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Contemporary Issues in Accounting, Special Topics in Accounting, MBA, University of Jordan
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  • 1. Solution Manual to accompany Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY: Michaela Rankin John Wiley & Sons Australia, Ltd 2012
  • 2. Chapter 5: Theories in accounting © John Wiley and Sons Australia, Ltd 2012 5.1 CHAPTER 5 THEORIES IN ACCOUNTING Contemporary Issue 5.1: News Corp reduces agency problems through executive remuneration plans 1. Both the horizon problem and risk aversion are agency problems that relate specifically to the relationship between owners and managers and which contracting can assist in overcoming. Explain these two problems. (K) Managers and owners have differing time horizons in relation to the entity. This is known as the horizon problem. Owners are interested in the long-term growth and value of the entity as the share value today reflects the present value of the expected future cash flows. As such, shareholders want managers to make decisions that enhance these future cash flows over the long term. Managers, on the other hand, are interested in the cash flow potential only as long as they expect to be employed by the entity. This is particularly an issue for managers who are approaching retirement. Managers who are seeking to move to another entity within the short term are also more likely to want to demonstrate the short-term profitability of the entity as evidence of effective management. Managers generally prefer less risk than shareholders. This is known as the risk aversion problem. Shareholders are not likely to hold all their resources as shares in one entity. They are able to diversity their risk through investing across multiple entities, cash or property investments. Shareholders may also receive regular income from other sources such as a personal salary from employment. As such, shareholders have ‘hedged’ or minimized the risk of one of these investments losing value. In addition, the liability of owners is limited to the amount they are required to pay for their shares. Managers, on the other hand, have more capital invested in the entity than shareholders through their ‘human capital’ or managerial expertise. It is likely that their remuneration is their primary source of income. As such, losing their job or being paid less can substantially impact on their personal wealth. Given higher risk has the potential to generate higher returns shareholders prefer managers to invest in higher risk projects. Conversely, managers wish to take less risk when deciding on projects for the entity because they have more to lose – they are more risk averse than owners.
  • 3. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 5.2 2. News Corp Ltd has recently introduced a new pay scheme to link executive pay to a range of performance measures, including share performance through ‘total shareholder return’. How does linking bonuses to share performance reduce the horizon problem and risk aversion? (J) Linking managerial bonuses to share performance by using a measure such as ‘total shareholder return’ encourages managers to focus on long-term performance because it is likely to affect their own wealth. Tying a greater proportion of managerial pay to share price movements as the manager approaches retirement is also likely to encourage managers to maximise long-term performance and to more closely align managerial time horizon with that of owners. Paying managers a cash bonus based on measures of share performance encourages managers to invest in potentially more risky projects that are likely to maximise the performance of the entity into the future. 3. Why is it important to link executive bonuses to a range of entity performance measures rather than one, as was previously the case with News Corp? (J) Linking executive bonuses to a range of entity performance measures plays two main roles. First, it encourages managers to consider different aspects of the entity’s performance – both short and long term – that will lead to an overall strengthening of the entity, and be more likely to lead to longer-term increases in firm and shareholder value. If managerial pay is tied to only one measure, such as profits, it will encourage managers to take a short-term focus and to engage in activities that might benefit the organization in the current year, but are less likely to be beneficial over the longer term. It might also encourage managers to use accounting methods, such as accruals management, to maximise profits in the current year rather than future periods. Second, given managers bear a large amount of risk, through their human capital investment in the organization, and it is likely to be their main source of income, it is more beneficial for managers to have their pay linked to a range of performance measures. If the company performs poorly on one measure in a year and managers do not meet targets for that performance target, for example profit, they are still likely to receive a bonus based on other measures of performance where targets were met. Contemporary Issue 5.2: Banksbreaching an impliedsocial contract 1. What is a ‘social contract’? (K) The term ‘social contract’ has often been used to describe how business interacts with society. It relates to the explicit and implicit expectations society has about how entities should act to ensure they survive into the future. A social contract is not necessarily a written agreement, but is what we understand society expects of entities. Some expectations could be explicit (legislation relating to pollution or employee health and safety are examples), while others are implicit. Evidence of implicit terms
  • 4. Chapter 5: Theories in accounting © John Wiley and Sons Australia, Ltd 2012 5.3 of the social contract can be gained from communications and writing of a society at a point in time. Media attention to high executive bonus payments when share prices are declining could be an example of the degree of public importance placed on these issues, and therefore an implied component of a social contract. 2. What do you think might be the implied terms of the social contract between banks and customers with respect to interest rates and charges? (J) While there is no explicit contractual responsibility of banks to pass on interest rate cuts announced by the Reserve Bank, there is an implicit expectation, as part of ‘social contract’ between banks and society, including customers, that banks do so. Some implied terms of the social contract between banks and customers might include (but are not limited to) the following:  When banks receive rate cuts from the Reserve Bank they will be passed on to customers in a timely manner so that banks benefit from rate cuts to a greater extent than their customers  Any interest rate cuts will be passed on in full so the bank does not benefit more than customers from any federal rate cuts  Banks are expected to charge for customers in a realistic manner, and not penalize customers unduly for services  Banks are expected to provide services to customers and not penalize those living in remote or rural areas
  • 5. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 5.4 Review Questions 1. Differentiate a normative theory from a positive theory. Provide an example of each. Normative theories provide recommendations about what should happen. They prescribe what ought to be the case based on a specific goal or objective. It is not based upon what is happening in the world, but on what should be the case given the objective upon which it is based. A positive theory, on the other hand, describes, explains or predicts activities. Positive theories can help us to understand what is happening in the world, and why organisations act the way they do. As such they rely on real world observations. 2. Explain what an agency relationship is, and explain the following costs: monitoring costs, bonding costs, residual loss. An agency relationship is one where a person, or group of persons – known as the principal – employs the services of another – referred to as the agent – to perform some activity on their behalf. In doing so the principal delegates the decision making authority to the agent. Monitoring costs are incurred by the principal, and relate to measuring, observing and controlling the agent’s behavior. They could include audit of financial reports, putting in place rules, or costs incurred to set up a management compensation plan. Bonding costs are costs incurred by managers in an attempt to provide some assurance that they are making decisions in the best interest of principals. Residual loss refers to the additional divergence between agents and principals that can’t be contracted for, or cannot be monitored in its entirety. It is likely to be too costly to guarantee an agent will make decisions optimal to the principal at all times and in all circumstances. 3. Why would managers’ interests differ from those of shareholders? Managers’ interests might differ from owners for a number of reasons, given both managers (agents) and owners (principals) are assumed to act in their own interest, and these actions might not necessarily align. Agency theory points to three main problems which highlight differences between interests of managers and owners: the horizon problem (managers and owners have differing time horizons in relation to the entity); risk aversion (managers generally prefer less risk than shareholders); and dividend retention (managers prefer to maintain a greater level of funds within the entity, and pay less of the firm’s earnings to shareholders as dividends).
  • 6. Chapter 5: Theories in accounting © John Wiley and Sons Australia, Ltd 2012 5.5 4. Outline the three agency problems that exist in the relationship between owners and managers. The three main agency problems that exist in the relationship between owners and managers are: the horizon problem; risk aversion; and dividend retention. The horizon problem exists because managers and owners have differing time horizons in relation to the entity. Shareholders have an interest in the long-term growth and value of the entity as the share value of the entity today reflects the present value of the expected future cash flows over the long-term. Managers, on the other hand, are interested in the cash flow potential only as long as they expect to be employed by the entity. Risk aversion refers to the fact that managers generally prefer less risk than shareholders. Owners diversify their risk through investing across multiple entities, and are also likely to receive income from other sources. Managers have a large amount of ‘human capital’ tied up in the entity and rely on the entity as their main source of income. As such they are likely to be more risk averse than owners, and are less likely to want to invest in risky projects. Managers prefer to maintain a greater level of funds within the entity, and pay less of the firm’s earnings to shareholders as dividends. This is referred to as dividend retention. Managers wish to expand the business they control, whereas shareholders wish to maximize the return on their investment in the entity through increased dividends. 5. Outline the four agency problems that exist in the relationship between lenders and managers. The four agency problems that exist in the relationship between lenders and managers are: excessive dividend payments; underinvestment; asset substitution; and claim dilution. When lending funds, lenders price debt to take account of an assumed level of dividend payout. Excessive dividend payments, while good for shareholders, could lead to a reduced asset base securing the debt or leave insufficient funds in the entity to service the debt. Underinvestment arises when managers, on behalf of owners, have incentives not to undertake positive NPV projects if the projects could lead to increased funds being available to lenders. This might particularly be the case when the entity is in financial difficulty. Given creditors rank above owners in order of payments in the event of liquidation, any funds form these projects would go towards debt rather than equity. Managers have incentives to use debt finance to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns to shareholders. This is referred to as asset substitution. Lenders bear the risk of this strategy as they are subject to the ‘downside’ risk of this strategy but do not share in any ‘upside’ returns.
  • 7. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 5.6 When entities take on debt of a higher priority than that on issue it is referred to a claim dilution. While taking on additional debt increased funds available to the entity, it decreases security to lenders, making lending more risky. 6. What is a debt covenant and why is it used in lending agreements? A debt covenant is a restriction or a term included in a debt contract that is designed to protect the interests of lenders. They could include things such as a dividend payout ratio, working capital ratio, leverage ratios, or the restriction of the borrowing of higher priority debt. 7. Why would managers agree to enter into lending agreements that incorporate covenants? As a result of agreeing to the terms of debt covenants managers are able to borrow funds at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods of time. 8. What role does accounting information play in reducing agency problems? Accounting information plays two roles in reducing agency problems. The first is where the terms of managerial compensation or lending agreements are written in terms of accounting information; and the second is where accounting information is used to determine performance against the terms of the contracts. 9. How might institutional theory explain accounting disclosures? Institutional theory is used to understand the influences of organizational structures such as rules, norms and guidelines. Accounting disclosures are likely to be a way of demonstrating corporate legitimacy by disclosing how the organization is meeting the expectations of these rules, norms and guidelines. 10. What is a social contract and how does it relate to organisational legitimacy? A social contract is used to describe how business interacts with society. It relates to the explicit and implicit expectations society has about how businesses should act to ensure they survive into the future. A social contract is not necessarily a written agreement, but is what we understand society expects. While the relationship between society and business is explained by the social contract, organizational legitimacy describes the state in which an organization has met the terms of the social contract. It explains the process by which the terms of a social contract is gained or maintained.
  • 8. Chapter 5: Theories in accounting © John Wiley and Sons Australia, Ltd 2012 5.7 11. How can corporate disclosure policy be used to maintain or regain organisational legitimacy? Four ways an organization can obtain or maintain legitimacy have been identified in the academic literature: (a) Seek to educate and inform society about actual changes in the organisation’s performance and activities (b) Seek to change the perceptions of society, but not actually change behavior (c) Seek to manipulate perception by deflecting attention from the issue of concern to other related issues (d) Seek to change expectations of its performance Disclosure can be used as a technique in each of these strategies. An entity might provide information to offset negative news that may be publicly available. They could also use disclosure to draw attention to strengths or to down play information about negative activities. Disclosure can also be used to advertise actual changes in performance or activities. 12. Why would managers decide to voluntarily disclose environmental performance information in an annual report? Public reporting of information that is not mandated, such as details of environmental performance is a powerful tool in showing an organization is meeting the expectations of society, and therefore maintaining organizational legitimacy. This can be used to draw attention to the company’s strengths, and to play down any weaknesses. 13. There are two branches of stakeholder theory. How do they differ? The two versions of stakeholder theory are: a normative theory, known as the ‘ethical branch’ and an empirical theory of management. The normative branch of stakeholder theory relates to the ethical or moral treatment of organizational stakeholders. It is argued that organization should treat all stakeholders fairly, and the organization should be managed for the benefit of all stakeholders. The managerial branch of stakeholder theory is a positive theory that seeks to explain how stakeholders might influence organizational action. Rather than considering each stakeholder as equal (as is the case under the normative branch), the managerial branch proposes that the extent to which an organization will consider its stakeholders is related to the power or influence of those stakeholders, with executives managing these competing interests. 14. The managerial branch of stakeholder theory proposes that stakeholder power will affect the extent to which an entity meets the stakeholders’ needs and expectations. Identify two stakeholder groups and outline how they might have ‘power’ relating to an organisation’s activities.
  • 9. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 5.8 Any two of the following organizational stakeholders can be identified and discussed:  Investors/owners – investors, and particularly institutional investors have power through the provision of equity funds, and their role in appointing the board of directors. Some investors will have more power or influence than others, and this is likely to be related to the extent of their shareholding in the organization.  Political groups – these groups can incorporate community groups, lobby groups and shareholder associations amongst others. Their power lies in their ability to influence the operations of the organization with respect to their area of influence. For instance environmental lobby groups can influence public opinion about an entity’s environmental performance, so the entity needs to ensure they manage this relationship.  Customers – these are major providers of cash funds to the entity. In many industries meeting consumer needs is the driving force behind the organization, and it will find it difficult to operate successfully without the source of customers.  Communities – some companies have a major impact on local communities. A specific example is the mining sector where towns and the communities which live there are significantly impacted by the organization, and the entity is reliant on local communities for support including labour, services and other resources. In these circumstances community groups can be seen as powerful parties, as it is important for entities to ensure a close working relationship.  Employees – as the suppliers of one major resource to companies – labour – employees are important to the smooth operation of the entity. Issues with employee conditions can significantly affect this supply of labour and therefore the continuous operation of the entity.  Governments – government at all levels have a significant amount of power over the operations of entities through legislation that impacts on operations. This can relate to corporations legislation, legislation that dictates taxes, fees, tariffs and allowances
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