Module 2 Flashcards
1
Q
Why Firms Exist (Coase 1937)
A
- To minimise contracting costs
- Competition between markets and other firms ensure the firm survives; The structures are the most cost-efficient as possible
- Firms can be defined as a nexus of contracts, an organisation is the centre of a contractual relationship
2
Q
Agency Theory
A
- A contract under which principals engage an agent to perform something on their behalf, which involves some decision-making authority
- The key assumption underlying this theory is that individuals are rational self-interested wealth maximisers
- A has a fiduciary duty to act in the best interest of P, but A and P are utility maximisers, so A may not always act in P’s best interest
3
Q
Agency Costs
A
- Monitoring costs: Costs to observe, evaluate and control the agent’s behaviour e.g. auditing financial statements, corporate governance.
- Bonding costs: Costs incurred by the agent to provide assurance that they are acting in the best interests of the principal. e.g. linking their remuneration (bonus) to the entity’s performance.
- Residual loss: Monitoring and bonding can never completely remove all situations where the agent does not act in the best interests. Residual loss is the reduction in the value of the firm that results from the cost of monitoring exceeding the benefit - that is the net value of A’s output being less than it would be if they were always acting in P’s best interest.
4
Q
Shareholder/Manager Conflict
A
- Shirking: avoidance of effort and responsibilities
- Consume perks: excessive consumption of non-cash benefits
- Horizon problem: Shareholders are interested in long term growth and value of the firm as this reflects the share price. However, managers’ interest may be limited to their employment period, making them only motivated towards short term goals. e.g. delay maintenance, reduce R&D costs
- Risk aversion: Managers prefer less risk, more is at stake for them than shareholders. More risk means more returns for shareholders, but managers could negatively affect their career.
- Dividend retention: Managers may prefer to maintain more funds within the entity, meaning less is given to the shareholders
5
Q
Shareholders can price protect
A
A bonus plan contract gives managers the incentive to align interests by limiting the amount of opportunism. Such a contract means that managers receive a fixed salary and the bonus is given based on satisfactory performance, the greater the earnings = greater bonus.
6
Q
Debtholder/Manager conflict
A
There are four problems that may allow the firm to be opportunistic and increase lenders risk:
- Excessive dividends: They may make excessive dividend payments to shareholders, meaning fewer funds to pay the debt is available
- Dilute existing debt claims: Entity refinances or takes on debt that is of equal or higher priority. This reduces the assets available to the original, unsecured creditor in the event of default.
- Asset substitution: Substituting low-risk investments for high-risk investments. This can be management investing in riskier assets after arranging the agreement. Higher risk investments put repayments at stake, and debtors do not receive any benefit should the investment be successful.
- Underinvestment: This can happen when the company faces liquidation/hardship. Debtors must be paid, so managers are inclined to invest less in positive NPV investments since this will only increase funds for lenders rather than increasing wealth. Managers act on behalf of owners, so they lack the incentive to undertake projects that could lead to increasing lender funds.
7
Q
Debtholders can price protect
A
They can charge a higher interest rate or not lend to them at all. This gives the incentive to align their interests. This can be done by:
- Restrictive covenants: These restrict and monitor the firm’s ability to be opportunistic. Can be done by accounting restrictions, such as the debt to tangible assets ratio or interest coverage ratio.
Breaching the restrictive covenants can result in costly penalties or trigger immediate repayment.
8
Q
The Efficient Contracting View
A
- All parties benefit as the contracts are considered to maximise the wealth of the firm
- Monitoring manager performance (using accounting numbers in their bonus plan, such as earnings)
- The use of accrual accounting; recognises consequences better when the transactions occur
- Defining accounting policy: revenue recognition.
- Debt contract monitoring: ratios usually include contingent liabilities and excludes intangibles and non-cash credits
- Leverage ratio: using intangible assets is inefficient because they are not a good source of security against a debt
- Departures from GAAP: offset managers ability to inflate/deflate the earnings and asset/liabilities ( a more conservative approach)
9
Q
The Opportunistic View
A
Accounting is used to transfer wealth from one party to another since conflicts cannot be eliminated.
The intent is to use accounting to deceive and mislead.
There are three hypotheses.
10
Q
Bonus Plan Hypothesis
A
Managers with bonus plans are more likely to choose accounting policies that shift reported earnings from future to current periods
- Can accelerate income or defer earnings by using different accounting policies
- Bonus plans can specify upper and lower bounds of earnings.
- earnings between LB and UB: use increasing policies
- earnings greater than UB: no extra bonus payable so use decreasing policies to move earnings
- earnings lower then LB: if no chance of reaching LB, use decreasing policies
11
Q
Debt/Leverage Hypothesis
A
- The higher the leverage ratio, the more likely managers are going to select accounting policies that shift earnings from future periods to current periods
- To prevent breaking covenants, to keep the ratio safe and avoid the consequences
- May capitalise expenditure rather than having an expense, or revalue intangible assets to decrease the ratio
12
Q
The Political Process/Cost Hypothesis
A
- Managers of larger entities are more likely to prefer policies which reduce profit
- Large entities are more politically visible and this puts them at risk of being criticised by governments and media.
- Using the policies to reduce profit will reduce their visibility and ensure they are out of the spotlight, which will also reduce the pressure from the government.
- These costs transfer wealth away from the company and can reduce the value of the company.
13
Q
Other Mechanisms to Control Agency Conflict
A
- Market mechanisms: the threat of takeover, the market for managerial talent, corporate governance
- External directors: will help internal directors monitor the activities of the business
- Auditing mechanisms: voluntary audits, audit committees to align interests
14
Q
Distinguishing Efficiency vs Opportunism
A
- If accounting is opportunistic, then we want to regulate more to remedy market failures.
- If accounting is efficient, the regulation would be counterproductive and create additional costs
