A Positive Theory of Accounting Policy and Disclosure

A Positive Theory of Accounting Policy and Disclosure

The article also suggests that total salary may have to be increased. 2. How is the introduction of a ‘cap’ (upper limit) on termination payments likely to affect Coo’s remuneration if firms make no adjustments to the compensation packages? Other components consisting of bonuses and equity-based compensation (such as shares or options to acquire shares) on top of base salary is likely to increase, particularly in the period leading up to termination of employment. To provide an incentive to the CEO to outperform the market in the pre- termination period non-salary components of the compensation package ay be added to the remuneration package.

The instructor might mention at this point the tie in with agency theory: According to agency theory, agents (managers/executives) are utility maximizes and there is no reason to believe that they will necessarily act in the best interest of principals (shareholders) unless the principals’ and age interests are aligned. For example, managers have incentives to increase perquisite consumption at the principals expense. In order to solve this agency problem, shareholders need to align managers’ remuneration with their performance in maximizing the firm’s value.

By including non-salary monuments in the Coo’s remuneration package, firms will provide incentives to Coos to act in a manner that will increase firm value. 3. How could researchers evaluate the general impact of a ‘termination pay cap’ on the structure of management compensation packages? This question is aimed at starting the students to think empirically (positive) about consequences. Suggestion: By analyzing the components, structure and size of executive compensation packages pre- and post- the imposition of a termination pay cap, and attempt to identify any impact on firm value as measured by market capitalization or other factors.

This analysis might need to consider lagged share prices as the new compensation packages might have behavioral impacts that might not have an immediate impact on the firm’s market value. 4. What sort of key performance indicators are likely to be included in Coos’ compensation packages? What role might accounting numbers play in these indicators? The most likely key performance indicators would be linked to the financial structure and the market value of the firm. Indicators could include: Percentage and absolute change in share price Percentage and absolute change in debt level Constancy/improvement of earnings

Levels/increases in Earnings Per Share (PEPS) Also, the firm’s performance could be compared to the relative performance of an index or group of firms that operate in similar sectors. It is possible that the Coos might choose accounting policies to best suit the achievement of key performance indicators, in which case a key performance indicator could be consistency in accounting policies. Accounting numbers are often used as thresholds or ceilings in setting targets for the incentive components of management remuneration.

For example, it is not uncommon for a Coo’s salary package to contain an incentive bonus hat is paid only after the firm achieves a certain level of profits that is deemed challenging, but not impossible. From there, the manager achieves a bonus, possibly payable at a particular percentage of the firm’s earnings in excess of that threshold. There might also be a ceiling on the profit that forms the basis for the bonus payment. This recognizes that sometimes, profits can only be achieved at the expense of future earnings (e. G. By not maintaining equipment, or not conducting any research and development).

As such, the role of accounting numbers in this case is to motivate the manager to achieve Geiger, sustainable, profits that are challenging, and increase the value of equity. Sometimes, these accounting numbers are set as overall targets for the firm; sometimes they might be set as targets per share, recognizing that it is the return to individual shareholders that the manager is to maximize. Students may think of other roles that accounting numbers play in these targets. Consider each on its merits. Theory in Action 1 1. 2 Debt Contracting 1 .

Explain why the Stella Group’s debt position would have ‘dragged down’ the C.V. Asia Pacific organization’s balance sheet? If debt forms a significant part of a firm’s financial structure, the risk that the firm will not be able to meet its interest obligations increases, as does the chance that it will breach its debt covenants. If debt had been issued under more onerous terms and conditions than are currently available and if the organization was not able to repay and reissue the debt under more favorable terms, then the existing debt would be burdensome.

Generally, shareholders are likely to prefer debt financing to equity in order to (a) obtain tax deductions for the interest on the debt (dividends are not tax deductible to the company); (b) avoid diluting their control over the firm; and/ or (c) ensure that future profits in excess of the interest paid on debt accrue to them and are not spread across a broader shareholder base. Note that, in relation to the above: Interest is tax deductible for companies; their own dividend payments are not.

Debt has little or no impact on control of the firm. Debt holders do not share ownership of the firm, and therefore they cannot have influence in managing the firm. Shareholders, on the other hand, share ownership of the firm through the possession of their shares. Consequently they share control of the firm and may influence its management by imposing some restrictions to protect their interests. Note that the level of control for an individual shareholder is generally very small unless the firm is small or the shareholder is extremely large.

In terms of firm profits, debt holders cannot share the firm’s profits, whereas shareholders will share the firm’s profits through dividend payments. 2. From a lenders perspective, what are the costs associated with high leverage? How can these costs be mitigated? There are some agency costs associated with high leverage from a lenders respective. When leverage increases, managers (acting for shareholders) will have incentives to transfer wealth away from debt holders to shareholders. This can be done through different ways such as excessive dividend payments, asset substitution, underinvestment, and claim dilution.

These costs can be mitigated by establishing a debt covenant, in which the lender specifies terms and conditions that restrict the activities of management or require management to take certain actions upon receiving the borrowings. For example, the lender might require the firm to not pay beyond a certain bevel of dividend, have its accounts audited by an industry specialist audit firm, or to not borrow money from any other lenders without approval from the current lender, or to covenant that it will not allow leverage to exceed a certain ratio, etc. . From a shareholder’s perspective, what are the costs of high leverage? How can these costs be mitigated? From a shareholder’s perspective, high leverage may impair the firm’s credit rating since the firm appears risky, and may affect the firm’s ability to raise money in the future. If the firm’s ability to raise money in the future creases due to excessive current borrowings, the firm may not be able to obtain sufficient funds needed for its expansion and growth.

This is the cost that shareholders will bear, as inability to grow will prevent shareholders from maximizing their wealth in the firm. In addition, a high leverage firm may also be considered as a risky and unsafe investment by the market. This will cause the share price to fall, which reduces the value of shareholders’ investment in the firm. These costs can be mitigated by aligning management’s interest to shareholders’ interest, and thus preventing management from borrowing excessively at the shareholders’ expense.

One way to align management’s interest with shareholders’ is through equity based remuneration, whereby manager’s remuneration is tied to the firm’s share price. By doing so, management will be more cautious in making decision that can damage the firm’s share price, such as excessive borrowings. Students may raise other ways in which shareholders’ and lenders’ interests are aligned to reduce the likelihood that high leverage will reduce the value of equity. 4.

What are some incentives that might explain why C.V. chose to restructure he Stella Group by contributing further equity (by buying Activator’s 35 per cent stake)? The contribution of further equity would have resulted in a restructuring of the financial position of the group. If the debt/equity ratio was high and approaching the level of any existing debt covenants, the equity injection would have mitigated this unfavorable situation by reducing the level of debt relative to the level of equity.

This alone would provide a significant incentive for the equity contribution. A further reason for increasing the level of equity is to ensure that it had rater influence or to secure control, over the group. This could provide it with the ability to determine the future financial policies and actions of the group including the flow of dividends. 5. What are the potential ‘covenants’ and ‘ending terms’ that are likely to have been overhauled in the Stella Group’s financial restructure?

The financial covenants that are likely to have been overhauled could include: Links between level of debt and equity, revenue, profit, dividends (and potentially a range of other accounting number) Links between debt and financial statistics such as PEPS, Diluted PEPS, Dividend ratio (to profit) Lending terms that are likely to have been changed could include: Interest rate Repayment schedule including final repayment date(s) Events likely to crystallite (trigger repayment) the outstanding debt Theory in Action 11. 3 What do profits signal? 1 .

Navigates announcement of soaring profit is a strong signal of the firm’s earnings prospects. Other comments in the article reinforce that signal. What could Navies do in relation to its profits to strengthen the signal even further? Explain your answer. TO strengthen its signal even further, Navies could announce a dividend policy. As firms normally smooth their dividend payments, an increase of dividends in the future would give a signal that Navies is expecting its business operations and outcomes to improve and be sufficient to support the higher level of dividends. . What factors might increase or decrease the credibility of the signal provided by Navigates announcements and press attention? Some factors that might increase the credibility of the signal provided by Navies are: upward trend in global demands for its product/service as a result of the global financial crisis the fact that Navies has low debt and good ash flow in a period when other firms are struggling to raise debt and are facing diminishing cash flows positive press releases by Navies positive forecasts and buy recommendations by analysts.

Some factors that might decrease the credibility of the signal provided by Navies are: increased competition from other education providers uncertainty about the length and depth of the global financial crisis changing regulations in the education export sector negative analysts’ forecasts, or ‘sell’ recommendations increased exchange rate which increases the relative cost of Australian education unfavorable Reese about overseas student experiences in Australia. 3. What do you expect will be the impact of the ‘soaring profits on management compensation contracts of Navies?

As top management compensation is often partially based on accounting profits as a proxy for management performance, record earnings produced by Navies would probably increase the amount of remuneration received by management. In addition, management remuneration is often tied with the company’s share price to align management’s interest with shareholders’ and minimize agency costs. Assuming Navigates share price increases after the announcement of its record earnings, its management would also receive even higher remuneration.

Theory in Action 1 1. 4 The politics of promoting products 1. What is the potential impact of the increased fines on the content of the accounting reports of firms in the pharmaceutical industry, particularly in relation to accounting information? It is likely that the increased fines would result in a decrease in profits Of firms in the pharmaceutical industry as a direct consequence of the increased fines. This would be offset by reduced corporate taxes however the net impact would be a reduction in profit.

Future accounting policies chosen by firms in the pharmaceutical industry could address the profit reduction, perhaps through the capitalization of research and development expenditure that had previously been written off as incurred, or adjustments to depreciation and/ or impairment adjustments. Or, the accounting policies could be selected in order to further reduce profits and thus diminish the political profile of the firm. These accounting policies might be chosen on the basis that they defer profits to future periods. 2. How does the article demonstrate political processes?

In your answer, explain what, if anything, firms in the pharmaceutical industry can do to manage political costs. The political process is a competition for wealth transfers. The likely wealth transfer is away from firms in the pharmaceutical industry, to other sectors most notably, to government in the form of increased fines. The pharmaceutical industry also faces a wealth transfer in the form of increased compliance costs it must bear. It is likely that firms in this sector will choose accounting policies that will reduce profits, defer profits, or otherwise reduce the public profile Of the firm. . What do you expect will be the impact of the increased fines in the (1) earnings and (2) management compensation contracts, of firms in the pharmaceuticals industry? If fines are imposed it is likely that the earnings of the firms will reduce. If so, management contracts are likely to be adjusted to counter the impact of performance indicators that are based on profit/earnings measures, so that the compensation of management is not adversely impacted by the effect of the fines on profit. QUESTIONS 1. What is the difference between normative and positive accounting theory?

Give examples of each. Positive accounting theory (PAT) is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historical cost accounting system. Examples of PAT include: explaining why firms select specific accounting policies predicting which firms will oppose new or revised accounting rules explaining share price reactions associated with accounting information releases.

This approach can be compared with normative accounting theories that isms conventional historical cost accounting as being meaningless or not decision useful and prescribe the use Of more ‘useful’ systems Of accounting (usually) based on inflation adjustments. Examples of normative theories include: specification of the preferred measurement system theories as to the objective of general purpose financial reporting defining elements of financial statements. . What were some of the factors that led to the development of positive accounting theories of accounting policy choice? In the 1 sass, positive accounting theory gained dominance in accounting search, mostly through the publication of capital market research, as it became clear that researchers could not prescribe how to prepare financial statements until they knew whether and/ or how investors used financial statements in their decision-making.

However, the early positive accounting research relied on perfect market assumptions where, for example, information is available freely, there are no transaction costs, taxes, and monopolistic control. These assumptions imply that capital market researchers could not explain why share prices did not respond immediately to reflect accounting information as predicted. It then became apparent to the researchers that they needed a theory to explain why accounting reports were prepared, before they could explain capital market reactions to accounting information.

In investigating market reactions to firms’ accounting practices and earning releases, researchers observed some factors that led to the development of positive accounting theories of accounting policy choice such as: There should be benefits in preparing financial reports as many firms voluntarily incurred the costs of preparing financial reports even prior to any regulation requiring them to do so. Companies lobbied in relation to reposed accounting standards, which is a costly activity that would be only conducted by rational managers if the benefits outweighed the costs.

Firms made consistent patterns of accounting policy choice that were related to the economic and governance characteristics of the firms. Firms tended to choose accounting methods that offered conservative measures of profit, assets, and equity. Neither normative theories nor capital markets theories could explain these observations. Positive accounting theory developed as a means of doing so. 3. Why might managers choose accounting methods that increase current erred reported earnings?

Managers might choose accounting methods that increase current period reported earnings in order to increase their remuneration. Normally managers’ remuneration is tied with accounting numbers, such as profits, as a benchmark in determining how shareholders compensate them for their performance. Therefore, managers tend to choose accounting methods that result in increased profits so that they can maximize their remuneration. In addition, increased current period reported earnings usually will give positive signal to the market.

If the investors believe the signal, the firm’s share price ill increase and both shareholders and managers will benefit as well (the purpose of managers is to maximize shareholders’ wealth). Shareholders will benefit from capital gains, whereas managers will get more remuneration as some components of their remuneration are determined by the firm’s share price. 4. Why might managers choose accounting methods that reduce current Managers might choose accounting methods that reduce current period reported earnings in order to avoid political costs.

For example, high reported earnings can be seen by employees as the results of exploiting their labor, ND consequently they might lobby for increased salary through labor unions. Alternatively, managers might reduce current period reported earnings if high earnings are considered to be an indication of a mature industry, and the government might then remove tariff or subsidies that protect the industry.

Other reasons why managers might choose accounting methods that reduce current period reporting include: (a) to smooth income trends in a high profit year (saving this period to boost the next periods’ reported earnings) (b) to ‘take a bath’ by reducing profits this year in order to have higher profits next ear, when earnings might be sufficiently high to earn a performance-based bonus for the manager (c) to signal to shareholders that there are reduced earnings in the future (rather than have future profits suddenly slump, the signal might be gentler to shareholders) (d) to warn of bad news early so that management mitigates the likelihood that shareholders or others will litigate against them for misleading their investment or other decisions with high reported earnings. 5. What does it mean when researchers claim that for a signal to be credible, it must be ‘costly’ to replicate? Consider an example here accounting information is used for signaling purposes. Is the signal credible? What are the potential costs of replicating that accounting signal? For a signal to be credible, that signal must not be easily and costless replicated by other firms. A good example of credible signaling is when BP Billion announced their record profit of LOS$6. 4 billion in 2005, which is a strong signal of the firm’s future earning prospects (see Theory in Action 10. 3).

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