Solution Manual

to accompany

Contemporary Issues in
Accounting
Michaela Rankin, Patricia
Stanton, Susan McGowan,
Kimberly Ferlauto & Matt Tilling
PREPARED BY:

Michaela Rankin

John Wiley & Sons Australia, Ltd 2012

Solution manual to accompany: Contemporary Issues in Accounting

CHAPTER 5
THEORIES IN ACCOUNTING

Contemporary Issue 5.1: News Corp reduces agency problems

through executive remuneration plans

1. Both the horizon problem and risk aversion are agency problems that relate
specifically to the relationship between owners and managers and which
contracting can assist in overcoming. Explain these two problems. (K)

Managers and owners have differing time horizons in relation to the entity. This is
known as the horizon problem. Owners are interested in the long-term growth and
value of the entity as the share value today reflects the present value of the expected
future cash flows. As such, shareholders want managers to make decisions that
enhance these future cash flows over the long term. Managers, on the other hand, are
interested in the cash flow potential only as long as they expect to be employed by the
entity. This is particularly an issue for managers who are approaching retirement.
Managers who are seeking to move to another entity within the short term are also
more likely to want to demonstrate the short-term profitability of the entity as
evidence of effective management.
Managers generally prefer less risk than shareholders. This is known as the risk
aversion problem. Shareholders are not likely to hold all their resources as shares in
one entity. They are able to diversity their risk through investing across multiple
entities, cash or property investments. Shareholders may also receive regular income
from other sources such as a personal salary from employment. As such, shareholders
have ‘hedged’ or minimized the risk of one of these investments losing value. In
addition, the liability of owners is limited to the amount they are required to pay for
their shares. Managers, on the other hand, have more capital invested in the entity
than shareholders through their ‘human capital’ or managerial expertise. It is likely
that their remuneration is their primary source of income. As such, losing their job or
being paid less can substantially impact on their personal wealth. Given higher risk
has the potential to generate higher returns shareholders prefer managers to invest in
higher risk projects. Conversely, managers wish to take less risk when deciding on
projects for the entity because they have more to lose – they are more risk averse than
owners.

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 Chapter 5: Theories in accounting

2. News Corp Ltd has recently introduced a new pay scheme to link executive
pay to a range of performance measures, including share performance
through ‘total shareholder return’. How does linking bonuses to share
performance reduce the horizon problem and risk aversion? (J)

Linking managerial bonuses to share performance by using a measure such as ‘total

shareholder return’ encourages managers to focus on long-term performance because
it is likely to affect their own wealth. Tying a greater proportion of managerial pay to
share price movements as the manager approaches retirement is also likely to
encourage managers to maximise long-term performance and to more closely align
managerial time horizon with that of owners.
Paying managers a cash bonus based on measures of share performance encourages
managers to invest in potentially more risky projects that are likely to maximise the
performance of the entity into the future.

3. Why is it important to link executive bonuses to a range of entity performance

measures rather than one, as was previously the case with News Corp? (J)

Linking executive bonuses to a range of entity performance measures plays two main
roles. First, it encourages managers to consider different aspects of the entity’s
performance – both short and long term – that will lead to an overall strengthening of
the entity, and be more likely to lead to longer-term increases in firm and shareholder
value. If managerial pay is tied to only one measure, such as profits, it will encourage
managers to take a short-term focus and to engage in activities that might benefit the
organization in the current year, but are less likely to be beneficial over the longer
term. It might also encourage managers to use accounting methods, such as accruals
management, to maximise profits in the current year rather than future periods.
Second, given managers bear a large amount of risk, through their human capital
investment in the organization, and it is likely to be their main source of income, it is
more beneficial for managers to have their pay linked to a range of performance
measures. If the company performs poorly on one measure in a year and managers do
not meet targets for that performance target, for example profit, they are still likely to
receive a bonus based on other measures of performance where targets were met.

Contemporary Issue 5.2: Banks breaching an implied social contract

1. What is a ‘social contract’? (K)

The term ‘social contract’ has often been used to describe how business interacts with
society. It relates to the explicit and implicit expectations society has about how
entities should act to ensure they survive into the future. A social contract is not
necessarily a written agreement, but is what we understand society expects of entities.
Some expectations could be explicit (legislation relating to pollution or employee
health and safety are examples), while others are implicit. Evidence of implicit terms

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Solution manual to accompany: Contemporary Issues in Accounting

of the social contract can be gained from communications and writing of a society at a
point in time. Media attention to high executive bonus payments when share prices
are declining could be an example of the degree of public importance placed on these
issues, and therefore an implied component of a social contract.

2. What do you think might be the implied terms of the social contract between
banks and customers with respect to interest rates and charges? (J)

While there is no explicit contractual responsibility of banks to pass on interest rate

cuts announced by the Reserve Bank, there is an implicit expectation, as part of
‘social contract’ between banks and society, including customers, that banks do so.
Some implied terms of the social contract between banks and customers might include
(but are not limited to) the following:
 When banks receive rate cuts from the Reserve Bank they will be passed on to
customers in a timely manner so that banks benefit from rate cuts to a greater
extent than their customers
 Any interest rate cuts will be passed on in full so the bank does not benefit more
than customers from any federal rate cuts
 Banks are expected to charge for customers in a realistic manner, and not
penalize customers unduly for services
 Banks are expected to provide services to customers and not penalize those
living in remote or rural areas

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 Chapter 5: Theories in accounting

Review Questions

1. Differentiate a normative theory from a positive theory. Provide an example

of each.

Normative theories provide recommendations about what should happen. They

prescribe what ought to be the case based on a specific goal or objective. It is not
based upon what is happening in the world, but on what should be the case given the
objective upon which it is based.
A positive theory, on the other hand, describes, explains or predicts activities. Positive
theories can help us to understand what is happening in the world, and why
organisations act the way they do. As such they rely on real world observations.

2. Explain what an agency relationship is, and explain the following costs:
monitoring costs, bonding costs, residual loss.

An agency relationship is one where a person, or group of persons – known as the

principal – employs the services of another – referred to as the agent – to perform
some activity on their behalf. In doing so the principal delegates the decision making
authority to the agent.
Monitoring costs are incurred by the principal, and relate to measuring, observing and
controlling the agent’s behavior. They could include audit of financial reports, putting
in place rules, or costs incurred to set up a management compensation plan.
Bonding costs are costs incurred by managers in an attempt to provide some
assurance that they are making decisions in the best interest of principals.
Residual loss refers to the additional divergence between agents and principals that
can’t be contracted for, or cannot be monitored in its entirety. It is likely to be too
costly to guarantee an agent will make decisions optimal to the principal at all times
and in all circumstances.

3. Why would managers’ interests differ from those of shareholders?

Managers’ interests might differ from owners for a number of reasons, given both
managers (agents) and owners (principals) are assumed to act in their own interest,
and these actions might not necessarily align. Agency theory points to three main
problems which highlight differences between interests of managers and owners: the
horizon problem (managers and owners have differing time horizons in relation to the
entity); risk aversion (managers generally prefer less risk than shareholders); and
dividend retention (managers prefer to maintain a greater level of funds within the
entity, and pay less of the firm’s earnings to shareholders as dividends).

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Solution manual to accompany: Contemporary Issues in Accounting

4. Outline the three agency problems that exist in the relationship between
owners and managers.

The three main agency problems that exist in the relationship between owners and
managers are: the horizon problem; risk aversion; and dividend retention.
The horizon problem exists because managers and owners have differing time
horizons in relation to the entity. Shareholders have an interest in the long-term
growth and value of the entity as the share value of the entity today reflects the
present value of the expected future cash flows over the long-term. Managers, on the
other hand, are interested in the cash flow potential only as long as they expect to be
employed by the entity.
Risk aversion refers to the fact that managers generally prefer less risk than
shareholders. Owners diversify their risk through investing across multiple entities,
and are also likely to receive income from other sources. Managers have a large
amount of ‘human capital’ tied up in the entity and rely on the entity as their main
source of income. As such they are likely to be more risk averse than owners, and are
less likely to want to invest in risky projects.
Managers prefer to maintain a greater level of funds within the entity, and pay less of
the firm’s earnings to shareholders as dividends. This is referred to as dividend
retention. Managers wish to expand the business they control, whereas shareholders
wish to maximize the return on their investment in the entity through increased
dividends.

5. Outline the four agency problems that exist in the relationship between
lenders and managers.

The four agency problems that exist in the relationship between lenders and managers
are: excessive dividend payments; underinvestment; asset substitution; and claim
dilution.
When lending funds, lenders price debt to take account of an assumed level of
dividend payout. Excessive dividend payments, while good for shareholders, could
lead to a reduced asset base securing the debt or leave insufficient funds in the entity
to service the debt.
Underinvestment arises when managers, on behalf of owners, have incentives not to
undertake positive NPV projects if the projects could lead to increased funds being
available to lenders. This might particularly be the case when the entity is in financial
difficulty. Given creditors rank above owners in order of payments in the event of
liquidation, any funds form these projects would go towards debt rather than equity.
Managers have incentives to use debt finance to invest in alternative, higher risk
assets in the likelihood that it will lead to higher returns to shareholders. This is
referred to as asset substitution. Lenders bear the risk of this strategy as they are
subject to the ‘downside’ risk of this strategy but do not share in any ‘upside’ returns.

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 Chapter 5: Theories in accounting

When entities take on debt of a higher priority than that on issue it is referred to a
claim dilution. While taking on additional debt increased funds available to the
entity, it decreases security to lenders, making lending more risky.

6. What is a debt covenant and why is it used in lending agreements?

A debt covenant is a restriction or a term included in a debt contract that is designed

to protect the interests of lenders. They could include things such as a dividend
payout ratio, working capital ratio, leverage ratios, or the restriction of the borrowing
of higher priority debt.

7. Why would managers agree to enter into lending agreements that incorporate
covenants?

As a result of agreeing to the terms of debt covenants managers are able to borrow
funds at lower rates of interest, to borrow higher levels of funds or to borrow for
longer periods of time.

8. What role does accounting information play in reducing agency problems?

Accounting information plays two roles in reducing agency problems. The first is
where the terms of managerial compensation or lending agreements are written in
terms of accounting information; and the second is where accounting information is
used to determine performance against the terms of the contracts.

9. How might institutional theory explain accounting disclosures?

Institutional theory is used to understand the influences of organizational structures

such as rules, norms and guidelines. Accounting disclosures are likely to be a way of
demonstrating corporate legitimacy by disclosing how the organization is meeting the
expectations of these rules, norms and guidelines.

10. What is a social contract and how does it relate to organisational legitimacy?

A social contract is used to describe how business interacts with society. It relates to
the explicit and implicit expectations society has about how businesses should act to
ensure they survive into the future. A social contract is not necessarily a written
agreement, but is what we understand society expects. While the relationship between
society and business is explained by the social contract, organizational legitimacy
describes the state in which an organization has met the terms of the social contract. It
explains the process by which the terms of a social contract is gained or maintained.

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Solution manual to accompany: Contemporary Issues in Accounting

11. How can corporate disclosure policy be used to maintain or regain

organisational legitimacy?

Four ways an organization can obtain or maintain legitimacy have been identified in
the academic literature:
(a) Seek to educate and inform society about actual changes in the organisation’s
performance and activities
(b) Seek to change the perceptions of society, but not actually change behavior
(c) Seek to manipulate perception by deflecting attention from the issue of
concern to other related issues
(d) Seek to change expectations of its performance
Disclosure can be used as a technique in each of these strategies. An entity might
provide information to offset negative news that may be publicly available. They
could also use disclosure to draw attention to strengths or to down play information
about negative activities. Disclosure can also be used to advertise actual changes in
performance or activities.

12. Why would managers decide to voluntarily disclose environmental

performance information in an annual report?

Public reporting of information that is not mandated, such as details of environmental

performance is a powerful tool in showing an organization is meeting the expectations
of society, and therefore maintaining organizational legitimacy. This can be used to
draw attention to the company’s strengths, and to play down any weaknesses.

13. There are two branches of stakeholder theory. How do they differ?

The two versions of stakeholder theory are: a normative theory, known as the ‘ethical
branch’ and an empirical theory of management. The normative branch of stakeholder
theory relates to the ethical or moral treatment of organizational stakeholders. It is
argued that organization should treat all stakeholders fairly, and the organization
should be managed for the benefit of all stakeholders.
The managerial branch of stakeholder theory is a positive theory that seeks to explain
how stakeholders might influence organizational action. Rather than considering each
stakeholder as equal (as is the case under the normative branch), the managerial
branch proposes that the extent to which an organization will consider its stakeholders
is related to the power or influence of those stakeholders, with executives managing
these competing interests.

14. The managerial branch of stakeholder theory proposes that stakeholder

power will affect the extent to which an entity meets the stakeholders’ needs
and expectations. Identify two stakeholder groups and outline how they
might have ‘power’ relating to an organisation’s activities.

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 Chapter 5: Theories in accounting

Any two of the following organizational stakeholders can be identified and discussed:
 Investors/owners – investors, and particularly institutional investors have
power through the provision of equity funds, and their role in appointing the
board of directors. Some investors will have more power or influence than
others, and this is likely to be related to the extent of their shareholding in the
organization.
 Political groups – these groups can incorporate community groups, lobby
groups and shareholder associations amongst others. Their power lies in their
ability to influence the operations of the organization with respect to their area
of influence. For instance environmental lobby groups can influence public
opinion about an entity’s environmental performance, so the entity needs to
ensure they manage this relationship.
 Customers – these are major providers of cash funds to the entity. In many
industries meeting consumer needs is the driving force behind the
organization, and it will find it difficult to operate successfully without the
source of customers.
 Communities – some companies have a major impact on local communities.
A specific example is the mining sector where towns and the communities
which live there are significantly impacted by the organization, and the entity
is reliant on local communities for support including labour, services and other
resources. In these circumstances community groups can be seen as powerful
parties, as it is important for entities to ensure a close working relationship.
 Employees – as the suppliers of one major resource to companies – labour –
employees are important to the smooth operation of the entity. Issues with
employee conditions can significantly affect this supply of labour and
therefore the continuous operation of the entity.
 Governments – government at all levels have a significant amount of power
over the operations of entities through legislation that impacts on operations.
This can relate to corporations legislation, legislation that dictates taxes, fees,
tariffs and allowances the entity receives, and that dealing with how entities
need to treat employees, the surrounding environment and consumers, as just
some examples. These all have the potential to incur financial costs on the
entity in terms of compliance.
 Suppliers – raw materials are also a major cost to the entity, so any demands
from suppliers for information, performance expectations etc are likely to
significantly impact on the entity. Decisions not to supply to an entity can also
be costly as it requires the entity to seek out alternative sources.
 Trade associations – these bodies oversee the terms and conditions provided to
the labour forces employed by entities. They are in a position to significantly
impact on the ongoing operations of the organisation

15. What are the factors a manager might consider in making various
expensing–capitalising choices?

Agency theory would propose that where a manager has discretion about the timing
and the nature of activities, they are likely to choose to expense or capitalise in order
to maximize profits, which would lead to increased bonuses to managers. It is also

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Solution manual to accompany: Contemporary Issues in Accounting

likely to ensure the entity is not close to breaching any debt covenant that might be in
place.

16. How can positive accounting theory explain corporate social and
environmental reporting?

Positive accounting theory highlights the importance of minimising information

asymmetry between owners and managers. Managers need to be mindful of
presenting both good and bad news about the entity as it impacts on reputation and
future share values. As such they are likely to provide information about social and
environmental performance to ‘bond’ themselves to shareholder expectations
regarding sustainability performance, and to reduce information asymmetry, thus
leading to a reduction in the cost of capital.

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 Chapter 5: Theories in accounting

Application questions

5.1 Making managerial pay contingent on measures of managerial and/or firm

performance motivates them to deliver good performance for shareholders.
However, it also burdens them with greater risks than they may like. How do
organisations balance these two considerations when choosing managerial
pay and performance measures? (J)

The board of directors will choose a range of measures, both accounting and non-
accounting to use as performance target for managers. This will ensure managers
work towards improving firm performance on a number of levels – both short and
long term, which is in the best interest of owners. It also serves to reduce the risk to
managers. If managerial pay is only linked to one measure of performance, and it is
not met, managers arguably receive no bonus. With a range of performance
measures, if the managerial team meets performance on some measures but not others
it means they will not lose all bonus.

5.2 Obtain the Remuneration Report for a publicly listed company. Examine the
compensation contract for the Chief Executive Officer (CEO). Prepare a
report which summarises your findings relating to the following issues:
(a) What amount is short-term in nature (salary and cash bonus) and what
is based on long-term firm or managerial performance?
(b) What proportion of the CEO’s pay is performance based, and what
proportion is not?
(c) What measures of accounting performance are used to determine the
CEO’s bonus?
(d) Given the accounting firm performance measures in the contract, what
accounting decisions could the CEO might make in order to maximise
their bonus?
(e) Can agency theory provide an explanation for the various remuneration
components? Justify your answer. (SM, CT and K)

The responses to each of the above questions will depend upon which company
students choose. All the information in parts (a) to (c) are required to be disclosed in
the Remuneration Report. The answer to (d) will depend upon the accounting
performance measures disclosed in the report. It is likely that they are all short term
measures such as return on assets (ROA) and profitability. These will lead to
managers taking a short term approach to performance, perhaps decreasing expenses
and capitalizing costs where possible. In answering (e) students should refer to the
use of remuneration contracts to limit the following agency problems: horizon
problem, dividend retention, risk aversion.

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Solution manual to accompany: Contemporary Issues in Accounting

5.3 Bonus plans are used to reduce agency problems that exist between
managers and shareholders. Discuss two (2) of these problems specific to the
relationship between shareholders and managers and identify how bonus
plans can be used to reduce the agency problems you have identified. In your
answer you should provide examples of specific components that should be
added to a bonus contract to address the issues identified. (K, J)

There are three agency problems: the horizon problem, dividend retention and risk
aversion.
Bonus plans will be used in different ways to reduce each of these problems. To
reduce the horizon problem, long-term bonuses such as shares or options are useful,
as it encourages managers to improve long-term performance, and take a longer-term
focus. Tying a greater proportion of managerial pay to share price movements, using
ratios such as total shareholder return, particularly as the manager approaches
retirement is also likely to encourage managers to maximize long-term performance.
Linking bonuses to ratios such as a dividend payout ratio will likely encourage
managers to enhance dividend payouts to shareholders. Similarly, linking bonuses to
profits will also encourage managers to seek additional profits, which in turn are
going to be available for dividends, thus alleviating the dividend retention problem.
Including incentives to encourage managers to invest in more risky projects can
reduce the risk aversion problem. For instance, linking a bonus partly to profits can
encourage managers to consider more risky projects that have the potential to increase
profits. Limiting the share-based compensation as a manager’s ownership in the
company increases is also likely to encourage managers to invest in more risky
opportunities as it increases a manager’s ability to diversify their own risk.

5.4 You have recently been appointed as a lending officer in the commercial
division of a major bank. The bank is concerned about lending in the
current economic environment, where there has been an economic
downturn. You have been asked by your supervisor to provide a report
indicating how you can safeguard the bank against the risks of lending. In
your report you should outline how covenants in debt agreements can be
used to reduce the risks, what agency problems the bank should be
concerned with, and how accounting information can be used to assist in this
process. (CT, SM, K)

Debt covenants are designed to protect the interests of lenders. They also bond
managers, representing the firm, and allow managers to borrow funds at lower rates of
interest, to borrow higher levels of funds or to borrow for longer periods.
The bank should be concerned about the following agency problems:
Excessive dividend payments: if managers issue a higher level of dividends than the
payout ratio assumed in the calculation of a lending agreement this can lead to a
reduction in the asset base securing debt, and potentially leave insufficient funds
within an entity to service the debt. A restriction on dividend policy, or including a
maximum dividend payout ratio can reduce this problem.

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 Chapter 5: Theories in accounting

Underinvestment: arises when managers have incentives not to undertake positive

NPV projects if the projects would lead to increased funds being available to lenders.
Covenants that restrict the investment opportunities of the entity, or working capital
ratios can reduce the problem.
Asset substitution: managers have incentives to use debt finance to invest in
alternative, higher risk assets in the likelihood that it will lead to higher returns to
shareholders. Debt covenants can restrict investment opportunities, including merger
activity. Including clauses that secure the debt against specific assets, or including a
leverage ratio in the covenant can also reduce the risk of asset substitution.
Claim dilution: entities take on debt of a higher priority than that on issue. Debt
covenants could restrict the borrowing of higher priority debt, or debt with an earlier
maturity date.
Accounting information can play two roles in this process. (1) it can be used as part of
the covenants in debt contracts, and (2) can be used to assess performance against
these covenants. The bank can require lenders to provide audited financial statements
half-yearly or annually so it can ensure restrictions in debt contracts are not being
breached.

5.5 A clothing manufacturer has decided to close its factory in a regional

Australian town and move its operations offshore to another country where
they are going to be able to employ workers at a substantially reduced cost.
Closing the factory will result in the loss of 400 jobs in the town. Outline the
issues the company might face with regards to its implied social contract.
You should identify what groups or people are likely to be concerned or
affected by the decision and whether the decision is likely to be seen as
advantageous or disadvantageous to these groups. You should also discuss
actions the company could take to reduce any potential negative reaction to
the decision. (J, K)

In a regional town a clothing factory that employs 400 workers is likely to be

responsible for employing a major proportion of the community, in fact it may be the
major employer in the region. This means closure will have a significant effect
through increased unemployment. This will have a flow-on effect to other businesses
in the area which are supported by the clothing factory employees (e.g. retail stores,
housing, medical services, child care services etc).
Because of this close association with the community it has an implied social contract
with the local community to communicate with employees and the broader
community with regards to its intentions. Many employees may have moved
themselves and their families to the area to seek employment. The company is likely
to face opposition and lobbying by employees themselves, other businesses in the
area, local government and employer associations. The decision is likely to be
disadvantageous to all these groups.
Shareholders of the company are also likely to be affected by the decision, and are
likely to be supportive, given reduced costs is likely to lead to increase profits.
Customers of the company are also going to be affected, and may make a decision to
boycott the company’s products if they are not supportive of the company’s move

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offshore. This is likely to lead to adverse publicity, which may also be seen by
shareholders as negative.
The company can take a number of actions to reduce the potential negative reaction to
the decision. They should communicate with all interest groups, both in the local
community and externally, to explain fully their decision. They need to highlight the
advantages to the Australian economy, and to interest groups. They should also seek
ways to reduce the impact on employees and the local community by seeking
alternative employment opportunities for employees etc.

5.6 You work for a mining entity which is about to commence exploration in a
remote area of the Northern Territory. You have been asked to assist the
mining entity to manage its stakeholders to ensure the exploration permit is
approved and there is no negative publicity associated with the operation.
You are to identify the various stakeholders the mining entity needs to
consider, and identify the issues each might be concerned with. In your
answer you should identify whether these issues are potentially costs or
benefits to the organisation. (J, K)

There is a range of stakeholders who will be concerned with the operation. Some of
these include:
Shareholders: As one of the major financial supporters of the company shareholders
have an interest in future operations as it is likely to affect future shareholder value.
Shareholders expect the company to keep them informed on any issues regarding the
venture – likelihood of success, issues it faces of a legal nature and issues that are
likely to impact on the future successful operation of the venture. It is anticipated that
shareholders will be supportive of the venture, if there is no negative publicity and the
permit is approved. If not, shareholders might see the negative publicity as a potential
to impact negatively on firm value so may look to sell shares.
Government: the government will be responsible for issuing any permit. This will be
related to the location, indigenous ownership issues, environmental impacts and the
potential for national income. It is important the company communicate with a range
of government departments, as the success of the venture, and the granting of the
exploration permit will rest upon government decisions.
Indigenous landowners: It is important that the company consider any land rights
issues and the possibility that the exploration might impact on indigenous sacred sites.
The company needs to communicate with local elders to manage these issues to
ensure the success of the project.
Employees and potential employees: the successful exploration could increase
employment prospects within the area and the company generally, which would be a
benefit to current and future employees. It is important that the company
communicate with employees about benefits and costs of working in a remote
location.
Local communities: If the exploration is successful then local communities are going
to be affected by an influx of company employees. This could put a strain on existing
infrastructure so the company needs to consider this and manage the provision of

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additional infrastructure to support the mine, employees and families, as well as

contributing to the community.
Lenders: costs of exploration and development need to be managed through the
provision of financial resources. The company needs to manage its relationship with
lenders to ensure their financial support of the project. Borrowings, and their cost are
likely to be affected by the probability of success so it is important that lenders are
kept informed of developments, including successful application for exploration
permits, and environmental impacts.

Case Study Questions

Case study 5.1: Boral hoses down concerns over debt covenants

1. Debt covenants or restrictions are commonly used in Australian lending

agreements. Discuss how they are used to reduce agency problems that exist in
the relationship between entities and lenders. (J, K)

Excessive dividend payments: A restriction on dividend policy, or including a

maximum dividend payout ratio can reduce this problem.
Underinvestment: Covenants that restrict the investment opportunities of the entity, or
working capital ratios can reduce the problem.
Asset substitution: Debt covenants can restrict investment opportunities, including
merger activity. Including clauses that secure the debt against specific assets, or
including a leverage ratio in the covenant can also reduce the risk of asset
substitution.
Claim dilution: Debt covenants could restrict the borrowing of higher priority debt, or
debt with an earlier maturity date.

2. Why would a company choose to enter into a lending agreement which

contains a covenant that puts a restriction on the maximum debt to assets
(leverage) that a company can take on? (J, K)

As a result of agreeing to the terms of debt covenants managers are able to borrow
funds at lower rates of interest, to borrow higher levels of funds or to borrow for
longer periods of time

3. If a company is close to breaching its leverage covenant what actions can it

take? (J, K)

The company can take a number of actions. These could include, but are not restricted
to: manage accruals to move expenses to later periods, where the company has some

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discretion, thus increasing assets and lowering the leverage ratio. The company could
also look at asset values and revalue fixed assets to fair value, if it is an increasing
market. This will also serve to lower the leverage ratio. It is costly to renegotiate debt,
so using discretion to alter accounting values and capitalizing/expensing decisions is
less costly and will ensure the company does not breach its leverage ratio.

Case study 5.2: Pay backlash prompts shift to bonuses

1. One of the problems in the shareholder/manager agency relationship that pay

contracts are designed to overcome is the risk aversion problem. Outline what
this problem is, and how the contract between managers and shareholders can
be designed to reduce risk aversion. (J, K)

Managers prefer less risk than shareholders because their human capital is tied to the
firm. Shareholders have a greater diversification of risk, as they are likely to have
investments across a variety of projects/property/shares. Managers are less likely
therefore to invest in risky projects as if it fails they will lose more than shareholders
with diversified risk.
Including incentives to encourage managers to invest in more risky projects can
reduce the risk aversion problem. For instance, linking a bonus partly to profits can
encourage managers to consider more risky projects that have the potential to increase
profits.

2. How does equity as a pay component work to reduce the horizon problem?
What role, if any, does accounting information play in specifying the
contractual terms of bonus plans designed to reduce the horizon problem? (J,
K)

Equity as a pay component in the form of shares or options are useful, as it

encourages managers to improve long-term performance, and take a longer-term
focus. Tying a greater proportion of managerial pay to share price movements, using
ratios such as total shareholder return, particularly as the manager approaches
retirement is also likely to encourage managers to maximize long-term performance.
Accounting information is used within pay contracts to specify the performance
targets against which managerial performance is assessed. This dictates the number of
shares and/or options to be paid, and to assess performance against these contracts.

3. The article discusses a range of non-salary components that are contained

within the management compensation packages of top-100 companies. What
is the purpose of including non-salary components in executive pay
arrangements? (J, K)

© John Wiley and Sons Australia, Ltd 2012 5.15

 Chapter 5: Theories in accounting

The non-salary components mentioned in the article include: cash bonus, shares,
options or other equity schemes. The purpose of these is to align managerial interests
with those of shareholders. If managers are just paid a base salary, they have no
incentives to maximize firm value as they do not benefit in any growth in value.
Managers are rational self-interested parties and as such are motivated to perform if
they are likely to receive some financial reward for this. Shareholders wish managers
to run the company for their long-term benefit, so wish managerial pay to align with
this. As such paying managers shares and options ensures they seek to perform over
the longer-term. Similarly a cash bonus as part of a comprehensive package ensures
managers maximize profits in the short term too.

4. Why would managers prefer short-term cash over long-term equity bonuses?
Why does this not align with shareholder interests? Explain your answer. (J,
K)

There is less risk for a manager in receiving short-term cash payments. It aligns more
with managers’ preferences not to have funds tied up for the long term. Managers
could choose to invest their cash whatever way they choose, which might involve
property, other shares or shares in their own firm, so they would prefer this flexibility.
In addition, managers tend to have a short-term rather than long-term focus, so prefer
to be rewarded on this basis.
This time horizon does not align with shareholder interests because short-term cash
bonuses lead managers to have a shorter time horizon for decision making, while
owners prefer long-term decision making. In addition, managers will not be looking to
invest for future growth of the firm, whereas shareholders prefer positive investments
for the future.

5. Shareholders of Australian entities have the ability to vote to show either their
support or dissatisfaction with companies’ remuneration reports. While this is
non-binding on the Board, they are obliged to take note of shareholders’
views. Explain why shareholders might choose to vote against reports with too
high a proportion of pay as short-term cash bonuses rather than long-term
incentives. (J, K)

Cash bonuses imply a short term focus, rather than a long-term focus as required by
shareholders. As such short-term methods to contract with and pay managers are not
aligning the interests of managers with the owners. Paying out large amounts of cash
to managers means reduced cash flow in the business, which might leave less
available for future expansion of the business etc. In addition, cash bonuses do not
indicate a clear relationship to the shareholders understanding of the goals of the firm
– which is long-term growth.

© John Wiley and Sons Australia, Ltd 2012 5.16