Topic 7 - Economic Consequences - Agency Theory Flashcards
What is the nexus of contracts theory?
That corporations are nothing more than a collection of contracts between different parties
To what extent do Accounting numbers represent ‘reality’?
to the extent that people believe and act upon the respective rights and obligations defined by the financial statements
what are the two main factors of considering a company as an entity?
- the company is separate legal entity
- it has a separate existence from its shareholders.
what is the main importance of being a separate legal entity for the purpose of accounting theory?
that the entity can have it’s own objective (usually to maximise profits)
why is it said that the entity theory isn’t useful in explaining accounting policy choices? give an example
If decisions are based on a profit objective, why would different firms choose different accounting policies? ie FIFO vs LIFO
what are four examples of “factors of production” in the nexus of contracts theory? (ie contract holders)
- employees
- managers
- shareholders/investors
- creditors (funding through debt)
what does the nexus of contracts imply for the entity’s objectives?
contracting party has its own property rights and objectives – utility maximising
which theory does the nexus of contracts underlie?
agency theory
does the entity theory or the nexus of contracts theory provide a better understanding of why managers choose accounting policies?
nexus of contracts
what impact do contracts have on accounting policy choices in relation to agency theory?
contracts create economic incentives to choose one set of accounting policies over another
why are Accounting policies important for an entity? give an example
they have economic consequences – i.e., shift wealth between one group and another (e.g., management compensation based on reported profits)
if people are not indifferent to economic consequences, what impact does this have on the choice of accounting policies?
people have incentives to choose accounting policies that reflect their expected impact on the amount and distribution of wealth
what is a measure that can be taken to ensure that ‘proper’ accounting practices are implemented?
auditing
what are the three aspects of the agency theory framework (what does it try to explain)?
- positive’ theory (descriptive, not prescriptive)
- Aims to predict and explain manager/firm behaviours
- Accounting policy choices are not disinterested, they lead to economic consequences
What are the two basic components of agency theory?
- Separation of Ownership and Control
- Utility Maximiser Assumption
give two examples of agency relationships?
Manager-shareholder agency relationship
Manager-creditor agency relationship
what is the theoretical role of an agent?
Agents should, but do not always, act in the best interests of the principals
Utility Maximiser Assumption assumes which two things?
- people are rational
- they seek to maximise their own utility
what are the two main issues faced by principles?
what does this lead to?
- Information asymmetry
- Agent Utility Maximisation
- leads to Problem of Moral Hazard
how does Agent Utility Maximisation create moral hazards?
creates conflict between those who are associated with a company (reducing wealth for all) unless some constraints are imposed on such behaviour
list 4 agency problems in the Manager-Shareholder Relationship?
- 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
what is a key assumption that is made when assessing Agency Theory: Manager-Creditor Relationship?
managers’ interests are aligned with shareholders’ interests, when dealing with creditors.
what are four agency problems in the Manager-Creditor Relationship?
- 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
how are moral hazard problems decreased?
through contracts between agents and principles
how are accounting numbers used in contracts? (3)
- performance measurement
- specify terms of contract
- determine distribution of wealth ie % of bonus based on profit
what three things are usually included in contracts designed to reduce control conflicts?
- Performance evaluation
- Rewards and punishment
- Distribution of power
why are contracts costly, outline three costs?
- Monitoring costs
- Bonding costs
- A ‘residual loss’
to what “point” will contracts be established?
will only occur to that point where marginal costs of contracting equal the marginal benefits
what does Economic Darwinism (Survivorship Principle) outline? what are the three principles of this theory?
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
list three forms of management remuneration
–cash
–Shares
–executive stock options
what is the purpose of a Management Bonus Plan?
align the interests of managers with the interests of shareholders
what are the two main problems with Management Bonus Plans?
–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)
what bonus plan hypothesis?
accounting-based bonus plans result in executives being more likely to adopt or lobby for accounting methods that increase earnings
if it is assumed that creditors have rational expectations about the risk associated (asset substitution, etc.) how do they ‘price protect’ themselves?
charging higher interest
what are Debt covenants?
rules specified in the loan/debt contracts that restrict firm behaviours
What are three examples of firm restrictions that a debt covenants can impose?
- Maximum leverage ratio (D/E ratio)
- Minimum interest coverage ratios
- Restrictions on types of investment
What to debt covenants aim to reduce? (3)
- Claim Dilution
- Excessive dividends
- Asset Substitution
why might firms agree to debt covenants?
lower costs of capital for the borrowing companies.
what is the main problem with debt covenants?
management have an incentive to choose accounting policies that will avoid breaching the covenants
What is the debt hypothesis
firms with higher leverage (gearing) are more likely to use earnings-increasing accounting methods to avoid default
what are three examples of earnings management?
- Make use of a collection of accounting policies (visible)
- Changes in the timing of accruals – e.g., timing of when revenue or expenses are recognised (less visible)
- Income smoothing
what is earing management?
Deliberately intervening in external reporting process to obtain a preferred result, either for personal benefit or to signal information
what is income smoothing?
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
under agency theory, what is said to explain accounting policy choices?
accounting policy choice as determined by expected economic consequences
what is said to form expected economic consequences?
Expectations formed by terms of contracts and by economic circumstances
why do different firms have different accounting policies?
As contracts will differ across firms, then accounting will differ across firms
what two things need to be understood so as to understand a firms accounting policy choices?
we need to understand the specific terms of the contracts AND the economic characteristics of the specific firm (limitation low R2 indicate other influences)
what are other control mechanisms of the capital market?
- raising funds
- managerial labour market
- risk of takeovers
