1. Lecture 5 Contracting and Other Economic Determinants of Financial Reporting

2. Lecture Overview u Economic determinants of financial reporting (module 3 continued) u Review of last lecture u Debt contracting (3.3.3) u Other economic determinants of financial reporting (3.3.4) u Empirical research results (3.4)

3. Review - positive accounting theory (PAT) u Major focus is on stewardship role of accounting u Looks at reasons underlying financial reporting decisions u Emphasis on relationship between financial reporting decisions and contracts, particularly management compensation contracts and loan agreements (debt contracts) u Based on ‘agency theory’

4. Review - Agency Theory u Conflicts of interest give rise to agency costs u Contracts are used to reduce these conflicts of interest (bonding) - contract terms sometimes rely on accounting information u Firms prepare audited accounting reports to facilitate monitoring of these contracts (stewardship role of accounting)

5. Review - Agency Costs u Due to self interest, the agent might act in his/her own interest rather than that of the principal (moral hazard) u This agency problem gives rise to agency costs u Agency costs can be categorised into u monitoring costs u bonding costs u residual loss

6. Review - Opportunistic and efficient contracting perspectives u opportunistic - self interest objective u efficient - maximisation of firm value objective

7. Review - Implications for financial reporting decisions u Because contracts are used to bond the agent to the principal, and financial statement information is often used to monitor the agent’s compliance with these contracts u Agents have incentives to present the financial statements in a way that ensures the best outcome under the contracts u Therefore, contracts need to be considered when making financial reporting decisions

8. Two important contracts u Two contracts that tend to be monitored using accounting information are: u management compensation (remuneration) contracts u debt contracts (bank loan agreements or debenture trust deeds)

9. Review - Management Compensation Contracts

10. Debt Contracting

11. Nature of the relationship u Debtholders are the principal u The manager, acting on behalf of shareholders, is the agent u Shareholders can opportunistically transfer wealth away from debtholders u firm value is the sum of debt and equity u equity claimholders can be made better off by u increasing the value of the firm (equity is the residual claim), or u by transferring wealth away from debtholders

12. Divergence of interests between shareholders and debtholders u Divergence of interests gives rise to agency costs (four agency costs of debt) u excessive dividend payments u asset substitution u underinvestment u claim dilution

13. Monitoring and Bonding activities - the debt claimholder problem u Debtholders can price protect via increased interest charges u The interests of shareholders can be bonded to those of debtholders via restrictions in lending agreements (covenants) u Covenants often rely on numbers contained in financial statements u Breach of a covenant can result in higher interest charges, seizure of secured assets, refinancing of debt

14. Typical debt covenants u Bonding covenants u provision of financial statements, audit reports etc. u Restrictions on financing and dividend policy u leverage limits, interest coverage and working capital provisions u Reading 3.1 gives details of typical Australian bank loan agreement covenants

15. Ex Post Financial Reporting Incentives - under debt contracts u Managers have incentives to ensure that the terms of the covenants are not violated u breaching a debt covenant is costly u As the firm approaches a leverage restriction, managers have incentives to adopt asset and/or earnings increasing, or liability decreasing accounting policies u the ‘debt-to-equity’ hypothesis

16. Summary of Agency Theory u Conflicts of interest give rise to agency costs u Contracts are used to reduce these conflicts of interest (bonding) - contract terms sometimes rely on accounting information u Firms prepare audited financial statements to facilitate monitoring of these contracts (stewardship role of accounting) u Existence of these contracts gives managers an incentive to present the financial statements in a way that ensures the best outcome under the contracts

17. Other economic determinants of financial reporting

18. Provision of information to investors u Accounting has an information role as well as a stewardship role u Managers have incentives to provide relevant information for user decision making u This incentive may impact on manager’s choice of accounting methods (and other financial reporting decisions)

19. Information and Efficient Contracting Perspectives u Difficult to distinguish information and efficiency perspectives u Information perspective u managers select accounting policies to signal how the future cashflows, and hence, the value of the firm (and claims against it) will change u Efficient contracting perspective u managers select accounting policies that best reflect economic events, transactions and cashflows that have already occurred

20. Stewardship and Information Roles of Financial Reporting u The stewardship role of accounting relates to both the opportunistic and efficient contracting perspectives u contract terms tend to relate to financial statement numbers rather than unrecognised disclosures u The information role of accounting relates to the information perspective u incorporates both financial statement numbers and unrecognised disclosures

21. Costs of the political process u Involves the relationship between the firm and other parties interested in the firm u government u trade unions u community groups u Interested parties monitor firm's profits to ensure that they are not excessive u seek opportunities to transfer wealth away from firms

22. Political costs u Profits which are considered to be excessive can be redistributed in society via u extra taxes, increased wages, removal of subsidies u ‘Political costs’ are the costs of these wealth transfers out of the firm u Highly profitable (and otherwise politically sensitive) firms have incentives to reduce reported earnings u Known as the ‘size’ hypothesis

23. Political costs must be assessed against incentives related to debt and compensation contracts when making financial reporting decisions

24. Summary of PAT u A theory of accounting based on agency theory (a ‘story’) u Empirical research is used to test the story u 3 early research hypotheses (predictions): u Bonus plan hypothesis u Debt/equity hypothesis u Political cost hypothesis u These hypotheses assume that managers act opportunistically u Empirical research has been used to test these hypotheses as well as ‘efficiency’ and ‘information’ based hypotheses

25. Empirical Research Results

26. Research results - Opportunistic perspective u Overall there is support for debt contract terms impacting on accounting policy choices u Managers of firms that are close to default on debt covenants tend to choose asset/income increasing accounting policies u The results in relation to the impact of management bonus plans are mixed u researchers need to focus on specific contract attributes, these are difficult to obtain

27. Implications of Results for Accounting Regulation u Regulation of accounting practice can reduce the ability of managers to choose accounting methods opportunistically u The cost of regulation is often less than the cost of controlling opportunistic behaviour within each firm

28. Implications of Results for Financial Reporting Decisions u Consider how the decision will impact payoffs under contracts u will management compensation be increased or decreased? u will debt covenants be violated? u Auditors should be aware of the potential for managers to choose accounting policies opportunistically

29. Research results - Efficient contracting perspective u The efficiency perspective is supported u Different types of firms have different contract terms and use different accounting policies u Difficult to distinguish empirically between u opportunistic perspective u efficiency perspective and u the information perspective

30. Implications of Results for Accounting Regulation u Uniformity in accounting methods between firms is not necessarily desirable u Firms’ investments in assets vary and give rise to unique agency / contracting problems u Regulations which prescribe the use of one method for all firms impose costs on firms for which the prescribed method is not optimal

31. Implications of Results for Financial Reporting Decisions u The assets held by each firm, as well the terms of its contracts, must be considered when making financial reporting decisions

32. Research Results - Political Costs u The evidence indicates that managers consider potential political costs when making financial reporting decisions u Managers of politically sensitive firms (including large firms) tend to choose income decreasing accounting methods

33. Implications of Results for Financial Reporting Decisions u The political sensitivity of the firm should be considered when making financial reporting decisions u Auditors should be aware of the potential impact of political costs on financial reporting decisions

34. Summary - Factors to consider when making financial reporting decisions u Contracts of the firm u Assets of the firm u Provision of relevant information u Potential political costs u Social/legitimacy considerations (module 4) u Expected impacts on financial statement users (modules 6 & 7)

35. For Tutorials u Required reading u Text chapter 7, pp. 227 – 235 u Self assessment questions u Remainder of questions from module 3 u Answers in tutorials