GODFREY HODGSON HOLMES TARCA

1. GODFREYHODGSONHOLMESTARCA CHAPTER 11 POSITIVE THEORY OF ACCOUNTING POLICY AND DISCLOSURE

2. Early demand for theory • Capital markets research tried to explain the effects of accounting • was ultimately inconclusive and inconsistent • mechanistic and no-effects hypotheses • This research relied upon the EMH • ultimately there were too many departures • Led to the development of a positive theory of accounting policy choice

3. Early demand for theory • Positive theory incorporated a number of observations • many firms voluntarily provided accounting reports • firms lobbied in relation to accounting standards • firms made consistent policy choices • firms tended toward conservatism

4. Contracting theory • The firm is seen as a ‘nexus’ of contractual relationships • The firm is seen as an efficient way of organising economic activity to reduce contracting costs • equity (management) contracts (an agency contract) • debt contracts (an agency contract)

5. Agency theory • An agency contract is one where one party (the principal) engages another (the agent) to act on their behalf • e.g. where there is a separation of management and ownership • Both parties are utility maximisers • agent may therefore act from self-interest • divergence of interests is the agency problem • contracts incorporating accounting numbers can be used to align the interests of both parties

6. Agency theory • The agency problem in turn gives rise to agency costs spent to overcome it • monitoring costs • bonding costs • residual loss

7. Agency theory • Monitoring Costs – the cost of monitoring the agent’s behaviour; initially borne by the principal but passed on to the agent through an adjustment to their remuneration (price protection) • auditing costs, operating rules… • Bonding Costs – the cost borne by the agent as a result of them taking action to align their interests with those of the principal • providing more regular financial reports (a cost to the manager in terms of time and effort) • constraints on their activities…

8. Agency theory • The agents incur bonding costs in order to reduce the monitoring costs they eventually bear • Agents stop spending on bonding costs when the marginal cost equals the marginal reduction in the monitoring costs they bear • $1 = $1

9. Agency theory • Residual Loss –theloss associated with not being able to fully align the interests of the agent with those of the principal • Ex post settling up – (ex post = at the end of each period) • agent’s future remuneration based on observed agent performance • the principal changes the remuneration to be paid to the agent to align it with their performance

10. Agency theory • In the real world, price protection and settling up are not perfect or complete • Agents perceive that they will therefore not be fully penalised for their divergent behaviour • They have incentives to act opportunistically • This increases the residual loss • This loss is borne by the principal as well as, or instead of, the agent

11. Agency theory • Agency theory attributes a role for accounting • Accounting is part of the monitoring and bonding mechanisms • Accounting numbers are used in contracts

12. Price protection and shareholder/manager agency problems • The separation of ownership and management leads to divergent behaviour by agents • Divergence comes about because of • the risk-aversion problem • the dividend-retention problem • the horizon problem

13. Price protection and shareholder/manager agency problems • Risk aversion • managers prefer less risk than do shareholders • different degrees of diversification affecting risk • limited liability accorded to shareholders

14. Price protection and shareholder/manager agency problems • Dividend-retention • managers prefer to pay out less of the profits as dividends than shareholders prefer • pay their remuneration • empire building

15. Price protection and shareholder/manager agency problems • Horizon • managers have a shorter time horizon with respect to their association with the firm than do shareholders • shareholders are interested in future cash flows • managers have a time horizon only as long as they intend to remain with the firm

16. Price protection and shareholder/manager agency problems • Contracting can be used to reduce the severity of these problems • manager remuneration is usually tied to firm performance in some way to motivate managers to act in the shareholders’ interest • performance can be related to accounting numbers such as sales, profits, return on assets, net asset growth, cash flow, etc • performance can be related to the firm’s share price

17. Shareholder-debtholder agency problems • In this context, the manager is assumed to be either the sole owner of the firm, or has interests that are totally aligned with the interests of the shareholders • the principal is the debtholder • the agent is the manager acting on behalf of shareholders

18. Shareholder-debtholder agency problems • Firm value is the value of debt plus the value of equity • The value of equity can be increased by • either increasing the value of the firm (efficient contracting); or • transferring wealth away from debtholders (opportunistic behaviour)

19. Shareholder-debtholder agency problems • Varieties of opportunistic behaviour • excessive dividend payments • asset substitution • underinvestment • claim dilution

20. Shareholder-debtholder agency problems • Excessive dividend payments • reduces the asset base securing the debt • shareholders have received cash but limited liability protects them from being personally liable for the debts of the firm in the event of bankruptcy • the debt becomes mispriced • reduces the value of the debt

21. Shareholder-debtholder agency problems • Asset substitution • firm invests in higher risk projects to benefit shareholders • no benefit to debtholders • but do share in possible losses • shareholders are able to diversify and have limited liability • debt becomes mispriced

22. Shareholder-debtholder agency problems • Underinvestment • in some circumstances, shareholders have incentives not to undertake positive NPV projects because to do so would increase the funds available to the debtholders but not to the shareholders

23. Shareholder-debtholder agency problems • Claim dilution • occurs when the firm issues debt of a higher priority than the debt already on issue • decreases the relative security and value of the existing debt

24. Shareholder-debtholder agency problems • Lenders will price protect • through interest rates, the withholding of funds and the length of the loan • The interests of shareholders can be bonded to those of debtholders via restrictions in lending agreements • loan covenants

25. Ex post opportunism versus ex ante efficient contracting Ex post opportunism • occurs when, once a contact is in place, agents take actions that transfer wealth from principals to themselves

26. Ex post opportunism versus ex ante efficient contracting Ex ante efficient contracting • occurs when agents take actions that maximise the amount of wealth available to distribute between principals and agents • ex ante – before contracts are finalised

27. Signalling theory • Managers voluntarily provide information to investors - signals - to assist in their decision making • Similar to efficient contracting • Aligned with the information hypothesis • Managers signal expectations and intentions regarding the future • Incentives to signal good, neutral and bad news

28. Political processes • Often firms try to avoid public attention that is costly to them • financially • in terms of public perception and reputation • They reduce their reported profit or its volatility • e.g. banking sector in Australia

29. Conservatism, accounting standards and agency costs • Conservatism shows a bias by accountants accelerating recognition of expenses and decelerating recognition of revenue • IASB argues this does not reveal the real financial picture and reduces information available to users

30. Additional empirical tests of the theory • Testing the opportunistic and political cost hypothesis • Tests using contract details • Refining the specification of political costs • Testing the efficient contracting hypothesis

31. Additional empirical tests of the theory • Evidence that managers use accounting numbers to • counter political pressure • gain political advantages • set management targets related to remuneration • minimise breaching debt covenants • provide dividend constraints • constrain management manipulation

32. Evaluating the theory • Mixed support for positive accounting theory • Two categories of major criticism • methodological and statistical criticism • empirical evidence is weak and inconclusive • philosophical criticism • contrary to its claims, it is laden with value judgments • focuses on human behaviour and not the behaviour and measurement of accounting entities • positivism is no longer taken seriously

33. Issues for auditors • The demand for auditing can be explained by agency theory as part of the monitoring and bonding activity and costs • higher quality auditors • industry specialist auditors

34. Summary • Positive accounting theory has been a major force in academic accounting research • Incorporates a theoretical model of contractual exchange between persons who use accounting numbers to effect their payoffs • Provides an explanation as to why accountants account as they do • minimises the cost of agency relationships • yet opportunistic behaviour by agents is the norm • but some efficient ex ante behaviour by agents

35. Key terms and concepts • Positive theory • Contracting theory • Agency theory • Agents • Principals • Monitoring costs • Bonding costs • Residual loss • Ex post settling up • Risk aversion problem • Dividend retention problem • Horizon problem

36. Key terms and concepts • Shareholder/manager agency problem • Shareholder/debtholder agency problem • Excessive dividend payment problem • Asset substitution problem • Underinvestment problem • Claim dilution problem • Ex post opportunism • Ex ante efficient contracting • Signalling theory • Political processes • Conservatism