CHAPTER 4 : AGENCY THEORY a. HOW FIRM CAN BE DESCRIBED AS A NEXUS OF CONTRACT Supplier *material *capital b.

*products *employees firm as nexus of contract consumer of product & service

CONTRACTING THEORY VS AGENCY THEORY CONTRACTING Firm as a legal nexus of contractual relationships btw suppliers & consumers Centralizes contracts betw suppliers & consumers. Reason firms existence: An efficient means of organizing economic activities Reduce contracting / transactions costs between suppliers & consumers in: employment contract debt contract supply of goods contract. Consumers could get products / services from firm @ cheaper price instead of producing @ high price AGENCY Contract which one party (principal) engages another party (agent) to perform services on principals behalf. principal delegates some decision-making authority to agent. Both parties are utility maximizer Agent may act from self-interest Instead maximizing principals interest, he / she maximize his / her interest by transferring wealth from shareholders to themselves Example manager (agent) has incentives to increase consumption of perquisites : Company car, use of company fund for personal benefits (travel)

c.

AGENCY COSTS SPENT TO OVERCOME AGENCY PROBLEM MONITORING COSTS cost of monitoring the agents behavior initially borne by the principal BUT passed on to the agent adjust remuneration (a.k.a price protection) eg: auditing cost cost adjusted based on performance example: manager + good performance little monitoring, high wages manager + poor performance high monitoring ,low wages BONDING COSTS cost borne by the agent they take action to align their interests with the principal interest guarantee agent to behave Example: Agent provide quarterly FS to principal rd He can manipulate FS & disclose info to 3 party BUT he doesnt do must align interest cost incurred by agent relates to bonding xtvt : less leisure time when need to produce more regular FS income foregone if he sell info to other high BC, reduce MC agent stop spending on BC when Margin BC = Margin MC Eg: (-$1 = $1 ) RESIDUAL LOSS loss associated when agents interest not able to fully align principal interest involve EX-POST SETTLING UP principal observe agent performance principle revise salaries ensure salaries = effort example: SHs decide agent are acting less than SHs interest less salaries do at the end of one period effective price protection for next period

d.

PROBLEM In the real world, price protection and settling up are not perfect or complete Agents perceive that they will not be fully penalised for their divergent behaviour DIVERGENCE PROBLEM They have incentives to act opportunistically This increases the residual loss This loss is borne by the principal as well as, or instead of, the agent

e.

HOW ACCOUNTING IS USED IN CONTRACTUAL SPECIFICATION TO REDUCE AGENCY COSTS Accounting can be used in contractual specification to align the interest between agent and principal & reduce agency cost. EXAMPLE: accounting number (profit level) can be used in employment contract as a basis for bonus payment. Gearing ratios can be used by lenders or banks that restrict the firms dividend and financing policy. HOW MANAGERS EX POST ACCOUNTING DECISION CAN TRANSFER WEALTH FROM SHAREHOLDERS TO MANAGERS After contractual terms have been specified and accepted by managers Managers have incentive to use accounting policy to show high profit Maximize own financial benefits at the expense of principals Example: Managers under provide PFDD Maximize reported profitManagers get higher bonus Reduce profit available to shareholders ECONOMIC CONSEQUENCE OF ACCOUNTING POLICY CHANGE Change in accounting policy choice has economic consequences. change the level of reported profit impact on the share price EMPIRICAL EVIDENCES ON THE CHOICE ACCOUNTING POLICY TO REDUCE POLITICAL COSTS Many studies have discovered that: Larger firms Choose income with decreasing accounting procedures attempt to become less visible avoid increased political costs. Firms with higher debt/equity ratios Choose income increasing accounting procedures avoid debt contract violation. Manager whose bonus compensation Choose income increasing procedures to maximise their benefits.

f.

g.

h. POLITICAL PROCESSES AND COSTS Firms are exposed to political cost either financially or in term of public perception or reputation Political costs result wealth transfer from firm to other parties (government, employees + community) Accounting profit is used as basis for political costs. EXAMPLE Employee ask higher salary, gov remove tariff / subsidies. Firms try to avoid public attention that is costly to them by: Reducing their reported profit / its volatility e.g : banking sector in Australia HOW ACCOUNTING CAN REDUCE POLITICAL COSTS Larger firms are expected to be more politically sensitive. To reduce political costs: Managers choose accounting procedures that defer accounting profit from current to future periods. Managers prefer accounting methods which reduce the variance of reported profits Volatile profits may attract political attention. Firm will use a poor financial situation to lobby increased in prices / charges / tariff protection.