1.

What is efficient contracting theory

Fokus pada peran informasi ACCOUNTING keuangan di moderasi
asimetri antara pihak kontraktor.
kontrak utang dan kontrak kompensasi manajerial
- Kepentingan dan manajer' Lender bunga mungkin bertentangan
dengan kepentingan pemegang saham Kontrak eficient menghasilkan kepercayaan antara kepentingankepentingan yang bertentangan dengan biaya terendah Untuk
perusahaan
2. Sources of EFficient Contracting Demand for financial Accounting
Information
Lenders
Lenders face payoFf asymmetry
- They can lose heavily if firms does poorly, but do not directly share in
gains if firm does well.
- As a result, they demand early warning of financial distress
Shareholders :
- Managers assumed rational and will act in their own interest, which may
conflict with shareholders interests
- As a result, shareholders demand information to encourage responsible
manager eFfort and limit opportunistic actions
3. Accounting Policies for EFficient Contracting
Reliability
- Lenders demand reliable informaTion to help protect against
opportunisTic manager policies that hide losses and record unreliazed
gains
ConservaTism - Lenders demad reliable informaTon to help predict
Fnancial distress - Shareholders demand conservaTve informaTon for
stewardship purposes compensaTon, by recognizing unrealised gains
Bukti Empiris Penelitan oleh Dichev & Skinner (2002) (DS) mendukung
argumenT bahwa kebijakan akunTansi iTu pentng. Dari sampel yang
diambil oleh DS, hasilnya konsisTen dengan argumenT konsekuensi
ekonomi. Manajer bekerja sangaT keras unTuk mengelola rasio perjanjian
sehingga manajer menghindari pelanggaran perjanjian awal. emuan ini
mendukung asumsi bahwa manajer Telah bersikap rasional ( kiTa dapaT
mengharapkan manajer unTuk bekerja lebih keras pada saaT biaya
kegagalan lebih tnggi)

Create

Chapter 8 | The Efficient Contracting

Approach to Decision Usefulness
Contrasts with Decision Usefulness Approach; focus on efficient corporate governance,
responsible manager performance, and efficient contracting in the role of financial reporting.
Original Alphabetical

Chapter Structure for ECT

Efficient Contracting Theory (ECT)
- Takes view that firms organize themselves in the most efficient manner to maximize their
prospects for survival
- Focus is on role of financial accounting info in moderating info asymmetry between
contracting parties
- Efficient contract generates trust between conflicting interests at lowest cost to firm
- Contracts may be formal written documents or implicit (which would arise from continuing
business relationships and modelled as non-coop games)

What are the sources of contracting demand for financial accounting info?
Lenders
- Face payoff asymmetry
Can lose heavily if firm does poorly, but do not directly share in gains if firm does well
Result: demand early warning of financial distress
Shareholders
- Managers are assumed rational and will act in own interest (which may conflict with
shareholders interest)
Result: shareholders demand info to encourage responsible manager effort and limit
opportunistic actions

Accounting Policies for Efficient Contracting

Reliability
- Lenders demand reliable info to help protect against opportunistic manager policies that
hide losses and record unrealized gains
Conservatism
- Lenders demand conservative info to help predict financial distress
Conditional conservatism (impairment tests)
Reporting unrealized losses

- Shareholders demand conservative info for stewardship purposes

Conflict with Conceptual Framework
- Framework more orientated towards future-oriented info (FV accounting) AND info needs
of investors, not stewardship

How to solve for contract rigidity and possible changes to accounting policies?
1. Unlikely contracts can be renegotiated to allow for changes in GAAP (b/c timely + costly)
2. Incorporate provisions into contract itself to deal with unexpected events (however effetely
impossible to predict the future)
3. "Freeze" the accounting policies used to calculate covenant values at those in effect at the
time the contract is signed
4. Allow flexibility for managers in accounting policy choice so they can adapt to unexpected
circumstances (however opens up chance for opportunistic behaviour)

Contract Rigidity Results...

Result: Managers are concerned about changes in accounting standards and policies (even if
it doesn't affect cash flows)
- May lobby against proposed standards
- May exploit flexibility of GAAP
- May change operating policies (i.e. R&D, extent of hedging)
- New accounting standard has economic consequences if it motivates managers to change
accounting and/or operating policies

Employee Stock Options (ESOs)

- Gives mgmt and employees the right to buy company stock over some time period
- Until 2005, there was no expense recorded for ESOs if intrinsic value=zero
- Now, ESOs are considered expenses

Intrinsic value for ESO

Difference between market value of shares on the date the option was granted and the
exercise price of the option

What was the problem with not recording an expense for ESO?
1. Understated firm's compensation cost and overstated net income
2. Lack of earnings compatibility across firm results

Measuring ESO expense?

1. Black/Scholes option pricing formula
- Not entirely accurate b/c assumes option is held to expiry date. however ESOs can be
exercised earlier
- Therefore Black/Scholes overstates ESO expense
2. Accountant's answer
- Use expected exercise date in Black/Scholes formula

How do managers abuse ESOs?

1. Since there used to be no effect on net income, firms used to overdose on ESO
compensation
2. Pump and Dump (whereby managers would take actions to increase share value shortly
before exercising options, then sell the shares)
3. Manipulate share price down prior to scheduled ESO grant dates
4. Spring loading (managers manipulating award date to grant unscheduled ESOs shortly
before good earnings news)
5. Late timing (extreme case of award date manipulation to backtrack to a date where the
share price was lower than the actual ESO grant date - p. 327)

Why such a strong manager resistance to ESO expensing, especially with no

effect on cash flows and expense is already reported as supplementary info?
- May lead to reduced use of ESOs as compensation
- Concerns about reliability of Black/Scholes
- Lower reported net income
- Rejection of market efficiency

Distinguishing Efficiency and Opportunism in Contracting

Are managers' accounting policy choices driven by opportunistic view (manager benefits at
expense of investors) or efficient contracting view (manager chooses accounting policies to
maximize contract efficiency)?

Research Consistent with Contracting Efficiency***

1. Mian and Smith (1990)
- Consolidated F/S
2. Dechow (1994)
- Net income more highly associated than cash flows with share returns
3. Dichev & Skinner (2002)
- Debt covenants
4. Wittenberg-Moerman (2008)
- Conditional conservatism and info asymmetry
- No association for unrealized gains

Research Consistent with Opportunistic Manager Behaviour***

1. Hope and Thomas (2008)
- For multinational firms that did not disclose earnings by geographic segment, foreign sales
increased but earnings did not (suggests empire building)
2. Dechow and Shakespeare (2009)
- Most firms in sample adopted aggressive fair value accounting for securitization so as to
avoid reporting a loss
Conclusion: while significant evidence for efficiency version, also evidence for opportunistic
accounting policy choice

Chapter Summary
- Contract theory argues that the role of financial reporting is to generate trust between
conflicting parties (debt and managerial compensation contracts emphasized)
- Contract theory conflicts somewhat with Conceptual Framework (Supports increased
emphasis on reliability and conditional conservatism)
- Managers have accounting policy choice (is this flexibility consistent with efficient
contracting or with manager opportunism? Empirical evidence is mixed)