AK0040

ACCOUNTING THEORY
An Analysis of Conflict

ACCOUNTING PROGRAM
Contents
• Overview
• Agency Theory
• Manager’s Information Advantage
• Protecting Lenders from Manager Information
Advantage
• Implication of Agency Theory for Accounting
• Reconciliation of Efficient Securities Market Theory
with Economic Consequences
 Overview
• There are many principal-agent relationship in society,
such as patient-doctor, client-lawyer, owner-hockey
palayer. In each case, the principal wants the agent to
worki hard on his/her behalf.
• However, the interests of the principal and agent conflict,
since working hard requires effort, and the principal may
want more effort than the agent is willing to exert.
• In many cases, the nature of the agent’s effort is too
complex for the principal to observe it directly – it is hard
for the patient to observe the doctor’s effort, for example.
• This creates a moral hazard problem, and the agent may
not work hard unless he/she is sufficently motivated.
While reputation and professional ethics contribute to
motivation, it is often desirable to further motivate hard
work by basing compensation on some observable
measure of the agent’s performance. Thus a hockey
player’s compensation may in large part depend on goals
scored.
Overview
• In our context, two important agency relationships
are of interest.
• These are employment contracts between the firm
(representing the firm owners) and its managers,
and lending contracts between the firm and its
lenders.
• Agency theory is relevant to acconting because
both types of contracts often depend on the firm’s
reported earnings.
 Overview
• Employment contracts frequently base managerial
bonuses on net income, and lending contracts usually
incorporate protection for the lenders in the form of
convenants that, for example, bind the firm not to go
below a stated times-interest-earned ratio, or not to
pay dividends if working capital falls below a specified
level.
• As a result, accounting policies matter to manageres,
since their compensation, and ability to avoid debt
convenant violation, are affected by these policies.
• As discussed that economic consequences are created
when accounting standards change during the term of
compensation and debt contracts.
• Consequently, managers hace a legitimate interest in
the design of new accounting standards.
Overview
• Reported net income has different role in a mangerial
contracting context than in reporting to investors.
• Its role is to predict the ultimate payoff from current
manager activities.
• In so doing, it monitors and motivates manager
performance. For this, net income needs to be
sensitive to manager effort and precise in its
predictions of the payoff from that effort.
• The characteristics needed to best fulfil this role are
not necessarily the same as those that provide the
most useful information to investors, leading to the
fundamental problem.
Overview
• The contract-based role for financial statements
that emerges form agency theory helps us to see
how the theory of efficient securities markets is not
inconsistent with economic consequences.
• Securities markets can be efficients and accounting
policies can have economic consequences once the
conflict implications for financial reporting are
understood.
Agency Theory
• Agency theory is a branch of game that studies the
design of contracts to motivate a rational agent to act
on behalf of a principal when the agent’s interest
would otherwise conflict with those of the principal.
• Agency theory contracts have characteristics of both
coopeartive and non-cooperative games. They are
non-cooperative in that both parties choose their
actions non-cooperatively.
• The two parties do not specifially agree to take
certain actions; rather, the actions are motivated by
the contract itself.
Agency Theory
• Nevertheless, each party must able to commit to
the contract-that is, to bind him/herself to
cooperate, or to “play by the rules”.
• For example, it is assumed that the manager in an
employment contract will not grab the total firm
profits and head for a foreign juridiction.
• Such commitment may be enforced by the legal
system, by use of bounding or escrow
arrangements, and by the ethical behaviour and
reputation of the contracting parties.
Agency Theory
Agency Contract Between Firm Owner and Manager,
can be follow with this steps:
• Designing a contract to control moral hazard
• Hire the manager and put up with “work hard” or
“shirk”.
• Direct monitoring
• Indirect monitoring
• Owner rents firm to the manager
• Give the manager a share of the profits
Manager’s Information Advantage
Earning Management
• To better understand the role of net income as a
performance measure, we must allow for the
possibility that the manager may bias or otherwise
manage reported earnings.
• There is a variety of forms that manager
information advantage can take, including:
Pre-contract information
Pre-decision information
Post-decision information
Manager’s Information Advantage
Earning Management
Pre-contract information
The manager may have information about payoff
prior to signing the contract.
Pre-decision information
The manager may obtain payoff information after
signing the contract but prior choosing an act.
Post-decision information
The manager receives information after the act is
chosen.
Manager’s Information Advantage
The Revelation Principle
• The revelation principle raises an intriguing question.
Why not design real compesation contracts to motivate
truth-telling? Then, opportunisctic earnings
management would be a thing of the past.
• While managers would tend to shirk, the shirking would
be no greater than what would take place without
truth-telling, and the owner’s expected utility would be
the same. But the firm would be worth more to
prospective buyers, due to increased investor
confidence that reported net income is free of manager
distortion and bias.
Manager’s Information Advantage
The Revelation Principle
• However, the revelation principle is not a panacea.
There are several conditions that must be met if it is to
hold. One such condition is that the owner must be
able to commit that the truth will not be used againts
the manager.
• A second condition is that there must be no
restrictions on the form of contract. For example, many
compensation contracts fo not provide for a bonus
unless performance exceed some specified level, such
as earnings greater than 10% of shareholders’ equity.
Manager’s Information Advantage
The Revelation Principle
• A third condition is that there be no restrictions on
the manager’s ability to communicate his/her
information. Suppose, for example, that a manager
has a forecast of next year’s earnings, but that honest
reporting of the forecast is potentially very costly to
the manager personally, due to loss of reputation and
possible legal liability if the forecast is not met.
• A contract to motivate truthful reporting of the
forecast could impose so much risk on the manager
that the level of conpensation needed to attain
resevation utility is more than the owner is willing to
pay. Honnest communication is effectively blocked.
Consequently, the owner may allow the manager to
report a biased forecastm or no forecast at all.
Manager’s Information Advantage
Controlling Earnings Management
• To control opportunistic earnings management, a
response is to strengthen corporate governance. For
example, audit and compensation committees of the
Board may include independent and financially literate
members, to monitor earnings management.
• Indeed, GAAP itself, when accompanied by a
competent audit, also fulfils a corporate role. When
GAAP allows discretion in choosing among different
accounting policies, it does limit the amount by which
earnings can be managed.
• A way to control earnings management is to limit it by
means of GAAP, to the point where the managers;s
incentive to work had is restored
Manager’s Information Advantage
Agency Theory with Psychologist Norms
• Fischer and Huddart (2008) pointed out psychological
research suggesting that individual behaviour is
affected by personal and social norms.
• A personal norms is an innate characteristic of an
individual such as a belief in hard work of a feeling that
earnigs management is bad.
• A social norm was defined by Fischer and Huddart as
the average behaviour of a peer group. For example, a
manager mau perceive that, on average, managers of
similar firms regard earnings management as
acceptable.
Manager’s Information Advantage
Agency Theory with Psychologist Norms
• These norms influence behaviour. Thus, a manager with
a storng work ethic and weak acceptance of a social
norm that a manager is acceptable will require a lower
profit share to motivate hard work than a manager
with a weak work ethic and strong acceptance of the
social norm.
• This letter manager will be motivated to work less hard,
perhaps substituting earnigns managemenet for the
effort he/she would otherwise deliver. In effect, the
personal and social norms interact to influence the
managers’s effort and earnings management
incentives.
Protecting Lenders from Manager
Information Advantage
• We now consider another moral hazard problem –
namely, the possibility that the manager may act
opportunistically againts the best interest of
lenders, thereby benefitting him/herself and/or the
shareholders at lenders’ expense.
• Since the financing decisions of most firms include
borrowing, often in excess of the capital raised
through share issues, it is important to control this
agency problem if the firm is to borrow at
reasonable cost.
Protecting Lenders from Manager
Information Advantage
• There are several ways that an opportunistic manager
may compromise lender interestd, for example by:
Paying excessive dividends
Undertaking additional borrowing
Undertaking excessively risky projects, particularly id
the firm is pproaching financial distress.
• While concern about reputation may reduce the
probability that the manager will act this way, reputation
effects are unlikely to be strong enough to fully ease
lenders concerns. We now consider an agency theory
approach to lender protection.
Implication of Agency Theory for
Accounting
Is Two Better Than One?
• In widely referenced paper, Holmstrom (1979) gave
rogorous extension of the agency model to allow more
than one performance measure. We now review aspects
of his model from an accounting perspective.
• Holmstrom assumed that the agent’s effort is
unobsevable by the principal but that the payoff is jointly
obsevable at the end of the current period.
• However, Feltham and Xie (1994) showed that
Holmstrom’s model carries over to the case of payoff
unobservable, holding the set of possible manager acts
constant.
• Consequently, for purposes of this discussion, we shal
continue to assume the payoff is unobsevable at the end
of the current period.
Implication of Agency Theory for
Accounting
Is Two Better Than One?
• Given the potential for increased contracting
efficiency from basing compensation on more than
one performance measure, the question then
becomes one of the relative proportion of
compensation based on net income, versus based on
share price, in compensation contracts.
• Hopefully, from accountant’s standpoint, this
proportion will be high. Thus, an interesting
implication of the Holmstrom model is that, just as
net income competes with other information sources
for investors under efficient securities market theory,
it competes with other information sources for
motivating managers undet agency theory.
Implication of Agency Theory for
Accounting
Is Two Better Than One?
• This raises the question of what characteristics a
performance measure should have if it is to
contribute to efficient compensation contracts.
• One important characteristic is its sensitivity.
Sensitivity is the rate at which the expected value of a
performance measure increases as the manager
works harder, or decreases as the manager shirks.
• Sensitivity contributes to efficient compensation
contracts by strengthening the connection between
manager effort and the performance measure,
thereby making it easier to motivate that effort.
Implication of Agency Theory for
Accounting
Rigidity of Contracts
• Agency theory assumes that the courts have
authority to costlessly enforce contract provisions and
adjudicate dispute. While the parties to a contract
could agree among themselves to amend contract
provisions following and unforesesn realization of the
state of nature, this can be suprisingly difficult.
• Contract tend to be rigid once signed. The reason for
this rigidity need some discussion. Otherwise, we
might ask, if economic consequences have their roots
in the contracts that managers enter into, why not
just renegotiate the contracts following a chage in
GAAP, or other unforseen state realization?
Implication of Agency Theory for
Accounting
Rigidity of Contracts
• Contract that do not anticipate all possible state
realizations are termed incomplete.
• If an unticipated state realization happens, building
a dormal commitment for renegotiation into the
contract beforehand is possible, but if the
renegotiation is generous toward manager, the
prospect of such as renegotiation reduce the
manager’s effort incentive, which would not be in
thbe owner’s best interest.
Reconciliation of Efficient Securities Market
Theory with Economic Consequences
• We now see how firms are able to align manager
and shareholder interests, consitent with efficient
contracting. Agency theory demonstrates that the
best attainable compensation contract usually
bases manager compensation on ome or more
measures of performance. Then, managers hace an
incentive to maximize percormance.
• Since higher performance leads to higher expected
payoff, this is a goal also desired by investors.
Reconciliation of Efficient Securities Market
Theory with Economic Consequences
• This alignment explains why accounting policies
have economic consequences, despite the
implications of efficient securities market theory.
• Under efficient securities market theory, only
accounting policy accounting policy choices that
affect expected cash flows create economic
consequences does not depend on accounting
policy choices having direct cash flows effects. This
argument is the same whether direct cash flows
effects are present or nor.
Reconciliation of Efficient Securities Market
Theory with Economic Consequences
• Rather, it is the rigidities produced by the signing of
binding, incomplete contracts that create managers’
concern, and that lead to their intervention in the
standard-setting process. These rigidities have nothing
to do with whether accounting policy changes affect
cash cfws.
• Thus, economic consequences and efficient securities
markets are not necessarily inconsistent. Rather, they
can be reconciled by contract theory, with normative
support from agency theory that suggest why firms
enter into employment and debt contracts that depend
on accounting information. Nothing in the above
arguments leading to managerial concern about
accounting policies conflicts with securities market
efficiency.
Reconciliation of Efficient Securities Market
Theory with Economic Consequences
• Similarly, nothing in the theory of efficient
securities markets conflicts with managerial
concern about accounting policies.
• Joint consideration of both theories, though, helps
us to see that managers may well intervene in
accounting policies, even though those policies
would improve the decision usefulness of financial
statements to investors. Thus, in the final analysis,
the interaction between managers and investors is
a game.
Questions and Answers