Read Accounting Headline 7.9 and, adopting a Positive Accounting Theory perspective, consider the following issues:

a)If a new accounting standard impacts on profits, should this impact on the value of the firm, and if so, why?

b)Will the imposition of a particular accounting method have implications for the ability of the organization to efficiently provide information about its performance?

Foster's: less goodwill, higher earnings ANTHONY HUGHES The challenges facing investors seeking a true picture of a company's earnings during the impending prot reporting season were underlined again on Friday when Foster's agged it would report a $1.2 billion reduction in net assets under new accounting standards. The transition to international nancial reporting standards ([FRS) means Foster's net assets will fall from $4.6 billion to $3.37 billion based on its last reported balance sheet, mainly as a result of the internally generated goodwill on brand names not being recognised. The other major contributor to the reduction is the requirement to allow for deferred tax liabilities based on the difference between the carrying value of assets and their cost base. Despite scepn'cism about the likely success of Foster's recent $3 billion acquisition of winemaker Southcorp and Foster's ability to extract sufcient merger synergies, the changes to the reported accounts do not relate to any issues with that acquisition. The brewing and winernaking group told analysts the balance sheet adjustments wouldn't affect its cash ows or ability to pay dividends. removal or gooowui amornsanon charges. Under the standards, goodwill is instead subject to an annual 'impairment test', with the elimination of amortisation expenses boosting reported prots. If the new standards were applied to Foster's half-year accounts to December 31, 2004, the company would have made a net prot of $783.2 million versus the $757 million reported. The reduced asset base reported by companies such as Foster's will also mean they will report more favourable returns on these written-down asset values. The transition to new standards has raised concerns that companies will announce potentially misleading prot numbers and will be reluctant to predict future prots because of the uncertainty around some aspects of the standards. There is also concern about how credit ratings agencies will react to such wild swings in balance sheet values. But the adoption of the standards will make it easier for investment analysts to compare companies to their global peers. In Foster's case, this means investment analysts will be able to better discern whether it is outperforming or underperforming global wine and brewing peers such as Diageo and Pernod Ricard. ABN Amro Asset Management's Mark Nathan said: 'It differs by company and industry. There will be some concern over whether the new standards result in a less realistic portrayal of what's happening than the current Australian standards, but by and large it's an improvement.' However, Goldman Sachs JBWere said in a note to clients that given the shortened period in which companies must now report their results, the new standards 'would only add to the data overload during the last two to three weeks of August'. Foster's closed 2 higher at $5.46. Accounting Headline 7.9 Foster's: less goodwill, higher earnings ANTHONY HUGHES The challenges facing investors seeking a true picture of a company's earnings during the impending prot reporting season were underlined again on Friday when Foster's agged it would report a $1.2 billion reduction in net assets under new accounting standards. The transition to international nancial reporting standards (IFRS) means Foster's net assets will fall from $4.6 billion to $3.37 billion based on its last reported balance sheet, mainly as a result of the internally generated goodwill on brand names not being recognised. The other major contributor to the reduction is the requirement to allow for deferred tax liabilities based on the di'erence between the carrying value of assets and their cost base. Despite scepticism about the likely success of Foster's recent $3 billion acquisition of winemaker Southcorp and Foster's ability to extract sufcient merger synergies, the changes to the reported accounts do not relate to any issues with that acquisition. The brewing and winemaking group told analysts the balance sheet adjustments wouldn't affect its cash ows or ability to pay dividends. But reported prots will be higher than they otherwise would be because of the removal of goodwill amortisation charges. Under the standards, goodwill is instead subject to an annual 'impairment test', with the elimination of amortisation expenses boosting reported prots, If the new standards were applied to Foster's half- year accounts to December 31, 2004, the company would have made a net prot of $783.2 million versus the $757 million reported The reduced asset base reported by companies such as Foster's will also mean they will report more favourable returns on these written-down asset values. The transition to new standards has raised concerns that companies will announce potentially misleading prot numbers and will be reluctant to predict iture prots because of the uncertainty around some aspects of the standards. There is also concern about how credit ratings agencies will react to such wild swings in balance sheet values. But the adoption of the standards will make it easier for investment analysts to compare companies to their global peers. In Foster's case, this means investment analysts will be able to better discern whether it is outperforming or underperforming global wine and brewing peers such as Diageo and Pernod Ricard. ABN Amro Asset Management's Mark Nathan said: 'It diifers by company and industry. There will be some concern over whether the new standards result in a less realistic portrayal of what's happening than the current Australian standards, but by and large it's an improvement.' However, Goldman Sachs JBWere said in a note to clients that given the shortened period in which companies must now report their results, the new standards 'would only add to the data overload during the last two to three weeks of August'. Foster's closed 2 higher at $5.46. OWNERMANAGER CONTRACTING 7.7 7.8 7.11 7.12 7.13 If the manager owned the rm, then rat manager would bear the costs associated with his or her own perquisite consumption. Perquisite consumption could include consumption of the fnrn's resources for private purposes (for example, the manager may acquire an overly expensive company car, acquire overly luxurious oices, stay in overly expensive hotel accommodation) or the excessive generation and use of idle time, As the percentage ownership held by the manager decreases, that manager begins to bear less of the cost of his or her own perquisite consutrrption. The costs begin to be absorbed by the other owners of the rm. As noted previously, PAT adopts as a central assumption rat all action by individuals is driven by self-interest, and that the major interest of individuals is to maximise their own wealth. Such an assumption is oen referred to as the 'rational economic person' assumption. If all individuals are assumed to act in their own self-interest, then owners would expect the managers (their agents) to undertake activities that may not always be in the interest of the owners (the principals). Further, because of their position within the rm, the managers will have access to information not available to the principals (this problem is frequently referred to as information asymmetry) and this may further increase managers' ability to undertake actions benecial to themselves at the expense of the owners. The costs of the divergent behaviour that arises as a result of the agency relationship (that is, the relationship between the principal and the agent appointed to perform duties on behalf of the principal) are, as indicated previously, referred to as agency costs (Jensen & Meckling, 1976). It is assumed in PAT that the principals hold expectations that their agents will undertake activities that may be disadvantageous to the value of the rm, and the principals will price this into the amounts they are prepared to pay the manager. That is, in the absence of controls to reduce the ability of the manager to act opportunistically, the principals expect such actions and, as a result, will pay the manager a lower salary. That is, the principals will price protect. This lower salary compensates the principals for the expected opportunistic behaviour of the agents. The manager will therefore bear some of the costs of the potential opportunistic behaviours (the agency costs) that they may, or may not, undertake. If it is expected that managers would derive greater satisfaction from additional salary man from the perquisites that they will be predicted to consume, then managers may be better off if they are able to commit themselves contractually not to consume perquisites. That is, they commit or bond themselves contractually to reducing their set of available actions (some of which would not be benecial to owners). Of course, the owners of the rm would need to ensure that any contractual commitments can be monitored for compliance before agreeing to increase the amounts paid to the managers. In a market where individuals are perfectly informed, it could be assumed that managers would ultimately bear the costs associated with the bonding and monitoring mechanisms (Jensen & Meelding, 1976). However, markets are typically not perfectly informed. Managers may be rewarded on a xed basis (that is, a set salary independent of performance), on the basis of the results achieved, or on a combination of the two. If the manager was rewarded purely on a xed basis, then, assuming self-interest, that manager would not want to take great risks as he or she would not share in any potential gains. There would also be limited incentives for the manager to adopt strategies that increase the value of the rm (unlike equity owners whose share of the rm may increase in value). Like debtholders, managers with a xed claim would want to protect their xed income Stream, Apart from rejecting risky projects, which may be benecial to those with equity in the rm, re manager with a xed income stream may also be reluctant to take on optimal levels of debt, as the claims of the debtholders would compete with the manager's own fixed income claim. 292 Assuming that selfinterest drives the actions of the managers, it may be necessary to put in place remuneration schemes that reward the managers in a way that is, at least in part, tied to the performance of the rm. This will be in the interest of the manager, as that manager will potentially receive geater rewards and will not have to bear the costs of the perceived opportunistic behaviours (which may not have been undertaken anyway). If the performance of the rm improves, the rewards paid to the manager correspondingly increase. Bonus schemes tied to the performance of the rm will be put in place to align the interests of the owners and the managers. If the rm performs well, both parties will benet. BONUS SCHEMES GENERALLY It is common practice for managers to be rewarded in a way that is tied to the prots of the rm, the sales of the rm, or the return on assets, that is, for their remuneration to be based on the output of the accounting system. It is also common for managers to be rewarded in line with the market price of the rm's shares. This may be through holding an equity interest in the rm, or perhaps by receiving a cash bonus explicitly tied to movements in the market value of the rm's securities. Deegan (1997) lists some of the accounting performance measures used in Australia as a basis for rewarding managers: 0 percentage of alter-tax prots of the last year a percentage of altertax prots aer adjustment for dividends paid 0 percentage of pre-tax prots of the last year 0 percentage of division's prot for the last year 0 percentage of division's sales for the last year 0 percentage of the last year's accounting rate of return on assets I percentage of previous year's division's sales, plus percentage of rm's aertax prots I percentage of previous year's division's sales, plus percentage of division's pretax prots 0 percentage of previous two years' division's sales, plus percentage of last two years' division's pre-tax prot 0 percentage of previous year's rm's sales, plus a percentage of rm's altertax prot 0 average of pre-tax prot for the last two years I average of pretax prot for the last three years I percentage of the last six months' prot aer tax. ACCOU NTING-BASED BONUS PLANS As indicated above, the use of accountingbased bonus schemes is quite common. In considering their use in the United States, Bushman and Smith (2001, p. 250) state: The extensive and explicit use of accounting numbers in top executive compensation plans at publicly traded firms in the Us is well documented. Murphy (1999) reports data from a survey conducted by Towers Perrin in 199619971 The survey contains detailed information on the annual bonus plans for 177 publicly traded US companies. Murphy reports that 161 of the 177 sample firms explicitly use at least one measure of accounting profits in their annual bonus plans 01 the 68 companies in the survey that use a single performance measure in their annual bonus plan, 65 use a measure of accounting profits While the accounting measure used is often the dollar value of profits, Murphy also reports common use of profits on a per~share basis, as a margin, return, or expressed as a growth rate lttner, Larker and Flaian (1997), using proxy statements and proprietary survey data, collect detailed performance measure information for the annual bonus plans of 317 US. firms for the 19931994 time periods The firms are drawn from 48 different two~digit SIC codes lttner, Larker and Rajan document that 312 of the 317 firms report using at least one financial measure in their annual plansr Earnings per share, net income and operating income are the most common financial measure, each being used by more than a quarter of the sample 293 Given that the amounts paid to the manager may be directly tied to accounting numbers (such as prots/sales/assets), any changes in the accounting methods being used by the organisation will affect the bonuses paid (unless the bonuses have been explicitly tied to the accounting numbers that would be derived from the use of the accounting methods in place when the bonus schemes were originally negotiatedthis is sometimes referred to as using 'frozen GAAl\").36 Such a change may occur as a result of a new accounting standard being issued. For example, IAS 138 Intangible Assets (released in Australia in 2004 as AASB 138) permits some development (but not research) expenditure to be capitalised as an intangible asset in certain circumstances. Consider the consequences if a new rule was issued that required all research and development expenditure to be written off. With such a change, prots for some rms that previously capitalised development expenditure could decline, and the bonuses paid to managers may also change. If it is accepted, consistent with classical nance theory, that the value of the rm is a function of the future cash ows of the rm, then the value of the organisation may change (perhaps because less expenditure will be incurred in relation to development). Hence, once we consider the contractual arrangements within a rm, Positive Accounting theorists would argue that we can start to appreciate that a change in accounting method can lead to a change in cash ows, and hence a change in the value of the organisation (because, as has already been emphasised, the value of an organisation is considered to relate directly to expectations about the present value of the organisation's future cash ows). This perspective is contrary to the views of early proponents of the EMH who argued that changes in accounting methods would not impact on share prices unless they had direct implications for expenses such as taxation. As a recent case in point, we can speculate on how the adoption of IAS 38 Intangible Assets (or, within Australia, AASB 138) in some countries (among other things, this standard requires that all research expenditure be expensed as incurred) will impact on the research and development activities of various organisations. For example, subject to certain requirements, Australian, New Zealand, French and Scandinavian listed companies could, prior to 2005, capitalise research expenditure. With the adoption of International Financial Reporting Standards (IFRS) from 2005, this is no longer permitted and all research expenditure must be expensed as incurred (subject to certain requirements, development expenditure can be capitalised). As a result, there might be some expectation that the accounting standard will impact on the amount of research being conducted by some rms in those countries. With specic reference to the 'bonus hypothesis', there could be an expectation that if a manager is being paid a bonus tied to accounting prots, and given the 'harsh' treatment required in relation to research expenditure ('harsh' because it has to be written off as incurred), the existence of a management bonus may motivate managers to reduce the level of research expenditure, thereby increasing the size of their bonus. Such a strategy of reducing research expenditure might be even greater the closer the manager is to retirementthe reason for this being rat the time lag between the research expenditure and the subsequent economic benets might be longer than the period until the manager retires (we will return to this 'horizon problem' shortly). Through the related impacts on cash ows, such a change in research activity in turn can be expected to impact on the value of the reporting entities' equity (share price). This example demonstrates how a change in an accounting standard can have real implications for an organisation's share price, of course, it is possible that the bonus may be based on the 'old' accounting rules in place at re time the remuneration contract was negotiated (perhaps through a clause in the management compensation contract) such that a change in generally accepted accounting principles will not impact on the bonus, but this will not always be the case. Contracts that rely on accounting numbers may rely on 'oating' 294 generally accepted accounting principles. This would suggest that should an accounting rule change, and should it affect an item used within a contract negotiated by the rm, the value of the rm (through changes in related cash ows) might consequently change. PAT would suggest that if a change in accounting policy had no impact on the cash ows of the rm, men a rm would be indifferent to the change. In explaining the use of accountingbased bonus schemes, Emanuel, Wong and Wong (2003, p. 155) state: Accounting earnings are often used to calculate the manager's payoff (Smith and Watts, 1962; Healy, 1965; Sloan, 1993) because it is a more efficient measure of the manager's performance than other measures such as stock prices and realised cash flows. There are two reasons torthis. First, stock prices are influenced more by market factors that are outside the control of management and, hence, are less effective in isolating that part of performance that results from the manager's actions (Sloan, 1993). Secondly, realised cash flows do not take into account the manager's actions at the time those actions are put in place to increase the value of the firm. Hence, realised cash flows do not provide a timely measure of the effect of the manager's actions on firm performance, especially when performance is measured over short intervals (Dechow, 1994). Further, accounting earnings possess a variety of desirable characteristics that other performance measures do not have, including objectivity, reliability, verifiability and conservatism (Watts and Zimmerman, 1986, pp. 205207). Since accounting earnings are efficient in measuring firm performance, they play an important role in determining the reward and punishment of performance. We observe the existence of eamings~based bonus plans that provide an efficient means of aligning the manager's and shareholders' interests so that the manager does not participate in activities that are opportunistic, because such actions detract from firm value maximisation. To the extent that earnings are a good measure of future cash flows and all things else are constant, higher earnings lead to higher firm value and more compensation to the manager. Besides compensation, accounting performance measures affect other rewards and punishments of the firm's employees, such as continued employment and promotion (Blackwell et al. 1994). INCENTIVES TO MANIPULATE ACCOUNTING NUMBERS In considering the costs of implementing incentive schemes based on accounting output, there is a possibility that rewarding managers on the basis of accounting prots may induce them to manipulate the related accounting numbers to improve their apparent performance and, importantly, their related rewards (the opportunistic perspective). That is, accounting prots may not always provide an unbiased measure of rm performance or value. Healy (1985) provides an illustration of when managers may choose to manipulate accounting numbers opportunistically due to the presence of accounting-based bonus schemes. He found that when schemes existed that rewarded managers acr a prespecied level of earnings had been reached, the managers would adopt accounting methods consistent with maximising that bonus. In situations where the prots were not expected to reach the minimum level required by the bonus plan, the managers appeared to adopt strategies that rrther reduced income in that period (frequently referred to as 'taking a bath') but would lead to higher income in subsequent periodsperiods when the prots may be above the required threshold for the bonus to be paid. As an example, the manager may write off an asset in one period, when a bonus was not going to be earned anyway, such that there would be nothing further to depreciate in future periods when protrelated bonuses may be paid?7 295 Investment strategies that maximise the present value of the rm's resources will not necessarily produce uniform periodic cash ows or accounting prots. It is possible that some strategies may generate minimal accounting returns in early years, yet still represent the best alternatives available to the rm, Rewarding managers on the basis of accounting prots may discourage them from adopting such strategies. That is, it may encourage management to adopt a short-term, as opposed to a longterm, focus. In Lewellen, loderer and Martin (1987) it was shown that US managers approaching retirement were less likely to undertake research and development expenditure if their rewards were based on accounting-based performance measures such as prots. This was explained on the basis that all research and development had to be written off as incurred pursuant to US accounting standards, and hence undertaking research and development would lead directly to a reduction in prots. Although the research and development expenditure would be expected to lead to benets in subsequent years, the retiring managers might not have been there to share in the gains. That is, the employment horizon of the manager is short relative to the 'horizon' relating to the continuation of the organisation (which might be assumed to be indenite). This difference in 'horizons' is often referred to as an 'horizon problem'. Hence, the self-interested manager who was rewarded on the basis of accounting prots was predicted not to undertake research and development in the periods close to the point of retirement because the manager would not share in any associated gains. This may, of course, have been detrimental to the ongoing operations (and value) of the business, In such a case it would have been advisable from an efficiency perspective for an organisation that incurred research and development expenditure to take retiring managers o\" a protshare bonus scheme, or alternatively to calculate 'prots' for the purpose of the plan aer adjusting for research and development expenditures. Alternatively, managers approaching retirement could have been rewarded in terms of marketbased schemes that are tied to the long-term performance of the organisation. For example, perhaps the manager of a company involved in research and development, and who is expected to retire in the near future, should be allocated options to buy shares in the company (share options) that cannot be exercised for, say, three or four years after he or she retires. In rat way, the manager would be encouraged to put in place projects that would be successful after he or she leaves the organisation. ACCOU NTING-BASED BONUS SCHEMES THAT RELY UPON CONSERVATIVE ACCOUNTING PRACTICES Conservative accounting policies are those methods that tend to delay the recognition of revenue, accelerate the recognition of expenses, and lead to lower asset and higher liability recogrition. For example, measuring assets at cost (or recoverable amount if it is lower) would be considered as a conservative accounting method relative to measuring the assets at fair value. If assets are measured at the lower of cost or recoverable amount then this means that increases in fair value would not be recognised (keeping asset values lower), but if there is a decrease in value then a reduction in assets, and a consequent expense, would be recognised. By contrast, the use of fair values is more asymmetric with equal consideration given to both increases and decreases in fair value. The use of fair values also provides management with some discretion in determining fair values, particularly if the values are determined by use of a valuation model rather than on the basis of quoted prices in active markets. It has generally been argued in the literature that potential conicts of interest between agents and principals are better managed when conservative accounting methods are used as they restrict the ability of the managers (agents) to opportunistically use income and net asset increasing accounting methods. As Iyengar and Zampelli (2010, p. 138) state: Accounting conservatism is critical to the alignment of the interests of managers and shareholders Consen/ative accounting practices can afford firms an opportunity to use incentive pay effectively to 296 increase firm value while lowering the probability of managerial opportunisml In its absence, the use of performance incentives in managerial and executive compensation contracts is fraught with the risks of managerial opportunism, aggressive accounting, the overstatemenl of the financial performance affirms, and the diminishment of the integrity and information content of financial reporting We will return to the issue of conservative accounting policies later in this chapter when we consider and evaluate the implications for contracting parties of the current eorts by the IASB and FASB to increase the use of fair value accounting, MARKET-BASED BONUS SCHEMES Firms involved in industries such as mining, or hightechnology research and development, may have accounting earnings that uctuate greatly. Successful strategies may be put in place that will not provide accounting earnings for a number of periods. In such industries, Positive Accounting theorists may argue that it is more appropriate to reward the manager in terms of the market value of the rm's securities, which are assumed to be inuenced by expectations about the net present value of expected future cash ows. This may be done either by basing a cash bonus on any increases in share prices or by providing the manager with shares or options to shares in the rm. If the value of the rm's shares increases, both the manager and the owners will benet (their interests will be aligned). lmportantly, the manager will be given an incentive to increase the value of the rm. In a survey of Australian managers, Deegan (1997) provides evidence that 21 per cent of the managers surveyed held shares in their employer. As already indicated, offering managers incentives that are tied to accounting prots might have the adverse effect of inducing them to undertake actions that are not in the interests of shareholders. This might particularly be the case in relation to expenditure on research and development. As already explained, within the United States all research and development is required to be expensed as incurred, and hence there is an immediate downward impact on prots when a rm undertakes research and development.38 Apart from the initial impacts on prots, there is also evidence that capital markets frequently do not put a great amount of value on research and development expenditure because of the many uncertainties inherent in such expenditure (Kothari et al., 2002; Lev & Sougiannis, 1996)that is, the market is considered to undervalue the benets attributable to research and development. In relation to the personal motivations of chief executive officers (CEOs) in the United States, Cheng (2004, p. 307) states: CEOs consider the benefits and costs of RED spending, and [consistent with the maintained assumption of self~interest] they invest in R&D only when the expected personal benefits dominate the personal costs. Their expected costs of R&D spending include the negative impact of R&D spending on shortvterm accounting and stock performance, since these measures affect CEO compensation and job security (Dechow and Skinner 2000; Murphy 1999). The negative impact of R&D spending on current accounting earnings is due to the fact that R&D spending is typically immediately expensed under US GAAP. Therefore, CEOs who want to boost current accounting earnings have incentives to reduce R&D spending (e.g., Baber et al., 1991; Dechow and Sloan 1991). In addition, CEOs may consider R&D investments as less desirable than other investments in terms of the impact of the investments on shortvtenn stock prices [because of the tendency of capital markets to undervalue R&D expenditures]. Relative to other investments, R&D projects are associated with higher information asymmetry between managers and shareholders (e.g., Clinch, 1991) and greater uncertainty of the future benefits (e.g., Chan et al., 2001; Kothari et al., 2002). As a result, current stock prices likely do not fully reflect the future benefits of R&D spending (Lev and Sougiannis 297 1996). Therefore, CEOs concerned with short-term stock prices may reduce R&D spending to increase other investments with benefits more fully (or better) reflected in current stock prices. These impacts are heightened as the manager approaches retirement. As Cheng (2004, p. 308) statcs: CEOs are concerned with short-term accounting and stock performance, and these concerns generate incentives for CEOs to reduce R&D spending. Such incentives become stronger when CEOs approach retirement or face earnings shortfalls (Baber et al. 1991; Dechow and Sloan 1991). As the CEO approaches retirement, it is less likely for the CEO to benefit from current R&D investments. Meanwhile, the CEO's career concern diminishes, and the CEO becomes more short-term oriented (Gibbons and Murphy 1992) due to weakened concern about the discipline from the managerial labor markets. Likewise, when facing deteriorating economic performance, the CEO is more concerned with the expected personal costs of R&D spending, since poor performance may trigger such results as job termination and corporate takeover, which may disentitle the CEO to the future of current FtD spending. Thus CEOs have incentives to reduce R&D spending in order to reverse a poor performance, especially if an expected shortfall is small and thus more easily reversed. Given that there would conceivably be incentives for senior management to reduce spending on research and development (particularly if managers are offered bonuses tied to accounting prot), it is perhaps predictable that additional contractual agreements might be put in place to reduce this motivation to reduce research and development. One approach would be to have those people who are responsible for determining senior management salaries (often done by way of a compensation committee that is established within the organisation and on which nonmanagerial directors oen serve) specically adjust the salaries in such a way that the salary is directly tied to research and development activity. As Cheng (2004, p. 308) states: When CEO incentives to reduce R&D spending become stronger, compensation committees may adjust CEO compensation arrangements to mitigate such incentives. This adjustment should affect CEOs' consideration of the expected personal benefits and expected personal costs of R&D spending in favour of R&D expenditures One possible adjustment is to establish a greater positive association between changes in R&D spending and changes in CEO compensation. Such a greater association makes increasing R&D spending more beneficial to the CEO, and reducing R&D spending more costly to the CEO. The results of research by/a study by Chcng (2004) indicate that compensation committees do often establish a link between changes in research and development spending and changes in CEOs' total compensation. Further, the compensation being offered to the retiring managers is ocn by way of the provision of share options. Granting share options increases the longer term focus of the managers, thereby further motivating them to embrace optimal levels of research and development activity.39 In considering the use of share options, and as with accountingbased bonus schemes, there are also problems associated with the manager being rewarded in ways that are inuenced by share price movements. First, the share price will be affected not only by factors controlled by the manager but also by outside, market-wide factors. That is, share prices may provide a 'noisy' measure of management performancenoisy in the sense that they are aectcd not only by the actions of management but also largely by general market movements over which the manager has no control. Further, only the senior managers would be likely to have a signicant effect on the cash ows of the rm and hence the value of the rm's securities. Therefore, market-related incentives may be appropriate only for senior management. Offering shares to lower-level management may be dcmotivational, as their own individual 298 actions would have little likelihood (relative to senior management) of impacting on share prices and therefore their personal wealth. Consistent with this, it is more common for senior managers than other employees to hold shares in their employer. Within the Dccgan (1997) sample, 35 per cent of the senior management, 16 per cent of the middle management and 6 per cent of the lower management hold shares in their employer. However, if managers hold share options, then this has also been argued to potentially inuence whether they engage in opportunistic earnings management (as is the case if managers are offered accountingbased management bonuses). In this regard, Bartov and Mohanram (2004) reviewed a sample of 1218 US companies that had senior executives who exercised large holdings of employee share options. Their results showed that if senior managers were potentially aware of deteriorating protability then such managers would be more likely to adopt income-increasing accounting methods in an effort to increase share prices and therefore the value of their share options. They would then exercise their share options thereby acquiring the shares, and fairly quickly thcrcacr they would sell the shares bcforc reported prots ultimately decline and the value of the shares fall. In other related research, Aboody and Kasnik (2000) provided evidence that if managers appeared to know that share options were soon to be granted to them as part of their remuneration package men they would disclose 'bad ncws' early so as to reduce share prices and therefore the likely future exercise price of the share options. This would mean that when they ultimately exercise the granted options, thereby buying the underlying shares, then they will pay less and therefore make greater nancial gain. Reecting the way executives ocn share in the performance of an organisation, Accounting Headline 7.4 shows how CSR Ltd rewards its CEO by way of shortterm and longtcrm incentives. The shortterm incentives relate to protsharing plans, whereas the longer term incentives relate to changes in share prices, It would be expected that rewarding the executives in the manner outlined should align the interests of the executives (agents) with those of the shareholders (principals)a view consistent with agency theory and PAT. It would be expected that such schemes would be restricted to senior managers, as they have the greatest ability to affect share prices. However, there has been considerable criticism from shareholders in recent years of the size of executive share option schemes. From the perspective of PAT, this might indicate that shareholders believe that the size of some such schemes potentially dilutes the value of shareholders' existing shares (through the issue of new shares at a substantial discount to future market values) by so much that the agency benets of the share options are outweighed by the cost to existing shareholders. Accounting Headline 7.4 Life's sweet: $4 m for CSR chief TERESA OOI CSR chief executive and managing director Alec Brennan has been rewarded for boosting earnings with a hey 43 per cent pay rise this year to $4.1 million, up from $2.9 million in 2004. Mr Brennan received $1.16 million in salary, $715,000 in short-term bonuses and $1.6 million in long-term incentives for the full year ending 31 March, compared with his total package of $2.9 million last year, which included $600, 000 in short-term incentives and $393,018 in long-term bonuses. Mr Brennan, who joined the sugar, building and construction materials company in 1969, has increased the company's net income by 79 per cent to $287 million. The earnings lift came as sugar demand soared in Asia where a two-year drought in India and Thailand hit sugar crops and helped drive up raw sugar prices. Sugar earnings more than doubled to $89.8 million from $37.6 million a year ago. Mr Brennan became managing director in 2003 alter the company split with cement producer Rinker, leaving CSR with sugar, building materials and aluminium business. At the time of the demerger CSR's market capitalisation was $1.5 billion. In two years it has grown to more than $2.2 billion. Mark Ebbinghaus of U135 said CSR has performed strongly in a challenging market for the building materials company which also faced votalile sugar prices. 'Mr Brennan's performance has exceeded expectations. He is known for running the business very tightly and is respected as a long-sighted chief executive.' The company explained that the majority of Mr Brennan's remuneration is 'dependent on increasing shareholder value'. 'Short-term incentive rewards performance in a given yearCSR's net prot before signicant items was up 25.3 per cent to $201 million \\lpar including signicant items it was up 79 per cent to $287 million). Cash ow was also up 10.5 per cent to $321 million and dividend increased to 12c Rom 11c. Alec has chosen to acquire CSR shares with his total short-term incentive of $715,000 for the year. 'A long-term incentive of 750,000 shares ($1.6 million) was purchased during the year as CSR's total shareholder return (share price plus dividend) was in the top quartile of companies in the ASX 200 accumulation index.' The company stressed that all shares purchased under the incentive scheme were bought on-market and 'therefore not dilutive to shareholders '. Mr Brennan now has 3.1 million CSR shares. CSR's shares rose 1c to close at $2.60 yesterday. The Australian, 16 June 2005 In general, it is argued that the likelihood of accountingbased or marketbased performance measures or reward schemes being put in place will, in part, be driven by considerations of the relative noise of market-based versus accountingbased performance measures. The relative reliance on accounting-based or market-based measures may potentially be determined on the basis of the relative sensitivity of either measure to general market (largely uncontrollable) factors. Sloan (1993) indicates that CEO salary and bonus compensation appears to be relatively more aligned with accounting earnings in those rms where: - share returns are relatively more sensitive to general market movements (relatively noisy) I accounting earnings have a high association with the rm-specic movement in the rm's share values; - accounting earnings have a less positive (more negative) association with marketwide movements in equity values. While the above arguments have discussed how or why managers might work in the interests of owners if they are o'ered rewards that are tied to the value of the shares of the organisation, there is also an argument that if managers are provided with an equity interest in the organisation this will have other positive impacts in terms of encouraging the managers to increase the level of ,Mduaolgitaladhlcns File Edit. Library '0 o o heading. Window Help Adobe Digital Editions - Financial Accounting Theory V Table of Contents Title Copyright Contents About the Author Preface Acknowledgments PCHAPTER1 INTRODUCTION TO FINANCIAL AC., P CHAPTER 2 THE FINANCIAL REPORTING ENVIR. P CHAPTER 3 THE REGULATION OF FINANCIAL A. P CHAPTER 4 INTERNATIONAL ACCOUNTING P CHAPTER 5 MEASUREMENT ISSUES: ACCOUN P CHAPTER 6 NORMATIVE THEORIES OF ACCOU. P CHAPTER 7 POSITIVE ACCOUNTING THEORY P CHAPTER 8 UNREGULATED CORPORATE REPO. P CHAPTER 9 EXTENDING CORPORATE ACCOUN P CHAPTER 10 REACTIONS OF CAPITAL MARKET. P CHAPTER 11 REACTIONS OF INDIVIDUALS T0 Fl P CHAPTER 12 CRITICAL PERSPECTIVES 0F ACC. Glossary Index > Page-List disclosure. 299 Without an equity inmrest in the organisation, managers might be motivated to withhold information from shareholders and other interested stakeholders. As Nagar, Nanda and Wysocki (2003, p. 284) state: Managers avoid disclosing private information because such disclosure reduces their private control benelits, For instanoe. a lack ol inlonnation disclosure limits the ability at capital and labour markets to ellectively monitor and discipline managers (snieiler and Vishny. 1989). The disclosure agency problem can thus be regarded as a iundamentai agency problem underlying other agency problems. practitioners also echo the view that managers exhibit an inherent tendency to withhold inlolmation lrom investors, even in the 'high disclosure' environment at us capital markets. A panellist at the recent STEFIN Stewart Executive Roundtahle states, 'all things equal, the managers or most companies would rather not disclose things it they don't have to. They don't want you to see exactly what they're doing; to see the little bets they are taking' tStern Stewart, 2001, p. 37), In relation to the concern that managers might be motivated to restrict disclosure, Nagar, Nanda and Wysocki (2003) suggest that providing managers with equity interests (for example, shares or share options) in the organisation will act to reduce the 'non-disclosure tendency', Specically, they state (p. 284): Stock [share] price-based incentives elicit both good news and bad news disclosures lrom managers. Managers have incenvss to release good news and bad news because it boosts stock price. 0n the other hand, the potential negative investor interpretation oi silence (Verecchia. 1553: Miigrom, test). and litigation costs (whlch reduce the value at the managers ownership interest) are incentives to release bad news. Therefore. we argue that managerial stock price-cased incentives, ooth as periodic compensation and and aggregate shareholdings. help align long-run managerial and investor disclosure prelerences and mitigate disclosure agency problems our basic premise is that stock pricehased incentives are contractual mechanisms that align managerial disclosure prelerenoes with those cl shareholders. The results of Nagar, Nanda and Wysocki's study are consistent with their expectations. Their results show that offering managers equity-based incentives increases the managers' propensity to disclose information, Specically, they found that rm disclosures, measured by both the frequency of earnings forecasts and analysts' ratings of the rms' disclosures, increase as the proportion of CEO compensation tied to the share prices and the value of CEO shareholdings increase, In considering the use of share-based versus accounting-based bonus schemes, accounting-based rewards have the advantage that the accounting results may be based on subunit or divisional performance, but one would need to ensure that individuals do not focus on their division at the expense of the organisation as a whole, PAT assumes that if a manager is rewarded on the basis of accounting numbers (for example, on the basis of a share of prots) then the manager will have an incentive to manipulate the accounting numbers. Given such an assumption, the value of audited nancial statements becomes apparent. Rewarding managers in terms of accounting numbers (a strategy aimed at aligning the interests of owners and managers) may not be appropriate if management was solely responsible for compiling those numbers. The auditor will act to arbitrate on the reasonableness of the accounting methods adopted, However, it must be remembered that there will always be scope for opportunism. The above arguments concentrate on how management's rewards will be directly affected by the particular accounting methods chosen. Management might also be rewarded in other indirect ways as a result of electing to use particular accounting methods. For example, DeAngelo (1988) provided evidence that when individuals face a contest for their positions as managers of an organisation they will, prior to the contest, adopt accounting methods that lead to an increase in reported prots (and the increased reported earnings could not be associated with any apparent increase in cash flows), thereby bolstering their case for re-elecon. DeAngelo also showed that, where the existing managers were unsuccessful in retaining their positions within the organisation, the newly appointed managers were inclined to recognise many expenses as soon as they took ofce (that is, 'talre a bath') in a bid to highlight the poor 'state of affairs they had inherited Such snategies would be consistent with the opportunistic perspective applied within PAT. The view that incoming CEOs may 'take a bath' was also conrmed by Wells (2002). Using Australian data Wells (p. 191) states: There is suppon lor the view that incoming secs take an 'eamings bath' in the year at the also change Tests of earnings management yield evidence ct income decreasing earnings management in the year oi the can change, with the strongest results lor ceo changes categorised as 'rlon-routine'. in this setting, the incoming ceo is typically not associated with past decisions. implicit criticism ol which may be embodied in downwards earnings management. Moreover, the outgoing CEO is unable to constrain such behaviour. This highlights an important corporate govemence issue, namely the elleot ol the CEO suwsssinn process in constraining the opportunities lor incoming management to undertake earnings management in the period subsequent to the ceo change.4 Wilson and Wang (2010) also provided some interesting insights into when we might expect the appointrnmt of senior corporate executives to lead to some form of earnings management. As they state (p. 452): 301 Oil particular interest in this study is the silent 01 senior managerial changes concurrent with CEO change. Specically. we investigate the attact ol concurrent changes in CEO and board chairperson. and CEO and Chief 029' /916 ' Adobe Digital Editions File Edit Library Reading Window Help A III 58% Wed 8:26 pm Q DE . . . Adobe Digital Editions - Financial Accounting Theory Library PA. financial officer (CFO). At the heart of our conjectures in this regard is the assertion that a CEO's ability to effect a downward bias in first period earnings is enhanced where the CEO's incentives are aligned with those of other parties whose complicity is required (the chairperson and the CFO). Where the CEO's goals conflict with those of the CFO and/or chairperson, there is a lesser chance that attempts by the CEO to influence reported earnings will be effective. In discussing the results of their research, Wilson and Wang (2010, p. 475) state: Table of Contents The paper has documented evidence that the relationship between earnings management and CEO changeover is conditioned by the presence of other senior management appointments concurrent with that of a new Title CEO. Specifically, we find that concurrent CEO and Chair appointments are associated with significant income-decreasing earnings management in the year of appointment. Conversely, CEO changes unaccompanied by Copyright other senior management changes, or accompanied only by a change in CFO are not significantly associated with discretionary accruals. We find no evidence of significant earnings management in the period immediately following managerial appointments Contents About the Author Therefore, from the above evidence, before we can predict whether incoming CEOs are likely to opportunistically manage earnings, we perhaps need to consider whether other senior managers have been appointed at the same time. Whatever the case, we are again being confronted with research-based evidence that accounting numbers are not always objectively determined and this has Preface implications for the effectiveness of accounting numbers for monitoring and controlling the behaviour of managers. The results of such research also have implications for the governance of the Acknowledgments organisation-with the above evidence in mind perhaps specific monitoring has to be implemented following changes in senior management in an endeavour to ensure that opportunistic earnings CHAPTER 1 INTRODUCTION TO FINANCIAL AC.. management has not been employed CHAPTER 2 THE FINANCIAL REPORTING ENVIR Apart from using particular incentive schemes to motivate employees to work in the interests of owners in the current period, particular remuneration plans can also be used to retain key CHAPTER 3 THE REGULATION OF FINANCIAL A. employees. For example, offering managers share options that cannot be exercised for a number of years, and that would be forfeited on departure from the organisation, can not only act to CHAPTER 4 INTERNATIONAL ACCOUNTING motivate them to increase the organisation's value but can also act as an incentive for them to remain with the firm (Deegan, 1997). As Balsam and Miharjo (2007, p. 96) state: CHAPTER 5 MEASUREMENT ISSUES: ACCOUNT Equity compensation, or more precisely, forfeitable equity compensation, can reduce voluntary executive turnover by imposing a cost on the executive, which a prospective employer may not be willing to reimburse ... CHAPTER 6 NORMATIVE THEORIES OF ACCOU The vast majority of publicly traded corporations provide equity compensation, usually stock options, to their executives in an effort to retain them and motivate them to act in the shareholders' interests. Equity compensation provides a direct link between executive compensation and shareholder wealth and consequently aligns the interests of a firm's executives with those of its shareholders. CHAPTER 7 POSITIVE ACCOUNTING THEORY CHAPTER 8 UNREGULATED CORPORATE REPO. Balsam and Miharjo provide evidence that offering executives share options that cannot be exercised for a number of periods does have the effect of retaining strongly performing executives. By CHAPTER 9 EXTENDING CORPORATE ACCOUNT contrast, they provide little incentive for poorly performing managers to stay with a firm, as poor performance will translate to lower share prices and hence may make the options worthless- thereby eliminating any retention effects. CHAPTER 10 REACTIONS OF CAPITAL MARKET.. Having considered the contractual relationship between managers and principals, and how accounting can be used as a means of reducing the costs associated with potential conflict, we can now CHAPTER 11 REACTIONS OF INDIVIDUALS TO FI consider the relationship between debtholders and managers. It will be seen that accounting can be used to restrict the implications of this conflict and thereby enable an organisation to attract funds CHAPTER 12 CRITICAL PERSPECTIVES OF ACC.. at a lower cost than might otherwise be possible. Glossary 302 Index Page-List DEBT CONTRACTING LO 7.7 7.8 7.11 7.12 7.13 When a party lends funds to another organisation, the recipient of the funds may undertake activities that reduce or even eliminate the probability that the funds will be repaid. These costs that relate to the divergent behaviour of the borrower are referred to in PAT as the agency costs of debt and, under PAT, lenders will anticipate divergent behaviour. For example, the recipient of the funds may pay excessive dividends, leaving few assets in the organisation to service the debt. Alternatively, the organisation may take on additional and perhaps excessive levels of debt (referred to as claim dilution). The new debtholders would then compete with the original debtholder for repayment-that is, their respective claims will be diluted. Further, the firm that has borrowed the funds may also invest in very high-risk projects (often referred to as 'asset substitution'). This strategy would also not be beneficial to the debtholders (who can also be referred to as 'creditors'). The debtholders have a fixed claim (that is, they are receiving a set rate of interest) and hence if the project generates high profits they will receive no greater return, unlike the owners, who will share in the increased value of the firm. If the project fails, which is more likely with a risky project, the debtholders may receive nothing. The 431 / 916 19 stv A wPy HAi MoheDIgltaIE'dltlons File Edit Library Reading Window Help qr g-ae-saemr Wadazzspm, Q 0 _ '00. Adobe Digital Editions - Financial Accounting Theory 1 V Table of Contents Title Copyright Contents About the Author Preface Acknowledgments P CHAPTER 1 INTRODUCTION TO FINANCIAL AC., P CHAPTER 2 THE FINANCIAL REPORTING ENVIR. P CHAPTER 3 THE REGULATION OF FINANCIAL A P CHAPTER 4 INTERNATIONAL ACCOUNTING P CHAPTER 5 MEASUREMENT ISSUES: ACCOUN P CHAPTER 6 NORMATIVE THEORIES OF ACCOU. P CHAPTER 7 POSITIVE ACCOUNTING THEORY P CHAPTER 8 UNREGULATED CORPORATE REPO. P CHAPTER 9 EXTENDING CORPORATE ACCOUN P CHAPTER 10 REACTIONS OF CAPITAL MARKET. P CHAPTER 11 REACTIONS OF INDIVIDUALS T0 Fl P CHAPTER 12 CRITICAL PERSPECTIVES 0F ACC. Glossary Index > Page-List debtholders therefore do not share in any 'upside' (the prots), but sn'er the consequences of any signicant losses (the 'downside'). Another problem that might negatively a'ect the interests of debtholders is 'unden'nvestment'l Underinvestment occurs when owners/managers, of an organisation elect not to undertake projects that would generate positive net present Values Underinvestrnent is thought more likely to occur when an organisation is approaching insolvency For example, assume that a company's total debts exceed its total assets by $100 million (meaning equity is negative $100 million) If a project arises that might generate a positive net present value of $25 million then owners/managers might di-iss such a project because all the gains would go to the debtholders, Therefore, from the above material we can see that there are at least four general strategies that owners/managers might adopt that can disadvantage debtholders, these being (Smith & Warner, 1979): payment of excessive dividends claim dilution asset substitution under'investrnenti In the absence of safeguards that protect the interests of debtholders, the holders of debt will assume that management will take actionssuch as those described abovethat might not always be in the debtholders' interest, and, as a result, it is assumed that they will require the rm to pay higher costs of interest to compensate the debtholders for the high-risk exposin'e (Smith &. Warner, 1979) If the rm agrees not to pay excessive dividends, not to take on high levels of debt or to underinvest, and not to invest in projects of an excessively risky nature, it is assumed that this will reduce the risks of lenders and as a result the rm will be able to attract debt capital at a lower cost than would otherwise be possible To the extent that the benets of lower interest costs exceed the costs that may be associated with restricting how management can use the available funds, management will elect to sign agreements that restrict their subsequent actions Again, signing such an agreement that includes restrictive debt covenants would be an efficient strategy from the fum's perspective as it will be likely to lead to a reduction in the nn's cost of attracting funds THE USE OF CONSERVATIVE ACCOUNTING METHODS TO REDUCE AGENCY COSTS OF DEBT Apart from explicitly agreeing not to undertake certain actions (such as taking on excessive levels of debts or agreeing not to invest in particularly risky ventures), management might also agree to 303 adopt particular accounting methods if such adoption leads to a reduction in the cost of attracting debt capital. For example, Zhang (2008) argues that managers might agree to adopt conservative accounting methods because they believe that this might reduce the perceived risks faced by the lender As we have already mentioned in our discussion of management compensation schemes, conservative accounting methods bias the organisation towards more readily recognising losses than gains, consistent with the traditional 'doctrine of conservatism'. Conservative accounting practices would also restrict the organisation from undertaking numerous (or perhaps, any) asset revaluations The eem of conservative accounting methods is that both prots and net assets (and therefore equity) would tend to be understated (that is, they provide 'conservative measures' of nancial position and nancial performance) relative to organisations that do not adopt conservative accounting methods As an example of a conservative accounting policy, we can consider an organisation that uses the 'cost model\" rather than the 'revaluation model' to account for non-cunent assets Under the cost model, which would be considered to be a 'conservative accounting policy', where a non-current asset is worth more than its carrying amount then no accounting adjustment is made; however, if it is worth less than its carrying amount (with carrying amount being cost less accumulated impairment costs and accumulated depreciation) then an impairment loss must be recognised, This description of conservative accounting practices is consistent with Watts (2003) who describes them as 'asymmetrical verication requiremmts for gains and losses that lead to persistent understatement of net asset values'i The use of conservative accounting procedures within an organisation means that debt covenants restricting the amount of debt relative to assets (or debt to equity), or the amount of times prots must cover interest (lorown as an 'interest coverage' clause), will tend to be more restrictive or binding compared to those organisations that do not adopt conservative accounting methods. As Zhang (2008) argues, the more binding covenants will provide an earlier warning of default risk, and will thereby reduce the risk exposure of the lending party (for example, a bank). The reason for this is that, because management will have less ability to circumvent restrictive covenants (for example, by undertaking asset revaluations), such covenants will create a technical default of a loan agreement earlier than if management has the scope to loosen the restrictions, perhaps through undertaking an asset revaluation The earlier the lender can take action to safeguard its funds, the lower the risk of the lender. Zhang (2008) repom that borrowers who adopt conservative accounting methods attract funds at lower rates of interest (a benet to the borrower). This is consistent with Ahmed et al. (2002), who also found that adopting conservative accounting methods leads to a reduction in the cost of attracting capitall According to Zhang (2008), borrowers that adopt conservative accounting methods are also more likely to violate debt contracts and to violate them sooner (and the early default signal creates lower risk for lenders, which explains why they are prepared to lend the money 433 /916 i MobsDigltaIEdltluns File Edit Library Reacting Window Help I; pig-5321: wadazzspm, Q 0 '00. Adobe Digital Editions - Financial Accounting Theory 1 V Table of Contents Title Copyright Contents About the Author Preface Acknowledgments PCHAPTER1 INTRODUCTION TO FINANCIAL AC., P CHAPTER 2 THE FINANCIAL REPORTING ENVIR. P CHAPTER 3 THE REGULATION OF FINANCIAL A. P CHAPTER 4 INTERNATIONAL ACCOUNTING P CHAPTER 5 MEASUREMENT ISSUES: ACCOUN P CHAPTER 6 NORMATIVE THEORIES OF ACCOU. P CHAPTER 7 POSITIVE ACCOUNTING THEORY P CHAPTER 8 UNREGULATED CORPORATE REPO. P CHAPTER 9 EXTENDING CORPORATE ACCOUN P CHAPTER 10 REACTIONS OF CAPITAL MARKET. P CHAPTER 11 REACTIONS OF INDIVIDUALS T0 Fl P CHAPTER 12 CRITICAL PERSPECTIVES 0F ACC. Glossary Index > Page-List at a lower cost). EVIDENCE OF TH E USE OF ACCOUNTING-BASED DEBT COVENANTS Historical evidence on Austalian public debt contacts is provided by Whitted and Zimmer (1986, p. 22), who found that for public debt contacts written between 1962 and 1985141 with law exceptions, trust deeds lot public debt plaoe restrictions on the amount at both total and secured liabilities that may exist. The Constraints were most commonly delined relative to total tangible 3m assets: less often relative to shareholders' iunds. The most irequently observed constraints were those limiting total and secured liabilities m some traction of total tangible assets,\" While Wirittred and Zimmer provided information about public debt issues, Cotter (19983) provided evidence of private debt contacts negotiated between Australian listed companies and banks between 1993 and 1995. Her ndings reveal that (p. 187): Leverage covenants are lrequently used in bank loan contracts, with leverage most rrequentty measured as the ratio at total liabilities to total tangible assets, In addition, prior charges covenants that restrict the amount at secured debt owed to other lenders are typically included in the term loan agreements or larger rms, a