UNIVERSITY THE OF
NEW SOUTH WALES
Australian School of Business
ACCT 3563: Issues in Financial Reporting & Analysis
TUTORIAL - WEEK 2
Positive Accounting Theory
This topics learning objectives (LO) are to:
1. Desribe agency theory including the notion of agency costs
2. Explain the implications of agency theory to accounting policy choice and
accounting judgments;
3. Analyse political costs as a positive explanation for accounting policy choice.
The tutorial questions and solutions are focused on addressing these objectives.
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A: BASIC CONCEPTS
A1. Questions from Deegan, Chapter 3
Question 2
Why and how might management not act in the interests of the firm? (LO 1)
Positive accounting theory assumes that all parties act in their own self interest. While
that assumption may not always be true in practice, the assumption has a number of
implications, one of which is that managers will sometimes act in ways that are not in
the interest of shareholders or creditors. These actions lead to agency costs of debt and
equity. The value of the firm is equal to the value of its equity plus the value of its debt.
The actions of managers that are not in the interest of equityholders include:
(a) excessive dividend retention
(b) horizon problem
(c) consumption of excessive perquisites
(d) shirking
(e) insufficient risk taking
The actions of managers that are not in the interests of creditors include:
(a) excessive dividend payouts
(b) claim dilution
(c) asset substitution
(d) underinvestment
Question 3
How can we use the output of the accounting system to help ensure that
managements actions are in the interests of the owners? (LO 1)
The output of the accounting system, for example annual reports, can be used to monitor
the performance of management so that owners can see how managers are performing.
Managers pay may also be linked to specific accounting-based targets such as reported
profits.
Question 4
How can management expropriate the wealth of debt holders? (LO 1)
See actions not in interest of debtholders in the answer to question 1. All those actions
except claim dilution transfer wealth from debtholders to equityholders. Claim dilution
transfers wealth from one group of creditors (unsecured creditors) to another group of
creditors (secured creditors).
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Question 8
What are debt covenants and why are they put in place? (LO 1)
In order to reduce the conflicts of interest between debtholders and equityholders, debt
contracts can be written which contain covenants. These covenants are restrictions or
conditions placed on what the firm can do. For example, to restrict excessive dividends,
a covenant could restrict how much dividends a firm can pay. To restrict claim dilution,
a covenant could prohibit the issue of debt with senior ranking to existing debt. To
restrict asset substitution, a covenant could prohibit major shifts in the risk profile of the
firm, e.g. prohibit mergers. To restrict underinvestment, a covenant could require
regular maintenance and inspection of key assets.
Question 20
Under Positive Accounting Theory, what are agency costs of equity and agency costs
of debt? (LO 1)
Jensen and Meckling (p. 308) define an agency relationship as a contract under which
one or more individuals (principals) engage another person (the agent) to perform some
service on their behalf which involves delegating some decision-making authority to the
agent.
Jensen and Meckling distinguish two types of agency costs that arise in the absence of
agency resolution mechanisms. The two main types of agency costs are:
1. Agency costs of equity (shareholder-manager conflict). Problems include dividend
retention, risk aversion, the overconsumption of perquisites and fraud. The methods
that are typically put in place to minimise these costs are bonus plans, share option
plans and other forms of compensation contracts tied to accounting numbers such as
return on asset ratios.
2. Agency costs of debt (shareholder/manager-debtholder conflict). Problems include
dividend increases, claim dilution, asset substitution, and underinvestment. The
methods used to minimise these cost are typically imposed through provisions in debt
contracts. These include maximum allowable debt levels, which are frequently based
on accounting ratios such as the debt ratio, current ratio, or interest coverage ratio.
Other provisions may include limits on dividend payouts, asset revaluation, fixed or
floating rate charges, negative pledge agreements (promises not to take particular
actions), and restrictions on investment activity. Lenders may also insist on the
provision of special purpose financial reports.
Students should be able to explain the meaning of each of the conflicts of interest in the
agency costs of debt and the agency costs of equity.
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Can mechanisms be put in place to eliminate all agency costs? If not, why not? (LO
1)
The answer is: No. Mechanisms put in place to minimise agency costs also impose costs.
These are classified as:
Monitoring costs for example the costs of audit of the firms general purpose
financial reports or special purpose financial reports prepared for debtholders
Bonding costs for example contractual arrangements to tie management
remuneration to firm performance or debt covenants that protect the position of
debtholders
However, because not all agency costs can be anticipated and because it is not
economical to include provisions in contracts to cover every contingency, some of the
costs of divergent behaviour remain (known as the residual loss). Agency costs are
equal to (a) the amount spent on monitoring & bonding plus (b) the residual loss.
What is the role of accounting information in agency theory? How does accounting
information reduce agency costs? (LO 2)
Agency theory involves contracting between the principal (e.g. shareholders) and the
agent (management) and the contracts are defined on accounting numbers. The contracts
have real consequences such as performance bonuses or costly debt renegotiation. It
follows that there are vested interests in how the accounting numbers are determined for
the purpose of the contracts.
Agency costs are what the principals pay (in reduced wealth or utility) when they
delegate decisions to the agent. For example, agency costs of equity occur where firm
value is reduced by management (insiders) acting in its own interests at expense of
outside shareholders. Such actions might include: Risk aversion, differences over
decision horizons, dividend retention, excessive perquisites, shirking & fraud. Some of
these actions arise from what economists call moral hazard, which is the problem of
unobserved effort.
These agency problems can be mitigated at least to some extent by
Monitoring costs e.g. costs of preparing and auditing of the firms financial
statements; and,
Bonding costs - typically imposed by the agent; e.g. contractual arrangements to tie
performance to the firm (bonus plans) or debt covenants to limit borrowings.
Production of accounting information is a cost incurred (i.e., a monitoring cost) which
serves to reduce information asymmetry. Thus, accounting information will reduce moral
hazard to the extent that management are less able to shirk because information regarding
firm performance is known by outside shareholders.
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A2. Opportunistic and Efficiency Perspectives
Distinguish between the opportunistic and efficiency perspectives in Positive
Accounting Theory (PAT) and give an example of each. Are the two perspectives
mutually exclusive? (LO 2)
The opportunistic perspective of PAT takes as given the negotiated contractual
arrangements between a firms insiders and outside equity holders and creditors, and
seeks to explain and predict certain opportunistic behaviours that will subsequently
occur given the existence of such contracts. The opportunistic perspective is often
referred to as ex-post meaning after the fact because it considers opportunistic
actions that could be taken once various contractual agreements have been put in place.
The contracting efficiency perspective deals with accounting policy choices that are
arrived at during the contracting process. These choices are ones which all contracting
parties agree upon because they suit all parties. It is also assumed with the efficiency
perspective, that firms adopt particular accounting methods because they best reflect the
underlying performance of the entity.
Examples:
Contracting efficiency use EBITDA instead of net profit, calculate total assets
excluding intangibles, include commitments for non-cancellable leases in total
liabilities, and adopt the percentage of completion method to account for profits earned
on long term projects being required in certain ship building companies
Opportunism capitalising computer software costs in property, plant and equipment,
smoothing income by stacking provisions and then releasing them, switching
depreciation methods on new fixed assets from reducing balance to straight line to boost
profits, structuring the group with debt in associates rather than subsidiaries.
Can you think of other areas of opportunistic behaviour by management especially in
the recognition and measurement of balances?
The accrual two perspectives are not mutually exclusive. They exist side by side in any given
firm because the contracting process, being costly, does not reduce all agency conflicts
to zero. In particular, the contracting process will not specify all accounting methods
that a firm should follow, and managers are left with some residual discretion including
discretion in the choice of some (but not all) accounting methods which they then are
assumed to exercise opportunistically. However, the contracting process will have
identified the contractually efficient accounting methods and specified in contracts that
they be adopted.
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A3. Agency Theory and Conservatism
Does agency theory imply a demand for hard or soft numbers? (LO 2)
Recall that contracts between firm principals depend on accounting numbers (such as
profit, assets and liabilities). Examples include debt covenants based on interest cover or
debt/assets and management performance bonuses based on return on assets.
Agency theory implies a demand for hard numbers, which means that the numbers can be
relied on by principals (e.g. debtholders) in their dealings with agents and minimize the
need for costly renegotiation of contracts between principals and agents.
Conservatism in financial reporting presents financial performance and financial position
with a downwards bias. In this sense, conservatism satisfies a demand for hard
numbers. The financial position and financial performance might be better than
presented but should not be much worse!
Recall that conservatism effectively means anticipate all losses but do not recognise gains
until they are realised. Examples of conservatism in financial reporting include:
lower of cost and net realizable value for inventory measurement
revaluation increments to reserve but revaluation decrements to expense in
relation to property, plant and equipment
immediate recognition of expected losses on construction contracts
allowance for bad and doubtful debts
the requirement to use the cost basis for goodwill and most other intangible assets
the requirement to writedown assets that are impaired and conduct annual
impairment reviews in the case of goodwill and intangibles with indefinite useful
lives
Conservatism is not part of the conceptual framework but it is what we observe. How
can we explain it?
Now you should understand how a positive theoretical approach in financial accounting
differs from a normative theoretical approach?
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B: APPLICATION OF CONCEPTS
B1. Management performance contracts
Review Paperlinx Limiteds Directors Report for 2008 and the remuneration
structure for executives set out therein. Is the remuneration structure consistent
with agency theory? An extract is shown below. (LO 1)
2.2 Remuneration Structure
Remuneration for PaperlinXs executives consists of two main elements:
1. Total Fixed Remuneration (TFR) includes all fixed costs such as base salary, car,
health insurance and mandatory superannuation.
2. Variable Pay comprises the short-term incentive (STI) (i.e. the annual cash incentive
plan), the strategic initiatives share plan (annual strategic targets with reward deferred into
shares) and the long-term incentive (LTI) (i.e. rights and options-based incentive plans).
The mix between fixed and variable pay for disclosed executives for the past year is shown
in Table 1.
Table 1: Percentage of total target remuneration (annualised)
Fixed
remuneration
T P Park
C B Creighton
E de Voogd
M J Fothergill
J A Henneberry
D M Lamont
R F OBrien
Variable
(performance-based
Remuneration)
71%
49%
47%
49%
50%
50%
50%
29%
51%
53%
51%
50%
50%
50%
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C: DISCUSSION QUESTION
C1. Question from Deegan, Chapter 3
Question 14
Positive Accounting Theory utilises the concept of political costs. Briefly define
political costs. What actions might a firms management undertake in an attempt
to minimise the political costs that might be imposed on the firm? (LO 3)
Political costs may be defined as costs or wealth transfers, which certain parties or
groups external to the firm may be able to impose on the firm. Such parties usually have
no explicit contractual arrangements with the firm. The most common source of
political costs is government pressure (of some sort) on the company. The Cole
enquiry in 2006 into the Australian Wheat Board (an ASX listed company) is a very
good example. Particular interest or consumer groups may be able to impose political
costs on the firm by lobbying the government to impose greater regulatory controls on
the firm. Green groups may be able to impose political costs on the firm by
recommending product boycotts of those firms that do not comply with the Green
groups own environmental standards or expectations. Although there is no explicit
contract in the foregoing cases, it can be argued that there exists an implicit contract
between the firm and society for the firm to do (or not to do) certain things and that
political costs arise when the firm breaks the implicit contract. The argument is rather
weak but it makes the incentives that arise from political costs analogous to those
arising from explicit contracts such as bonus plans and debt contracts.
Another example of political costs often given is that of trade union pressure. Here,
however, there is frequently an explicit contract such as an enterprise bargaining
agreement between the union and a company covering its members who are employees
of that company. Unions might be able to impose costs on the firm by instigating
strikes or claims for wage increases.
Where pushes for wage rises or reductions in prices of the firms goods and services
seem to be related to the reported profitability of the firm, then the firm may adopt
income decreasing strategies. This would be successful, it is assumed, if the parties
imposing the costs do not adjust the accounts to offset any changes in profits brought
about by the changes in accounting methods employed.
Where firms are subject to scrutiny by such groups as environmental parties then they
may elect to disclose additional qualitative information of a positive or favourable
nature in the annual financial statements. This information may act to reduce the effects
of the negative publicity being released by the particular interest groups. When faced
with political costs firms may also opportunistically choose accounting methods that
reduce the firms reported earnings so that the firm is not in the spotlight.
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D: PAST EXAMINATION QUESTIONS
D1. Debt Contract (LO 2)
A company has a debt contract in place which requires that the companys working
capital ratio (current assets / current liabilities) must never fall below 2 (meaning
that current assets must be at least twice current liabilities). As balance date
approaches, the company estimates that the working capital ratio will be 1.9 and the
company may default on its debt contract unless remedial action is taken. Which of
the following actions will increase the companys working capital ratio?
a)
b)
c)
d)
e)
Increase doubtful debts provision by 10%
Reduce depreciation of plant and equipment by 10%
Accelerate recognition of revenue by 10%
Increase balance day accrual for warranty claims on the company
Pay cash for plant and equipment about to be purchased
D2. Management Compensation Plan (LO 2)
A management compensation plan allows for a bonus equal to 1% of profit,
provided that profit exceeds $3,000,000; and that the maximum annual bonus is
$50,000. The initial calculation of profit for the current year is $5,500,000.
Positive accounting theory implies that the manager will choose accounting policies
that:
(a)
(b)
(c )
(d)
(e)
decrease reported profit as much as possible
decrease reported profit to $5,000,000
increase reported profit as much as possible
decrease reported profit to $3,000,000
make no change to the initial calculation of profit
D3. Debt Contract (LO 2)
A company has a debt covenant in place that limits the amount it can borrow to
60% of its total tangible assets. If the companys actual value for that ratio is
approaching the 60% limit then, according to Positive Accounting Theory,
management would try to relax the constraint by:
(A) Not amortising goodwill anymore
(B) Switching from straight line to reducing balance depreciation for new fixed
assets
(C) Increasing the allowance for doubtful debts from 5% to 10% of debtors
balances
(D) Revaluing fixed assets upwards
(E) A and D
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D4. Agency theory and accounting policy choice (LO 2)
Consider two shipbuilding companies X and Y.
X builds runabouts which take 8 weeks to complete. X then places them in a
showroom and waits for customers to come off the street to buy them.
Y builds large ocean liners which take two years to complete. Each ship is ordered
in advance by a specific customer and progress payments are made to Y over the
ships two year construction period.
If the underlying economics of each company is the only consideration, would X and
Y prefer to recognise revenue from shipbuilding at point of sale or during the
construction process? Which method would shareholders and creditors prefer in
evaluating management?
Hint: in each case, consider the uncertainty of being paid.
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