Week 2 Application of Acct Theory Flashcards Preview

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Flashcards in Week 2 Application of Acct Theory Deck (41):
1

What types of theories are there?

1. Normative theories: prescribe what SHOULD happen

2. Positive theories: explain/predict activities

2

Assumption of PAT?

rational economic person = act in own self-interest & rational wealth maximisers

3

What is NOC?

Nexus of Contracts - an org is the centre of contractual relationships

4

Issue of both parties being utility maximisers?

lack of goal congruence

5

What are some agency costs?

1. Monitoring costs (principal)
2. Bonding costs (agents)
3. Residual loss (both)

6

Define Monitoring costs.

To observe, evaluate & control agent's behaviour.

7

Define Bonding costs.

To provide assurance that they are acting in the principal's best interest residual loss.

8

Define Residual Loss.

Cost > benefit

9

List the Smith and Watts (1982) problems (Owner-Manager agency).

1. Horizon problem
2. Risk Aversion
3. Dividend Retention

10

Define Horizon Problem.

Long term vs. Short term

11

Solution to the Horizon Problem?

Remuneration in the form of shares

12

Define Risk Aversion.

Managers prefer less risk (don't put all eggs in 1 basket)

13

Solution to Risk Aversion?

link manager's bonuses to profits

14

Define Dividend Retention.

Empire effect; Manager's preference to hold onto funds and distribute less

15

Solution to Dividend Retention?

Link bonuses to dividend payout ratio

16

Define Credit Risk.

risk that borrower may not honour its obligations to repay.

17

Define Interest Rates.

To compensate for credit risk (price protection).

18

How does a debt contract protect the interest of lenders?

debt covenants

19

Define debt covenants.

allow managers to borrow funds at lower rates, larger amounts, and longer periods.

20

List the 4 problems (Smith & Warner 1979) that can increase lender's risk:

1. Excessive dividend payments to owners.

2. Asset Substitution

3. Claim Dilution

4. Underinvestment

21

What is the solution to Excessive Dividend Payments to Owners?

1. restrain div policy and restrict div payout.

2. Requirement to maintain a min working capital ratio

22

Define Asset Substitution.

Lender having downside of risk but NOT the upside of the effects of success when Manager invest in riskier assets after the loan.

23

Solution to Asset Substitution?

1. Debt Covenants restrict actions

2. Debt contracts impose restrictions on investment opportunities incl. mergers/takeovers

3. Lender can secure debt to tangible assets

4. Establishing minimum ratio of debt to tangible assets

24

Define Claim Dilution.

When a manager takes on a debt of an equal/higher priority. This reduces assets available to the og unsecured creditor in th event of default.

25

Solution to Claim Dilution?

Restrict borrowing of higher priority debt, or debt with an earlier maturity date.

26

Define Underinvestment.

In the event of a liquidation, funds from projects would go towards debt > equity.

Therefore, managers acting on behalf of owner have no incentive to undertake +NPV projects because it would only lead to increased funds being available to lenders.

27

Define Political costs.

Wealth transfers imposed on an entity (e.g. gov imposed tax)

28

Whom do lobbying groups target?

large, profitable companies

29

Define Bonus Plan hypothesis.

- M prefer increase profit

30

Define Debt hypothesis.

high leverage = increase profit/equity

31

Define Political cost hypothesis.

larger entities = reduce profit

32

Define Mechanistic Hypothesis.

Investors are easily fooled by cosmetic changes in acct policies

33

Define the Efficient Market Hypothesis.

security prices rapidly adjusts to new info.

34

3 forms of market efficiency.

1. weak - based on past prices
2. semi-strong - public info
3. strong - private/public info

35

Theories that explain voluntary disclosures.

1. Legitimacy theory
2. Stakeholder theory
3. Social contract

36

Explain legitimacy theory?

when companies make a voluntary disclosure in their actual report to manipulate the perception for the sake of environmental/social factors.

37

List Lindblom's 4 ways.

1. Educate
2. Change the perceptions
3. Manipulate perception
4. Exchange expectations

38

Define Stakeholder.

any group/ individual who can affect or is affected by the achievements of an org's objectives.

39

List the 2 versions of stakeholder theory.

1. Normative theory 'ethical branch'

2. Empirical theory of mgmt which is positive theory

40

Explain normative theory.

-Treat all stakeholders fairly
-For the benefit of all stakeholders

41

Explain Empirical theory.

A stakeholders' power is related to the degree of control they have over resources required by the org.