best interests (perks, pet projects)
Minimisation
* perioding FR (reports) provides measure of CEO’s dec. and efforts
* accounting is used to align incentives of CEO in contracts i.e. CEO copensation is linked to profit
What is the agency problem regarding debt holders and the manager/shareholders and how is this minimised?
when the shareholders or manageers act together in ways that are harmful for the debtholders via:
* paying exessive div
* takign excessive risk
* increasing indebtedness
debtholders only benefit from receiving principal & interest and dont receive any other benefit like shareholders would– so excessive risk means risk that they will only loose money.
minised:
* debt contracts/ covenants (i.e. interest coverage must be 3x and if breached debtholders can initiate bankruptcy or renegotiate the loan)
how is corporate governance used to alleviate the agency issue?
- external auditors represents and protects shareholder interest reducing earnings management and accounting errors
- Board of directors monitors CEO and senior management behavior and performance
- audit committee monitoprs the accounting process and external auditor independent of the CFO
- ASIC/ ASX /SEC can investigate and enforce penalties for breaches
- periodic disclosures required by law/ reg/ asx listing rules in terms of FR, prospectuses, contrinuous disclosure etc
- senior executive compensation contracts can link manager pay to company earnings
overall limitations:
* lack independence, precision or competence
what accounts can be overstated/ understated for operating income to be overstated?
- provision for doubtful debts ->understating
- prepaid expenses-> overestating
- contract assets -> overstating
- contract liabiltiies->understating
- accounts receivable ->overstating
- provision for warranty expenses-> understating
*contract assets is when a company has only completed some performance o
what are some general earnings management incentives?
- valuation: to mislead investors into believing that hte company is performaning better or is less risky than it would appear without earnings management
* maintain stock price or keep up with analysts expectations of stock
* to raise new capital which relies on strong financial performance to get favourable terms - to manipulate contractual outcomes that depend on accounting numbers
* to avoid breaching a debt covenant
* *to gain a higher compensation if earnings contract is tied to reported earnigns
what are potential red flags for earnings management
- close to reaching debt covenant/ company is about to issue more shares
- weak corporate governance (lack of independence, competence or experience
- issue of modified audit report(qualified, adverse or disclaimer of opinion)
- unexplained resignations (auditor, board of director, downgrade from audit company, resignation of audit firm for client without good explanation , late release of FR, unusual or poorly explained change in accounting policies/estimate
- previous regulatory issues from asx or asic
- new ceo may attempt to take a bath and blame previos ceo.
less indicitive:
* key audit matters section
