Tut 9 Solutions - HOMEWORK HELPS PDF

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Tutorial 9 1.

What is the difference between normative and positive accounting theory? Give examples of each. Positive accounting theory (PAT) is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historical cost accounting system. Examples of PAT include:  explaining why firms select specific accounting policies  predicting which firms will oppose new or revised accounting rules  explaining share price reactions associated with accounting information releases.

This approach can be compared with normative accounting theories that dismiss conventional historical cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’ systems of accounting (usually) based on inflation adjustments. Examples of normative theories include:  specification of the preferred measurement system  theories as to the objective of general purpose financial reporting  defining elements of financial statements. 2.

Explain the three types of agency costs and their relationships to each other in the context of: (a) debt contracts (b) equity contracts.

The three types of agency costs are:  monitoring costs  bonding costs  residual loss. Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the principal (e.g. shareholders, debtholders) to monitor the agent (that is, the manager). For example, shareholders or lenders could appoint an outside accounting firm to investigate the manager’s performance in managing the financial affairs of the firm. Being rational, the shareholders or lenders would reduce the remuneration to the agent by an amount that increases as monitoring costs increase. In the case of a shareholder–manager agency relationship, the manager’s remuneration will be reduced by the monitoring costs incurred by the shareholders. In the case of a lending contract, the lender (principal) will impose higher costs on the agent (management acting on behalf of shareholders) by demanding lower interest rates or other lending terms that are favourable to the lender. Either way, costs are incurred initially by the principal, but are then passed on to the agent. The agent, as an insider who has access to information about his or her performance, is deemed to be a wealth-maximiser. Therefore, they are likely to bond their actions to align them with the interests of the manager. The agent will incur bonding costs (for example, the costs of providing audited financial statements and voluntarily providing financial information to lenders) to the limit whereby the marginal cost of bonding

Chapter 11: A positive theory of accounting policy and disclosure

equals the marginal cost of monitoring that is imposed by the principal. As such, bonding costs are incurred by the agent. Generally it is not possible to eliminate all agent behaviour that is inconsistent with principals’ interests. The cost of this remaining behaviour is known as residual loss. The residual loss is borne by the principal in the first instance. However, if the principal anticipates the level of residual loss that eventuates, the residual loss will be priced into the agency contract. For example, the residual loss could be ‘charged back’ via reductions in the amount of management remuneration or the interest rate on debt in the case of shareholder–manager contracts and lending contracts respectively. The extent to which the principal or the agent bears the residual loss depends on the completeness of the ‘pricing’ in ex post settling up or ex ante price protection 3.

Bonus plans are used to reduce the agency costs of equity. Describe the agency relationship giving rise to the agency cost of equity and explain how bonus plans can reduce particular types of agency problems.

The separation of ownership and control means that managers can act in their own interests, which may be contrary to the interests of shareholders. This can be broken down into a number of specific difficulties:  Risk aversion problem. Managers prefer less risk than shareholders because

their human capital is tied to the firm. They prefer to diversify their own risk rather than maximising the value of the firm through higher risk projects.  Dividend retention problem. Managers prefer to pay out less of the firm’s

earnings in dividends in order to pay for their own perquisites.  Horizon problem. Managers are only interested in cash flows affecting their

remuneration for the period they remain with the firm, whereas shareholders have a long-term interest in the firm’s cash flows because share prices equal the present value of shareholders’ expectations of all future cash flows. Bonus schemes can reduce these problems by tying the manager’s remuneration to an index of the firm’s performance that has a high correlation with the value of the firm (for example, share prices, earnings). This aligns managers’ and shareholders’ interests by tying managerial compensation to performance ex ante without the need to rely on ex post mechanisms, such as renegotiating salary. Remuneration can also be tied to dividend payout ratios or to options or share bonus schemes. It is likely that a bonus plan will reward managers only after they have achieved an ‘expected’ level of firm profits for a period — then the remuneration will increase as profitability increases, thereby providing incentives for managers to increase their bonuses by increasing firm profitability. There may also be a ceiling on the amount of bonus paid to managers, to reflect the fact that profits can sometimes be increased to artificially high levels by actions that are not in the shareholders’ long-term interests (for example, by reducing repairs and maintenance, not undertaking research and development). 4. Explain the main agency costs of debt, and how debt contracts can be designed to reduce those costs. In particular, explain how accounting specifications within the contracts can be used to reduce the agency problems. The main agency problems involved in debtholder–shareholder relationships are:

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Solution Manual to accompany Accounting Theory 7e

 Excessive dividend payments. This lowers the value of debt because it reduces

available funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders.  Claim dilution. When further debt is issued, this makes the original debt riskier and lowers its value to the original debtholders.  Asset substitution. When debt is issued that reflects (and subsequently projects) a particular risk, a higher risk is undertaken.  Underinvestment. This occurs when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders. Debt covenants can be structured to restrict conflicts by bonding managers and shareholders to act in the interest of creditors, such as:  covenants to restrict the production-investment opportunities of the firm (asset substitution and underinvestment)  covenants restricting dividend policy to a function of net income  covenants restraining financing policy, usually expressed as gearing ratios  bonding covenants — such as increased financial reporting. Accounting would play a primary role if the above covenants were expressed in terms of accounting numbers. Whittred and Zimmer (1986) and Stokes and Tay (1988) found that debt covenants in Australia were mainly expressed in the form of accounting numbers. 5. Explain the efficiency perspective and opportunistic perspective of Positive Accounting Theory. Why is one considered to be ex post and the other ex ante? The efficiency perspective takes the view that contractual arrangements will be designed to reduce future conflicts of interest (and associated agency costs) between various individuals involved in the operations of an organisation. Well designed contracts are expected to reduce future transaction costs. By reducing future costs, welldesigned contracts can have the effect of increasing the value of an organisation. Because the contractual arrangements are designed to reduce future conflicts they are considered to be introduced on an ex ante (up-front) basis. Many of the contractual arrangements use the output of the accounting system (such as rewarding managers on the basis of a share of profits, or utilising debt to asset ratios in debt contracts). The opportunistic perspective relies upon the assumption that individuals are always motivated by their own self-interest (at the possible expense of others) and once they enter contractual arrangements they will subsequently capitalise upon any flexibility within the contracts to cause any related pay-offs to be more favourable to themselves (again, at the expense of others). Because it is not practical to attempt to write ‘complete contracts’, there will always tend to be some degree of flexibility in most agreements and it is anticipated that the opportunistic manager will uncover such flexibility. In relation to the selection of accounting methods, independent external auditors will frequently be used to ensure that the accounting methods adopted by managers appear to be reasonable and in accordance with generally accepted accounting practice. Because the opportunistic behaviours frequently occur after transactions have been negotiated (after the fact) the actions are described as occurring on an ex post basis.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 11: A positive theory of accounting policy and disclosure

6. When Kezza Ltd approached Steffs Banking Corporation Ltd for an unsecured loan of $100 million, Kezza Ltd had a good credit rating. However, the economy was depressed and Steffs Banking Corporation Ltd was concerned about lending such a large sum. You have been asked by Steffs Banking Corporation Ltd to provide a short report to the finance manager, Mike Hanshe, explaining how debt agreements and restrictive covenants can be used to safeguard debt in general. Mike wants the report to explain which agency costs of debt are controlled by specific covenants. Furthermore, he is interested to know how accounting numbers can be used in the debt covenants to help control any opportunistic behaviour on the part of Kezza Ltd. Students should provide an appropriately formatted report in answer to this question. The following are points that should be covered in such a report:  Shareholder–debtholder agency problems, discussed in detail in the text, can be categorised as relating to: – excessive dividend payments — this lowers the value of debt because it reduces available funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders. – claim dilution — when further debt is issued this makes the original debt riskier and lowers its value to the original debtholders – asset substitution — when debt is issued which reflects a particular risk a higher risk is undertaken. – underinvestment — when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders.  In general, a default covenant allowing debtholders to insist on immediate

repayment of the debt or renegotiation of the terms of the loan (including interest rates) can be implemented. Some possible ways in which debt agreements and restrictive covenants can be used to safeguard debt include: – the dividend problem may be controlled by tiering dividend payments to net income where the income calculation is stipulated, or by restricting dividends to a function of the debt–equity ratio – the claim dilution problem may be controlled by restricting the amount of debt that is allowed to be issued with priority over the existing debt, by controlling the debt to equity ratio, or by controlling the times–interestearned ratio – the asset substitution problem can be controlled by restricting the ability of management to undertake high-risk projects (for example, not allowing merger or takeover activity without the explicit approval of the lenders), or by having as a condition of the debt agreement that the interest may be altered with the changing risk profile of the firm – the underinvestment problem can be controlled by tying management compensation packages to a risk-adjusted measure of performance, or by using covenants that restrict or control the production-investment activities. Constraints on dividend distributions ensure that funds are retained within the firm, thereby encouraging managers to invest in positive NPV projects rather than leaving cash idle. The underinvestment problem is the most difficult agency problem to control since underinvestment is unobservable © John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

 Overall, bondholders can be protected by making debt rank higher than other

repayments in the event of winding up. Regular financial reporting using prespecified accounting methods can be used to control opportunism by managers. Furthermore, most of the covenants should be more effective if they are tied to accounting numbers. See also the empirical evidence in Whittred & Zimmer (1986), Stokes and Tay (1988), Stokes and Whincop (1990), Williamson (1988) and Begley (1990). 7. What is the debt hypothesis? Explain the logic (theory) underpinning it. The debt hypothesis predicts that as a firm’s leverage (that is, proportion of debt relative to the firm’s assets) increases, managers will select accounting procedures that shift reported profits from future periods to the present period. The theory underpinning the debt hypothesis comes from agency theory where managers (acting on behalf of shareholders) have incentives to transfer wealth away from debt holders to shareholders. In other words, they have incentives to decrease the value of debt so that residual equity increases in value. Recognising this incentive, debt contracts often include covenants whereby firms covenant to not allow their debt to exceed a certain percentage of total assets or total tangible assets. This is intended to ensure that there is sufficient equity to buffer the value of debt if assets lose value and/or the firm makes future losses. As the firm’s leverage increases and the firm gets closer to breaching its debt covenants, managers have incentives to ensure that the firm does not violate its debt covenants. Therefore, managers would choose accounting methods that increase assets or decrease liabilities in order to reduce the reported leverage. 8. What are the costs of breaching a debt covenant? How significant do you think these costs might be? As debt covenants normally stipulate the responsibilities and rights of both parties, breach of debt covenants constitutes technical default on the contracts and provides debt holders with rights to institute agreed-upon action such as the seizure of collateral. More importantly, breaching a debt covenant would send negative signals to the market through the reduction of the firm’s debt rating, which is likely to be followed by loss of reputation and a fall in the share price and a rise in the cost of debt. Hence, the costs of breaching a debt covenant does not only include material costs (i.e. seizure of collateral), but also includes the loss of reputation and credibility in the market, with consequences for the cost of capital. The latter cost is much more significant, and could have long-term impact on the firm. Therefore, managers have incentives to ensure that the terms of debt covenants are not violated.

9.

Why might managers choose accounting methods that increase current period reported earnings? Managers might choose accounting methods that increase current period reported earnings in order to increase their remuneration. Normally managers’ remuneration is tied with accounting numbers, such as profits, as a benchmark in determining how shareholders compensate them for their performance. Therefore, managers tend to choose accounting methods that result in increased profits so that they can maximise

© John Wiley and Sons Australia, Ltd 2010

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Chapter 11: A positive theory of accounting policy and disclosure

their remuneration. In addition, increased current period reported earnings usually will give positive signal to the market. If the investors believe the signal, the firm’s share price will increase and both shareholders and managers will benefit as well (the purpose of managers is to maximise shareholders’ wealth). Shareholders will benefit from capital gains, whereas managers will get more remuneration as some components of their remuneration are determined by the firm’s share price. 10. Why might managers choose accounting methods that reduce current period reported earnings? Managers might choose accounting methods that reduce current period reported earnings in order to avoid political costs. For example, high reported earnings can be seen by employees as the results of exploiting their labour, and consequently they might lobby for increased salary through labour unions. Alternatively, managers might reduce current period reported earnings if high earnings are considered to be an indication of a mature industry, and the government might then remove tariff or subsidies that protect the industry. Other reasons why managers might choose accounting methods that reduce current period reporting include: (a) to smooth income trends in a high profit year (saving this period to boost the next periods’ reported earnings) (b) to ‘take a bath’ by reducing profits this year in order to have higher profits next year, when earnings might be sufficiently high to earn a performancebased bonus for the manager (c) to signal to shareholders that there are reduced earnings in the future (rather than have future profits suddenly slump, the signal might be gentler to shareholders) (d) to warn of bad news early so that management mitigates the likelihood that shareholders or others will litigate against them for misleading their investment or other decisions with high reported earnings.

© John Wiley and Sons Australia, Ltd 2010

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