Académique Documents
Professionnel Documents
Culture Documents
CH2
Agency Relationship
a contract under which one or more persons
(the principal(s)) engage another
person (the agent) to perform some service on their behalf which involves
delegating some decision making authority to the agent
Monitoring costs e.g., auditing, Internal control systems, budget control,
performance review, and incentive compensation systems etc.
Bonding costs e.g., Preparing financial statements and contractual limitations
on the managers decision making power etc.
Residual loss e.g, company resources or facilities are heavily used for
personal purpose etc (Jensen and Meklcing, 1976)
Firm is defined as a legal fiction which serves as a focus for a complex process in
which the conflicting objectives of individuals (some of whom may represent other
organizations) are brought into equilibrium within a framework of contractual
relations
Firm with and without High Shareholding Concentration (HSC Firm and NonHSC Firm)
HSC is present when an entity or private individual holds directly or indirectly
(via an entity) substantial equity ownership (large shareholding) and can
thereby significantly influence the financial and operating policy decisions of
the firm. 20 per cent or more
Agency Problem I
In a firm that does not have HSC, small shareholders cannot all represent themselves
on the board of directors and the size of their shareholding is insufficient to justify the
costs of monitoring managers
Conflicts of interest are more likely to arise between the board of directors and
shareholders.
Agency Problem II
In a firm that does have HSC, conflicts of interest are more likely to occur between
large shareholders (e.g. directly via their appointed directors and their position on the
board) and other shareholders.
Two theories frequently used in PAT literature to explain and predict managers
actions
Opportunism Hypothesis
-Managers act in their own best interest to maximize their
wealth at the expense of some other contracting parties
(Holthausen, 1990)
Efficiency Hypothesis
-Managers act in the best interest of the firm to maximize
the value of the firm (Holthausen, 1990)
Operational Discretion
For example, managers are likely to accelerate or defer recognition of revenue by
either expediting or delaying delivery of goods and services to customers in the
last month of the financial year in order to fit their reporting incentive and/or
interest
use flexibility in the goodwill rule to determine the recoverable amount of goodwill to
either increase or decrease goodwill impairment loss
use their discretion to increase or decrease depreciation expenses of non-current assets
by changing estimates of the useful life and/or by expediting or delaying the write off
of non-current assets
Managerial Opportunism
A bonus plan based on annual profits may cause managers to maximize
short-term profits rather than to invest in the long-term projects
find US managers inflate earnings in the pre-option-exercise period to
maximize option payoffs.
Extant studies find associations between buyback decisions and managerial
compensation
Fenn and Liang (2001) find that management share options are positively
related to on-market buybacks and negatively correlated with dividend
payments. In other words, large management share options are related to
high on-market buy-backs. Large management options are associated
with low dividend payments.
Leuz et al. (2003) assert that controlling shareholders are motivated to
manage the firms earnings upward to please outside shareholders and to
avoid any intervention by outsiders in the operational management of the
firm.
Are those managers actions efficient or opportunistic?
Importance of Strong Corporate Governance
A strong governance environment is expected to reduce agency costs
between managers and shareholders (investors) and therefore increase
shareholder value in the long run.
A non-executive chairperson of the board,
a majority of independent
directors on the board, and an audit committee can strengthen the
boards monitoring of the management team in presenting quality
financial information and acting in the shareholders' best interest (Arthur
that the R2s from regression of share price on earnings and book values of equity (P
regression) significantly decline between 1984 and 2003 (coefficient = -0.012 and tvalue = -2.69), consistent with the prior literature
However, the R2s of the regressions derived using the two alternative value measures
(IV) do not exhibit a clear declining trend (the coefficient for Trend becomes
statistically insignificant with t-values of -0.85). This shows that the evidence of the
temporal decline in the value relevance of accounting information that has been
documented in prior studies is sensitive to the firm-value measures employed
read Fung et al. (2010) pages 849 to 851
When market price is replaced by two alternative measurements, we can see such
decline trend. So we can not conclude accounting information has lost its value. Such
decline may due to stock market inefficiency. Arbitrage or risk factors are also
associated with such inefficiency.
CH6
Objective of Fair Value Measurement
To estimate the price at which an orderly transaction to sell the asset or to transfer the
liability would take place between market participants at the measurement date under
current market conditions
The price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Principal Market
The market with the greatest volume and level of activity for the asset or liability.
Market participants
They are independent of each other
They are knowledgeable
They are able to enter into a transaction for the asset or liability.
They are willing to enter into a transaction for the asset or liability
Active Market
A market in which transactions for the asset or liability take place with
sufficient frequency and volume to provide pricing information on an
ongoing basis.
Valuation
Techniques
(If there is no active market)
Market approach
A valuation technique that uses prices and other relevant information
generated by market transactions involving identical or comparable (i.e.
similar) assets, liabilities or a group of assets and liabilities, such as a business.
Cost approach
A valuation technique that reflects the amount that would be required currently
to replace the service capacity of an asset (often referred to as current
replacement cost).
Income approach
Valuation techniques that convert future amounts (e.g. cash flows or income
and expenses) to a single current (i.e. discounted) amount. The fair value
measurement is determined on the basis of the value indicated by current
market expectations about those future amounts.
Fair Value Measurement: Advantage
If there is active market
Independent from management
Determined by market forces
Fair Value Measurement: Criticisms
Going concern (re-exit price)
When a debt covenant is violated by the borrower, the lender has a range of alternative
responses, including the following (non-exhaustive list):
CH 8
What is Meant by Debt?
Public debt: bond issues by firms (the issuer) to the public (the
investors)
CH9
The cost of equity is the rate of return that a firm pays to its equity investors
for the risk they undertake by investing their capital.
Our emphasis is on whether firms financial reporting practices also influence
cost of equity
There are several views in prior literature on whether and how financial
information affects a firms cost of (equity) capital:
1. Stock market liquidity:
Information is linked to the cost of (equity) capital through stock
liquidity. This view suggests that providing more (i.e., quantity)
information increases stock liquidity which in turn reduces transaction
costs or increases demand for a firms securities. Either of these
consequences reduce cost of equity.
2. Estimation risk:
This risk arises from investors estimates of the parameters of an asset return
or payoff distribution.
Information is linked to the cost of (equity) capital through estimation risk.
That is, information asymmetry in the market affects estimation risk and
providing more (i.e., quantity) information can reduce the estimation risk;
therefore, providing more information will reduce the firms cost of (equity)
capital.
3. Information quality in the absence of estimation risk:
Daske (2006)
during the transition period the expected cost of equity capital
appear to have rather increased under non-local accounting
standards
Daske et al (2008) examine the effects of mandatory IAS reporting on market
liquidity, cost of capital, and Tobins q in 26 countries. They find:
On average, market liquidity increases around the time of the
introduction of IFRS
A decrease in firms cost of capital and an increase in equity
valuations, but only if we account for the possibility that the
effects occur prior to the official adoption date
Week 11
those top executives that the consultant recommends their pay levels
consultants who are advising on executive pay are simultaneously
receiving millions of dollars from the corporate executives whose companies
they are supposed to assess (Waxman, 2007)
How do the CEOs of firms with weak corporate governance justify their pay
to the board of directors and/or shareholders?
Through claiming that CEO pay was determined by an expert compensation
consultant
Armstrong et al. (2012) argue that firms with weak corporate governance are
more likely to hire compensation consultants
Findings:
CEO pay is higher in firms with weaker governance and that firms with
weaker governance are more likely to use compensation consultants
CEO pay is higher in firms using consultants compared to firms not using
consultants
There is no significant pay differences in consultant users and nonusers when
controlling for governance strength
Does equity-based compensation provide an incentive for managers to manage
earnings?
Managers holding stock or options to purchase stock gain from increased
stock prices
Investors react positively to good earnings announcements, causing stock
prices to increase
As a result, managers with equity-based compensation have an incentive to
manipulate earnings to increase their wealth
The authors find that managers with high equity incentives are:
more likely to report earnings that meet or just beat analysts forecasts;
less likely to report large positive earnings surprises; and
report higher abnormal accruals
The authors found equity-based compensation was associated with
misreporting:
Firms are more likely to misreport when the CEOs stock option portfolio is
more sensitive to stock price movements
The magnitude of misreporting is also higher when the CEOs stock option
portfolio is more sensitive to stock price movements
Week 12
What is Tax Avoidance?
Aggressiveness tax reporting is a downward tax manipulation of taxable income
through tax planning.
Benefits
Primary benefit is the increased after-tax cash flows due to tax savings
Costs
Increased costs associated with tax planning strategies;