+ 3 functions of accounting: Contracting, Decision-making and Stewardship
+ Agency cost of debt: A problem arises from the conflict of interested created by the separation of management from ownership (the stockholders) in a publicly owned company. Because of different interests between shareholders and debtholders -> agency cost of debt.The agency costs of debt are: Management will use the debt to increase dividend payments to shareholders; borrow additional funds -> diluting the claim of the existing debt holders; use the funds for a purpose other than that stated (asset substitution); and NOT invest in a positive NPV project as all of the cash flow will flow to the debt holders (under investment).
Examples: + For example, managers may want to engage in risky actions they hope will benefit shareholders, who seek a high rate of return. Bondholders, who are typically interested in a safer investment, may want to place restrictions on the use of their money to reduce their risk. The costs resulting from these conflicts are known as the agency cost of debt. + Another example is about priority given to dividends. In their pursuit to please the shareholders, management may give cash dividends to shareholders, leaving very less to debt holders. To avoid this situation, there is a requirement that the interest must be paid before dividends.
+ Agency costs of equity:Problems arise due to the different interests between shareholders and management.Management may be tempted to take suboptimal decisions that may not work towards maximizing the value for the firm. The agency cost includes both, the cost due to the suboptimal decisions, and the cost incurred in monitoring the management to prevent them from taking these decisions. Management will not take on positive NPV (but risky) projects – as they are not as diversified as shareholders (risk aversion); and will not pay dividends to shareholders.
+ International Harmonisation:Aim of having all countries using the same reporting standard.- Argument for: + Lower cost to both company and investors (increase comparability and understandability)- Argument against: + Economic, political, cultural differences (one-size doesn’t fit all). Too expensive to transform.Lec 2: Revenue+ Management have incentives to manipulate profits for a variety of reasons, including:- To meet or beat analyst earnings forecasts- When issue new equity- Management compensation contract- To avoid breaching debt contract clauses
+ Why manipulate profit UPwards:- Reach bonus targets written into management compensation targets- Ensure earning increases, thus making it more likely share price will increase, which will positively impact the value of options or shares held- Ensure analyst earnings targets are reached- Ensure the company’s own public expectations of profit are reached- Reduce the likelihood of breaching a debt contract clause
+ Why manipulate profit DOWNward- Bonus targets written into management compensation targets have already been reached, and management are trying to “push” some profit into next year.- The company is about to head into wage negotiations with the labour unions, and are concerned that high profits may lead to increased wage claims.- The company is highly profitable, this leads to the introduction of a real cost
+ Example of manipulation that management may undertake:Examples include:- Capitalise expense items – lower current period expense thus increasing profits;- Bring forward revenue from a future period – increases current year revenues thus increasing profits;- Push revenue from current period to future period – lower current year profit but increases future profit;- Over‐provide for things like warranties – increases current period expense thus lowering profits; or- Under‐provide for things like warranties – decreases current period expense thus increasing profit.
Reasons include: (Why it is beneficial for management?)-…