Flashcards in Week 2 Application of Acct Theory Deck (41):
What types of theories are there?
1. Normative theories: prescribe what SHOULD happen
2. Positive theories: explain/predict activities
Assumption of PAT?
rational economic person = act in own self-interest & rational wealth maximisers
What is NOC?
Nexus of Contracts - an org is the centre of contractual relationships
Issue of both parties being utility maximisers?
lack of goal congruence
What are some agency costs?
1. Monitoring costs (principal)
2. Bonding costs (agents)
3. Residual loss (both)
Define Monitoring costs.
To observe, evaluate & control agent's behaviour.
Define Bonding costs.
To provide assurance that they are acting in the principal's best interest residual loss.
Define Residual Loss.
Cost > benefit
List the Smith and Watts (1982) problems (Owner-Manager agency).
1. Horizon problem
2. Risk Aversion
3. Dividend Retention
Define Horizon Problem.
Long term vs. Short term
Solution to the Horizon Problem?
Remuneration in the form of shares
Define Risk Aversion.
Managers prefer less risk (don't put all eggs in 1 basket)
Solution to Risk Aversion?
link manager's bonuses to profits
Define Dividend Retention.
Empire effect; Manager's preference to hold onto funds and distribute less
Solution to Dividend Retention?
Link bonuses to dividend payout ratio
Define Credit Risk.
risk that borrower may not honour its obligations to repay.
Define Interest Rates.
To compensate for credit risk (price protection).
How does a debt contract protect the interest of lenders?
Define debt covenants.
allow managers to borrow funds at lower rates, larger amounts, and longer periods.
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
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
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.
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
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.
Solution to Claim Dilution?
Restrict borrowing of higher priority debt, or debt with an earlier maturity date.
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.
Define Political costs.
Wealth transfers imposed on an entity (e.g. gov imposed tax)
Whom do lobbying groups target?
large, profitable companies
Define Bonus Plan hypothesis.
- M prefer increase profit
Define Debt hypothesis.
high leverage = increase profit/equity
Define Political cost hypothesis.
larger entities = reduce profit
Define Mechanistic Hypothesis.
Investors are easily fooled by cosmetic changes in acct policies
Define the Efficient Market Hypothesis.
security prices rapidly adjusts to new info.
3 forms of market efficiency.
1. weak - based on past prices
2. semi-strong - public info
3. strong - private/public info
Theories that explain voluntary disclosures.
1. Legitimacy theory
2. Stakeholder theory
3. Social contract
Explain legitimacy theory?
when companies make a voluntary disclosure in their actual report to manipulate the perception for the sake of environmental/social factors.
List Lindblom's 4 ways.
2. Change the perceptions
3. Manipulate perception
4. Exchange expectations
any group/ individual who can affect or is affected by the achievements of an org's objectives.
List the 2 versions of stakeholder theory.
1. Normative theory 'ethical branch'
2. Empirical theory of mgmt which is positive theory
Explain normative theory.
-Treat all stakeholders fairly
-For the benefit of all stakeholders