Aaron Jank

Chapter 9 Part 2

ACCT 803

Theme: Managers have a large advantage over owners because they know much more information about the company than the owners do. The managers also can use this information advantage to alter information/net income to their advantage without the owners finding out and using their position of power advantageously. Insights: Given separation of ownership and control, it is unlikely that the owner would be able to observe the detailed working of the firms accounting and reporting systems. Because of this information advantage that managers often enjoy, the managers will often choose to shirk from their duties as long as it doesnt have a drastic effect on their expected utility function. So many people ask whether the owners can do anything to control this obviously unsatisfactory situation? There has been found contracts where the same compensation is received regardless of what net income is reported, so management doesnt have incentive to distort net income (essentially a contract can be devised to incentivize the manager to tell the truth in financial statements used by the owners). GAAP also helps restrain the amount management is allowed to misstate/finagle earnings because auditors are likely to notice massive departures from GAAP in regularly scheduled audits. GAAP imposes limitations on the managers ability to manage net income, but it does allow for some earnings management. A moral hazard problem exists between lenders and firm managers- managers may act contrary to the best interests of the lenders. Rational lenders will anticipate this behavior and raise the interest rates they demand for their loans. So a manager has an incentive to not act in a manner against the lenders interests by inserting covenants into the debt agreements. This allows the firm to then borrow at lower rates. Research has also shown the net income and share price can together better reflect current manager effort than either variable alone. Sensitivity is the rate at which the expected value of a performance measure increases as the manager works harder, or decreases as the manager shirks. Sensitivity contributes to efficient compensation contracts by strengthening the connection between manager effort and the performance measure, thereby making it easier to motivate that effort. Another important characteristic of a performance measure is its precision in predicting the payoff from current manager effort. Precision is measured as the reciprocal of the variance of the noise in the performance measure. When a performance measure is precise, there is a relatively low probability that it will differ substantially from the payoff. When net income is biased, there is a tradeoff between sensitivity and precision. The economic consequences and the efficient securities markets theory are not necessarily inconsistent. Rather, they can be reconciled by positive accounting theory, with normative support from agency theory that suggests why firms enter into employment and debt contracts that depend on accounting information. Changes in accounting policies can affect provisions in contracts that firm managers have entered into, thereby affecting their expected utility and the welfare of the firm. Question: At what point does GAAP allowing earnings management go overboard and the managers take the leverage GAAP provides in order to drastically misstate financial statements? Do efficient market theory and economic consequences contradict each other at all or are they just mutually exclusive, because it doesnt seem like they really build on one another?