Part 4: Accounting quality, managerial incentives, and governance mechanisms Flashcards
What is important to consider when designing optimal contracts performance measures?
The performance measure must be informative of managerial actions. It should not only be precise and free from error and bias, but also filter out any components that are beyond the control of the manager.
What are the two types of performance measures in compensation contracts?
Accounting-based measures
Market-based measures
What is an accounting choice?
Any decision whose primary purpose is to influence (in form or substance) the accounting output. These can be non-opportunistic and reflect the underlying economic event, but can also be opportunistic
What is earnings management?
Opportunistic accounting choices which occur when managers use judgement in financial reporting and in structuring transactions to either mislead stakeholders about economic performance or influence contractual outcomes depending on the reported numbers
What are the four types of incentives in accounting choice?
Compensation contracts
Debt contracts
Political and regulatory forces
Market forces
Why are incentives important to consider?
Accounting choices that do not result in faithfully represented or relevant financial reports reduces quality.
What is enforcement, monitoring, and the institutional environment?
Enforcement – act of ensuring rule are followed in the way intended
Monitoring – act of overseeing a firm’s activities
Institutional environment – general term to explain the firm setting
What is the institutional environment?
General term to explain a firm setting
Country-level enforcement
Legal environment
What does corporate governance consist of?
Ownership structure
Board of directors
Auditors
How does accounting quality affect governance?
Accounting quality affects the structure and quality of governance, just as the structure and quality of governance affect accounting quality. The stewardship role of accounting is well-understood as the impact of accounting information on the efficiency of governance relationships.
Explain the debt hypothesis
Debt contracts usually contain accounting-based covenants and the conditions specified might influence accounting choices
Explain the compensation hypothesis
The effect of executive compensation plans and the incentives provided by those plans on certain accounting choices
What is the pay-performance relation?
Linking managerial performance evaluation/salary to firm performance when designing optimal contracts. However, this alignment of objectives could lead to earnings management
