Application of Accounting Theory Tute Flashcards
What is an agency relationship?
An agency relationship occurs when one party, who is referred to as the principal, employs another party, the agent, to undertake some activity on their behalf.
Explain how monitoring costs arise in agency relationships.
Costs incurred by the principal to observe, evaluate and control the agent’s behaviour are referred to as monitoring costs.
e.g. having financial statements audited
Explain how bonding costs arise in agency relationships?
Those costs incurred by the agents to provide assurance to the principal that they are acting in the principal’s best interests.
e.g. time & effort expended in producing and providing quarterly accounting reports to lenders
Explain how residual loss arise in agency relationships?
Reduction in value of the firm that results from the separation of ownership of control, when the marginal cost of additional monitoring or bonding exceeds the expected benefit.
How does acct info reduce agency problems M - S/H ?
- specify targets
- monitor performance
- determine rewards
How does acct info reduce agency problem?
Debt covenants:
- restrict leverage
- restrict dividend payout
How to fix Horizon Problem?
The horizon problem can be reduced by linking management rewards to the company’s performance over a longer period.
e.g. share-based remuneration, such as shares or executive share options
How to fix the Dividend Retention Problem?
Aligning the interest of managers with those of the firm through the use of incentive-based payments - bonuses.
e.g. bonuses linked to ROI and ROE
How to fix the Risk Aversion Problem?
Linking a bonus to profits can encourage manager to consider more risky projects that have the potential to increase profits.
Explain the mechanistic hypothesis.
Assumption that investors fixate on acct numbers, such as profit, ignoring the implications of any differences or changes in acct policies.
The share price will also increase in response to increase in profits (assuming other matters being equal).
How does deferral of bonuses fix horizon problem?
Providing an incentive to maintain or improve the share price over a longer period.
Making vesting contingent upon meeting performance targets in subsequent periods provides additional incentive for management to adopt a longer horizon so that previous equity-based rewards vest.
How does deferral of bonuses fix dividend retention?
By providing management with incentives to take actions that maintain or increase the share prices, in order to increase the value of the remuneration.
