Week 1: Objectives of financial reporting
Objective of financial accounting • Information reporting system
• Designed to relieve information asymmetry in economies or society
• In turn to facilitate efficient allocation of scarce resources Demand for accounting information • Two distinct type of information asymmetry give rise to two
distinct objectives of financial reporting
1. Valuation => address adverse selection problem and ensures capital market efficiency (primary objective under the frame work)
2. Stewardship=> address efficient contracting/ moral hazard problem and operation of managerial labor market
Informational Asymmetry • One party to a transaction is at an informational disadvantage to other ( has an information advantage over the other party)
1. Adverse selection (valuation)
2. Moral hazard (stewardship/ efficient contracting) Adverse selection (valuation)=> pre transaction • Type of informational Asymmetry where a party to a
transaction is has an informational advantage over the other parties
• Between the potential investors and the management (corporate managers have advantage information about the underline true value of the company) and between shareholders themselves ( in the share market some shareholders may have information advantage compared to other shareholders)
Moral Hazard (stewardship/ efficient contracting) • Party to a transaction can observe their actions in fulfillment of the transaction but the other cannot so possibility to act in their own interest
• CEO potentially involves in moral hazard problem since they can undertake actions that are in their best interest at the detriment of the shareholder
IA problem in typical business setting Adverse selection
• Managers know more about the current condition and future prospect of the firm than the outside investors
• Investors face adverse selection as managers may behave opportunistically => delay or selectively release information=>
reduce ability to investors to make good investment decisions
=> demand external financial reports that provide information to facilitate the valuation of firm
Moral hazard
• Moral hazard occurs due to separation of ownership and control as it is impossible for shareholders and the creditors to observe directly the extent and quality of managerial effort
• Demand information to hold corporate managers accountable
=> managers will act in the best interest of the shareholders rather than their own interest
Role of financial reporting in market economy Valuation
• To reduce adverse selection => improve efficiency of capital markets
• Facilitate the efficient allocation of resources
1. Lower the adverse selection => lower the information risk => more capital willing to invest in the share market
2. Lower adverse selection => improve efficiency of cross section allocation of capital => more precisely and timely recognition of failing firms => capital market will allocate capital away from low performing firms to high performing firms.
Stewardship/ contracting
• Better information provided to managers => improved decision making by managers in the labor market => more efficient allocation of capital with in firm
Fundamental problems of Financial accounting measurement
Introduction • The best measure of net income to control adverse selection (
fair value measurement) is not the same as the best measure to motive the managers performance ( historical cost accounting)
• Implies the interest of the investors and manager in conflict Valuation objective (decision usefulness) • Basic characteristic of the information demands for valuation
objective is need information to forecast future cash flows
• Ideal accounting for valuation => PV of value in use of future cash flows of all firms assets and liabilities in the balance sheet
• Relevance is the emphasis
• Conditions for ideal accounting using PV => need to know with perfect certainty future cash flows and the discount rate Stewardship/ contracting objective (efficient contracting view) • Basic characteristic of the information demand for efficient
contracting objective => need information that facilitate efficient contracting => historical costs
• Firm is basic of contracts => to maximize firm value should minimize contracting costs (moral hazard cost) => in turn monitor the performance of the counter party.
Key contracts (principle agent relationships) of firms
• Shareholder and manager
• Shareholder and debt holders
Manager and shareholder contracts
• Separation of ownership and control
• CEO’s actions cannot be observed in day to day basis => potential moral hazard problem => CEO may not always act in the best interest of the shareholders
• Partial or non ownership firms by managers provide incentive to managers to act contrary to shareholders interest because they do not bear the full cost of the dysfunctional behavior
Moral hazard costs due to the separation of ownership and control
Dividend retention • If the firm has cash with no +NPV projects => should
distribute cash to shareholders as dividends=> maximize the wealth of the shareholders as they can invest in other firms or projects
• CEO may retain dividend and act in their own interest
1. Empire building: If the cash is retained and dividend is not distributed the firm is larger than what it would be.
CEO prefer to be the corporate manager of lager firm than a small one because will lead to larger
compensation and higher reputation in a labor market 2. Excessive consumption of perquisites: Interest in the
projects in CEO’s best interest but not +NPV projects.
Risk aversion • Shareholders with diversified portfolio only care about the
firms Beta (systematic risk or the market risk) not firm specific risk.
• Shareholders would in vest in any + NPV project where projects return is greater than required rate of return.
• But CEO may be act in a self interest way and reject +NPV project due to high volatility.
• CEO’s portfolio is only consist of human capital which is highly correlated with firms success => CEO compensation is
based on firms specific volatility => CEO is risk averse in relation to firm specific risk not like shareholder
Horizontal problem • NPV takes account the expected future cash flows into
perpetuity
• Given CEO concern about labor market reputation and compensation in the immediate short term may reject projects with initial cash layout result in negative cash flows during first few years although have +NPV in long run.
Shareholder and debt holder contracts
• Assumption that the interest of managers and the shareholder are aligned
• The debt holder is the principle and the manager acting on behalf of the shareholder is the agent.
Moral hazard costs of debt holders
Excessive dividend payment • CEO may distribute all cash received from lenders to
shareholders. Since shareholders have limited liabilities debt holders bear the risk of loosing all the money.
Asset substitution • Safe assets are substitutes for risky assets.
• Lenders prefer to lend to firms with safe tangible assets while shareholders may benefit from potential upside investment in risky assets.
• But lenders do not share the benefits from this risky
investments given they have limited upside potential but bear the risk of potential downside risk.
Claim dilution • After the firm receives the first loan it get loans from other
lenders and give these loans greater priority over the firms assets than the original loan result in the dilution of the first lenders claim.
Under investment • The firm choose to invest in +NPV project => if successful repay debt but nothing is left to the shareholders given debt obligations should meet first.
• No benefit to the shareholders so reluctant to invest in these projects
Reduction of moral hazard cost
Compensation contracts • Link pat to reported performance
• Reduce moral hazard cost
Debt holder contract • Include covenant in to the borrowing contract
• Reduce moral hazard cost => low interest
Role of accounting • Management compensation contracts and debt contract are
based on accounting numbers
• Accounting numbers are the basis of assessment of the success or the failure of the contracts written by the managers.
Efficient contracting theory
Focus on the role of financial information in moderating information asymmetry between contracting parties. An efficient contract generates trust between parties with conflicting interest at the low cost to the firm.
Conservative accounting
Properties • Higher standard of verification required for recognition of
assets and unrealized gains as opposed to recognition of liabilities and losses
Unconditional conservatism • Non recognition of assets with uncertain profits
• Internally generated intangible assets not recognized due to conservatism
• Under AASB 138 intangible assets will be recognized only if 1. Its probable that the expected future economic benefits
that are attributable to the asset will flow to entity 2. The cost can be measured reliable
• Internally generated good will not be recognized
• No intangible asset arise from the research phase of an internal project => will recognize as an expense when incurred.
• Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognized as intangible assets.
Conditional conservatism • Recognition of unrealized losses but non recognition of
unrealized gain for recorded assets
1. Provisions, revaluations, consolidation
2. Impairment test: if the RV is lower than the CA =>
should written down but if RV > CA => no journal entry
3. Lower of the cost or NRV of inventory: net realizable losses are recorded but not the gains.
Sources of contracting demand for financial information
Lenders • Face asymmetry payoff functions and in turn demand
early warnings of financial distress
• Lenders derive no incremental benefit if the firm is doing well however may incur losses if the firm is doing poorly
=> concerned more about losses not gains
Managers actions • Managers may act in their own interest which may in
conflict with shareholders interest
• So shareholder demand information to encourage responsible manager effort and prevent or limit the managers engagement in opportunistic behavior Accounting policies for efficient contracting
Reliability • Lenders and shareholders demand reliable information to help
protect against management opportunistic policies that hide losses and record unrealized gain to artificially maintain covenant ratio and manipulate earnings upwards
Conservatism Lenders => increase trust =>low interest
• Protect from financial distress: due to asymmetry of payoff
• Limited dividends increasing the security
1. Conditional conservatism: timely recognition of losses 2. Reported unrealized losses help to predict financial
distress Shareholders
• Acting as a constraint on managerial opportunism by not allowing gains to be recognized until realized limit the discretion to manipulate earnings to enhance reputation and compensation.
• Timely recognition of losses even if unrealized allows the timely recognition of net NPV projects that managers have engaged in.
Efficient contracting
Efficient contracting characteristics • Reliable
• Conservative
• May be flexible
• Conflict with the current value accounting where the reliability is sacrificed for relevance
• Contracting costs include the moral hazard costs and the cost from monitoring contract performance and costs of possible renegotiation or contracting violation due to the unanticipated events => efficient contracts are the contracts with lowest costs
Accounting policies for efficient contracting conflict with conceptual
frame work • Efficient contracting demands for reliable and conservative
information
• Frame work is more future oriented => relevant information
=> fair value accounting => reliability downgraded to an enhancing characteristic
• Frame work more oriented to information needs of investors than stewardship => framework does state the investors need information about stewardship but ignores the fact that the information which best serve stewardship objective and valuation objective is not same.
Contract rigidity
Why flexibility in accounting choices gives rise to efficient
contracting • Many contracts depend on accounting variables
- debt contracts contain accounting based covenants - Manager compensation contracts depend on net income
• Both type of the contracts tend to be long term
• Accounting standards change during the contract term thus affect net income ( pay for performance link => demotivate the managers) and increase the probability of the debt covenant violation
• Since contracts are based on accounting numbers and contracts are rigid and fixed unlikely that the contracts can be
renegotiated to allow for the changes in GAAP.
Implications • Changes in accounting standards can have real cash flow effects
• Technical breach of the contract => unforeseen costs to the firm
• If the manager has no flexibility of accounting policy choice , ü Manager may react by reducing R&D, deferring asset
replacement to prevent debt covenant violation => real earning management => has direct cash flow impact =>
long run impact
ü High risk with compensation => reduce the acceptance of risky projects with +NPV => less risk => low expected return => result in cost on the diversified shareholders who are well protected from firm specific risks
Solutions • Efficient solution is allowing managers some flexibility in
accounting policy choice. Contracting efficiency may increase as managers can minimize cost of debt covenant violation and adverse manager reaction due to the reduced and riskier compensation by managing accruals and changing accounting policies.
• Also predicts that firm managers may exploit their flexibility to act opportunistically. Can use policy choices to manage
reported earnings upwards and delay public knowledge of bad news.
** so for both opportunistic view ( engage in policy choices to increase their utility at the expense of shareholders) and efficient contracting view( choose policies to attain efficient contracting =>
good corporate governance) managers will prefer to have flexibility of accounting policy choice. And emphatically evidence suggest both.