D17 Agency costs and corporate governance Flashcards
THE agency problem
The separation of ownership and control in modern public corporations creates significant conflicts of interest between managers and shareholders
Asymmetric information between shareholders and management
Shareholders do not observe:
Perks (MH)
Project choice (AS/MH)
could explain: bonuses, boards, M&A’s, accounting fraud
Insider moral hazard (MH)
The agent is hired by the principal to perform a task and may choose actions that are not in the interest of the principal, but not observable by him.
4 Examples of insider moral hazard
- *insufficient effort**: wrong allocation of work time to various tasks (inconvenient to fire people), insufficient effort to oversee subordinates, competing activities (political involvement)
- *extravagant investments**: pet projects and empire building (takeovers)
- *entrenchment strategies**: invest in project to make them indispensable, earning manipulation, resist hostile takeovers
- *self-dealing**: perks (private jets, etc.), nepotism, illegal activities
Self-dealing: Private jets for managers
interpretation: weak corporate governance, undesirable characteristics management
Entrenchment strategies: Two categories of earnings management (manipulation)
Two categories:
- Accounting methods („cooking the books”, exploiting flexibility in GAAP)
- Operating methods
Entrenchment: earnings management - accounting methods
How?
choice of reserves/provision for loan losses
choice of date at which sale is recorded
capitalize or expense maintenance and investment costs
balance sheet window dressing
Costs (besides fooling investors): time spent by managers, „bribes”, psychological cost
Entrenchment: earnings management - operating methods
How?
delay shipments or ask customers to take early delivery
delay/speed up maintenance, replacement of inventories
run end-of-period sales
Costs (beside fooling investors): bad timing, overtime pay, production disturbances
Definition Corporate Governance
Schleifer and Vishny (JF 1997): …deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment
BDeM: … system of controls, regulations, and incentives designed to minimze agency costs between managers and investors and prevent corporate fraud
4 managerial incentives
- monetary incentives
- implicit incentives
- monitoring
- product market competition
Managerial incentives: monetary incentives
Salary, bonus, stock-based incentives in order to induce managers to internalize the owners’ interests
Dark side: folly of rewarding A while hoping for B
Managerial incentives: implicit incentives
Managers want to keep their job:
Preventing poor performance (empirical evidence: higher executive turnover)
Preventing bankruptcy
Managerial incentives: monitoring
Active monitoring (forward looking): interfering with the management in order to increase value, exercise of control rights
(board of directors, auditors, large shareholders, large creditors, investment banks, rating agencies)
Speculative monitoring (backwards looking): measuring value; influence via compensation and managerial turnover
(additionally stock market analysts, short term creditors)
Managerial incentives: product market competition
- close competitors offer a benchmark against which the firm’s management quality can be measured
competition removes monopolist profits, so managers are under pressure to avoid bankruptcy
Sarbanes-Oxley Act (SOX)
Intent: Improve accuracy of information given to both boards and shareholders
3 ways to achieve this goals:
1. By overhauling incentives and independence in auditing process
2. By stiffening penalties for providing false information
3. by forcing companies to validate their internal financial control processes
German vs US corporate governance
