Topic 2 - Theories of Financial Accounting Flashcards
Theories of FA.
- Positive accounting theory.
- Normative accounting theory.
- Systems-oriented theory.
PAT
PAT is formed by agency theory.
- Agency relationship.
- Agency problems.
- Agency costs.
Agency relationship.
Delegation of decision making task from principal to managers.
Agency problems.
Delegation lead to loss of efficiency and increased costs.
Agency costs.
Cost resulted from agency relationship.
- Monitoring costs.
- Bonding costs.
- Residual costs.
Efficiency perspective of PAT.
Mechanism used to reduce future agency costs and align managers’ and owners’ goals ex ante.
Accounting methods used reflects the FP of entity best.
E.g. Audits done to get funds at a lower costs.
Regulations is said to impose unwarranted costs.
- Forces firms to provide inefficient perspective of performance as one-size-fits-all approach to reporting is needed.
Opportunistic perspective of PAT.
Assumes managers will opportunistically select accounting methods that increase their wealth.
E.g. Bonus plan encourages managers to up reported profit to enrich themselves.
Hypothesis of PAT.
- Bonus plan hypothesis.
Managers with BP will up firms’ FY profits. - Debt/equity hypothesis.
Higher D/E ratio, more likely up firms’ FY profits. - Political cost hypothesis.
Large companies affected by higher level of political scrutiny will more likely down FY profits than small companies.
Owner/Manager Contracting
- Rational economic person assumption:
Managers act in their own self interests. - Information asymmetry:
Managers knows more than owner. - Methods of reducing agency costs:
a. Price protection.
b. Monitoring.
c. Bonding.
d. Rewards & bonuses. - External factors that reduces agency costs:
a. Threat of takeovers by stronger players.
b. Well-informed labour market.
Bonus plans
Based on output of accounting systems.
Might be based on:
- Profit.
- Revenue/Sales.
- Return on assets.
Very common: accounting-based bonus structure. Also could be market-based.
Accounting based bonus scheme
Changes in accounting standards changes bonus payout.
Most managers’ contracts rely on “floating” accounting GAAPs, meaning, AP that change all the time.
Incentive to manipulate accounting numbers.
Accounting based bonus scheme may induce managers to manipulate FS to improve their bonuses.
Accounting profits does not provide unbiased measure.
Market-based bonuses scheme may be more efficient sometimes.
Market-based bonus schemes.
Market price influenced by future CFs.
Share price affected by market-wide factors, not just factors controlled by managers.
Methods:
- Bonuses awarded on the increases of share price.
- Share options or shares given directly.
Auditors
Monitoring role.
Checks the reasonableness of accounting methods adopted.
Agency costs of debt
Excess dividends.
Claim dilution.
Asset substitution.
Investment in risky projects.
