Topic 7 - Economic Consequences - Agency Theory

Question 1

What is the nexus of contracts theory?

Answer 1

That corporations are nothing more than a collection of contracts between different parties

Question 2

To what extent do Accounting numbers represent ‘reality’?

Answer 2

to the extent that people believe and act upon the respective rights and obligations defined by the financial statements

Question 3

what are the two main factors of considering a company as an entity?

Answer 3

• the company is separate legal entity

- it has a separate existence from its shareholders.

Question 4

what is the main importance of being a separate legal entity for the purpose of accounting theory?

Answer 4

that the entity can have it’s own objective (usually to maximise profits)

Question 5

why is it said that the entity theory isn’t useful in explaining accounting policy choices? give an example

Answer 5

If decisions are based on a profit objective, why would different firms choose different accounting policies? ie FIFO vs LIFO

Question 6

what are four examples of “factors of production” in the nexus of contracts theory? (ie contract holders)

Answer 6

• employees
• managers
• shareholders/investors
• creditors (funding through debt)

Question 7

what does the nexus of contracts imply for the entity’s objectives?

Answer 7

contracting party has its own property rights and objectives – utility maximising

Question 8

which theory does the nexus of contracts underlie?

Answer 8

agency theory

Question 9

does the entity theory or the nexus of contracts theory provide a better understanding of why managers choose accounting policies?

Answer 9

nexus of contracts

Question 10

what impact do contracts have on accounting policy choices in relation to agency theory?

Answer 10

contracts create economic incentives to choose one set of accounting policies over another

Question 11

why are Accounting policies important for an entity? give an example

Answer 11

they have economic consequences – i.e., shift wealth between one group and another (e.g., management compensation based on reported profits)

Question 12

if people are not indifferent to economic consequences, what impact does this have on the choice of accounting policies?

Answer 12

people have incentives to choose accounting policies that reflect their expected impact on the amount and distribution of wealth

Question 13

what is a measure that can be taken to ensure that ‘proper’ accounting practices are implemented?

Answer 13

auditing

Question 14

what are the three aspects of the agency theory framework (what does it try to explain)?

Answer 14

• positive’ theory (descriptive, not prescriptive)
• Aims to predict and explain manager/firm behaviours
• Accounting policy choices are not disinterested, they lead to economic consequences

Question 15

What are the two basic components of agency theory?

Answer 15

• Separation of Ownership and Control

- Utility Maximiser Assumption

Question 16

give two examples of agency relationships?

Answer 16

Manager-shareholder agency relationship

Manager-creditor agency relationship

Question 17

what is the theoretical role of an agent?

Answer 17

Agents should, but do not always, act in the best interests of the principals

Question 18

Utility Maximiser Assumption assumes which two things?

Answer 18

• people are rational

- they seek to maximise their own utility

Question 19

what are the two main issues faced by principles?

what does this lead to?

Answer 19

• Information asymmetry
• Agent Utility Maximisation
• leads to Problem of Moral Hazard

Question 20

how does Agent Utility Maximisation create moral hazards?

Answer 20

creates conflict between those who are associated with a company (reducing wealth for all) unless some constraints are imposed on such behaviour

Question 21

list 4 agency problems in the Manager-Shareholder Relationship?

Answer 21

• overspending i.e. all the perks only part or none of the costs born by managers
• Risk Aversion Problem (shareholders can diversify risk while managers are risk adverse)
• Horizon Problem - Managers are interested in firm performance over a shorter time frame
• Dividend Retention Problem - Managers prefer to retain dividends

Question 22

what is a key assumption that is made when assessing Agency Theory: Manager-Creditor Relationship?

Answer 22

managers’ interests are aligned with shareholders’ interests, when dealing with creditors.

Question 23

what are four agency problems in the Manager-Creditor Relationship?

Answer 23

• Excessive dividend payments
• Claim dilution ie additional borrowings/more senior debt
• Asset substitution ie investing in things other than what was agreed with creditor
• Underinvestment-potentially applicable if entity is in financial difficulties

Question 24

how are moral hazard problems decreased?

Answer 24

through contracts between agents and principles

Question 25

how are accounting numbers used in contracts? (3)

Answer 25

• performance measurement
• specify terms of contract
• determine distribution of wealth ie % of bonus based on profit

Question 26

what three things are usually included in contracts designed to reduce control conflicts?

Answer 26

• Performance evaluation
• Rewards and punishment
• Distribution of power

Question 27

why are contracts costly, outline three costs?

Answer 27

• Monitoring costs
• Bonding costs
• A ‘residual loss’

Question 28

to what “point” will contracts be established?

Answer 28

will only occur to that point where marginal costs of contracting equal the marginal benefits

Question 29

what does Economic Darwinism (Survivorship Principle) outline? what are the three principles of this theory?

Answer 29

Contracts and Efficiency

• existing contracts are most efficient as they have survived
• accounting policies chosen represent policies that minimise the cost of contracting
• accounting methods need to be regulated

Question 30

list three forms of management remuneration

Answer 30

–cash
–Shares
–executive stock options

Question 31

what is the purpose of a Management Bonus Plan?

Answer 31

align the interests of managers with the interests of shareholders

Question 32

what are the two main problems with Management Bonus Plans?

Answer 32

–may transfer more risk to management than they wish to accept
–create incentives for management to choose accounting policies that maximise the bonus (all other things equal)

Question 33

what bonus plan hypothesis?

Answer 33

accounting-based bonus plans result in executives being more likely to adopt or lobby for accounting methods that increase earnings

Question 34

if it is assumed that creditors have rational expectations about the risk associated (asset substitution, etc.) how do they ‘price protect’ themselves?

Answer 34

charging higher interest

Question 35

what are Debt covenants?

Answer 35

rules specified in the loan/debt contracts that restrict firm behaviours

Question 36

What are three examples of firm restrictions that a debt covenants can impose?

Answer 36

• Maximum leverage ratio (D/E ratio)
• Minimum interest coverage ratios
• Restrictions on types of investment

Question 37

What to debt covenants aim to reduce? (3)

Answer 37

• Claim Dilution
• Excessive dividends
• Asset Substitution

Question 38

why might firms agree to debt covenants?

Answer 38

lower costs of capital for the borrowing companies.

Question 39

what is the main problem with debt covenants?

Answer 39

management have an incentive to choose accounting policies that will avoid breaching the covenants

Question 40

What is the debt hypothesis

Answer 40

firms with higher leverage (gearing) are more likely to use earnings-increasing accounting methods to avoid default

Question 41

what are three examples of earnings management?

Answer 41

1. Make use of a collection of accounting policies (visible)
2. Changes in the timing of accruals – e.g., timing of when revenue or expenses are recognised (less visible)
3. Income smoothing

Question 42

what is earing management?

Answer 42

Deliberately intervening in external reporting process to obtain a preferred result, either for personal benefit or to signal information

Question 43

what is income smoothing?

Answer 43

An attempt to reduce volatility of earnings (that means to avoid big fluctuations in profit), Achieved by shifting income and expenses between periods, e.g., recognise a lot of doubtful debts and impairment losses in periods of high income

Question 44

under agency theory, what is said to explain accounting policy choices?

Answer 44

accounting policy choice as determined by expected economic consequences

Question 45

what is said to form expected economic consequences?

Answer 45

Expectations formed by terms of contracts and by economic circumstances

Question 46

why do different firms have different accounting policies?

Answer 46

As contracts will differ across firms, then accounting will differ across firms

Question 47

what two things need to be understood so as to understand a firms accounting policy choices?

Answer 47

we need to understand the specific terms of the contracts AND the economic characteristics of the specific firm (limitation low R2 indicate other influences)

Question 48

what are other control mechanisms of the capital market?

Answer 48

• raising funds
• managerial labour market
• risk of takeovers