week2A - Corporate Governance Accounting and Governance...

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Corporate Governance Accounting and Governance
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Accounting and Governance Insider rewards Reality Acct. System True performance Measured performance Manipulation
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Accounting and Governance Manipulation is a real problem World Com (2001) Capitalized costs of leasing other companies networks Enron (2001) Recognized income from the increase in value of derivative positions Allowed to use either bid or ask price Frequently was only active trader market maker in the market. Posted ask prices up to 8 times bid prices and picked the best prices to measure value of position.
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Simple Example Consider a firm that lasts for 1 period The firms income equals either $50M or $100M. Reported income equals either $100M or $50M. Part of the firms income depends on value changes which are hard to value.
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Example The CEO can invest his time in either working hard, distorting accounting reports, or playing golf. Playing golf makes the CEO happy Work cost the CEO 0.15M in effort costs. Distorting cost the CEO C in effort costs. Distorting reports also risks apprehension and a penalty of X . The chance of getting caught is p
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Example Assume the CEO receives a bonus of i if and only if he achieves a reported income of 100M (no bonus otherwise) and that the CEO has a base salary of 0.5M. Will the CEO distort?
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Example For the CEO to distort it has to be the case that the CEO likes distortion better than both work and playing golf. This will be true if 1/2 + (3/4) i - 15/100 < 1/2 + i - p X - C 1/2 < 1/2 + i - p X - C distort distort work golf
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Example 0.1 0.2 0.3 0.4 0.5 C + p X . 0 1 . 0 2 . 0 3 . 0 4 . 0 5 i Distort earnings Don’t distort earnings i-- incentive compensation C-- cost of distortion p -- probability of getting caught X --penalty for distortion Incentive compensation Cost of distortion to CEO
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Conservatism and Manipulation How hard is it manipulate earnings? Depends on how assets are valued by accounting system “ Unbiased value” : Economic value of assets given current use in the firm Conservative value” : Value of assets of the firm when separated from the firm and placed in second-best use.
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Conservatism and Manipulation Basic problem for accounting reporting Absent manipulation, value is ideal for valuation and compensation But, requires estimates by management that are not third-party verifiable. Thus unbiased valuation risks managerial manipulation Conservative value is not ideal but is Much more harder to manipulate
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Reducing Manipulation Reducing the role for manipulation in accounting information requires Reducing incentives : Make CEO compensation less
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week2A - Corporate Governance Accounting and Governance...

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