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BAC 3664 Accounting Theory

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Jessica Tee

on 15 December 2013

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Transcript of BAC 3664 Accounting Theory

Question 1
Discuss agency relationships and their problems.
Question 2
What does it mean when researchers claim that for a signal to be credible, it must be costly to replicate? Consider an example where accounting information is used for signalling purposes.
Signalling theory
Useful for describing behaviour when two parties (individuals or organizations) have access to different information.
Typically, one party, the sender must choose whether and how to communicate (or signal) that information, and the other party, the receiver, must choose how to interpret the signal.
Question 3
Review business newspaper articles, Bursa and SC websites. Choose news about a company that has a management-shareholder dispute. Prepare a 10 minute presentation describing the company and nature of the dispute.
Discuss how the agency theory explains why the dispute came about.
BAC 3664 Accounting Theory

1. Travis Puah Khai Yang (1092700684)
2. Wong Yem Sung (1091100295)
3. Chin Pei Pei (1091101459)
4. Saw June Min (1091101924)
5. Jessica Tee Sze Tze (1092700763)
6. Chia Woon Pin (1091100023)

Problem of Reliability
Arises when we ask why companies do not mislead stakeholders when they are given the often strong incentive to do so
Due to the competitive environment, companies strive to produce positive signals to investors via the accounts.
Signalling Theory (continued)
It is concerned with understanding why certain signals are reliable and others are not
What keeps signal reliable?
The answer is
COSTS
.

There are two main sources of costs:
The signal itself may be costly to produce or;
The punishment if caught cheating may be high
Costs
1. The signal itself may be costly to produce

High signalling costs which is only affordable by high quality individuals (profitable organizations) but it is costly for others (unprofitable organizations)
E.g. It is costly for an unprofitable company to report positive news by providing dividend signals as it involves cash payout to investors
Costs
2. Punishment costs

If the punishment cost for producing a false signal is high, it is seldom worth risking them
E.g. Costs can include long-term loss of credibility if actual performance does not match the level that has been signalled to stakeholders via the accounts
An example of accounting information used for signalling purposes is the dividend policy. A model developed by Merton Miller and Kevin Rock in 1985 suggested that dividend announcements convey information to investors regarding the firm's future prospects.
Example
For instance, an increase in dividend price indicates that the firm has large amount of cash reserve and investors will respond positively

In contrast, a decrease in dividend price signals worsening of its future profitability

Definition of agency relationship
Relationship between a principle and an agent
Principal legally appoints the agent to act
The agent act on behalf of the principal should not have a conflict of interest in carrying out the act
Who is a principal?
Any person who has the legal capacity to perform an act
Legal capacity means the person cannot be insane or in a certain circumstances a minor
Who can be an agent?
Any individual capable of comprehending the act to be undertaken is qualified to be an agent.
Purpose of the relationship
This relationship allows the principal to authorize somebody to carry out his/her actions
The relationship can be entered into by formal or informal agreement
The acts carried out by the agent must be legal
Basis of Agency Relationship
Agent will act for and on behalf of the principal
The agent have an obligation of loyalty to the principal
The agent is not suppose to take personal advantages of the business opportunities that agency position uncovers
For the principal, he/she suppose to trust the agent
3 Types of Problems
1. Risk aversion problem

2. Dividend retention problem

3. Horizon problem
1. Risk Aversion
Problems
The managers prefer less risk than the shareholders
Shareholders had diversified their investments and hence, they expect the managers to undertake the risks on behalf of them
Managers prefer less risky, lower net present value projects
1. Risk Aversion
Problems (Cont.)
Undiversified human capital invested in the business
Losing the job or being paid less affects manager's wealth. Thus, managers prefer to minimize their own risk rather than maximize the value of firm.
2. Dividend-retention Problem
Managers prefer to pay out less of the company's profits in dividends than shareholders
Managers retain money in the business to pay for their own salaries and benefit
To increase the size of their control
2. Dividend-retention Problem (Cont.)
For example, a firm's best investment opportunity will earn 8% rate of return for shareholder but shareholder could personally invest to earn returns of 15%
Under these circumstances, shareholders want to be paid dividends to invest in the higher earning investment rather than leave money in the firm
Managers may prefer differently. If management does retain funds that otherwise could be paid as dividends, then shareholders lose 7% (15%-8%)
3. Horizon Problem
A difference in the time horizon interests of shareholders and managers
Shareholders interested in the cash flows of the firm for an infinite number of periods into the future
3. Horizon Problem
(Cont.)
Shareholder has a long horizon interest because of the firm's future cash flows affect how much other investors will pay for shares
Managers are interested in the cash flows of the firm only for as long as they intend to stay with the firm
MHB was incorporated on 3 April 1978 as a public limited investment holding company

Its principle objective is to foster inter-communal economic cooperation in conjunction with the economic policy of the country
The issued and paid up capital of the Company was increased from RM2 to RM600,000,002 after the allotment of 120,000,000 shares of RM0.50 each to members of the MCA Johor State issued on 2 November 1981.

The first business venture of the Company was the selling of the entire extractable timber concession obtained from the Johor State Government at Hutan Simpan Maokil, Labis.
Dispute between minority shareholders and BOD
Started on 19th November 2012.
BOD announced the reverse takeover of Scope Industries by Matang Holdings.
The intention is to enable Matang to become a listed company.
This is done through injecting Matang’s cash and assets into Scope.
Minority Shareholders' Concern
If reverse takeover is approved, RM200 millions cash should be returned to the shareholders but the BOD failed to do so.
Matang was valued below market price at RM48 millions while their own valuation found that the company is valued at RM200millions.
Minority Shareholders' Concern
(Cont.)
Matang shareholders cannot dispose of their shares in the next 4 years if the takeover is approved.
After the takeover, only 3 Matang directors would be appointed on the new board whereas Scope, the minority shareholder, can appoint 5 directors.
Why this takeover does not make sense?
Scope has poor financials. (loss making company)
Matang makes more money than Scope.
Shareholders would not benefit from this takeover.
Management counter that it is value-adding
How the agency theory explains why the dispute came about?
Agency relationship is described as a contractual relationship between two parties where the principal engages the agent (management) to perform service on behalf of principal.

Hence, the principal would delegate some decision making authority to the agent [Matang’s BOD & Management is given authority by shareholders]

No efficient price protection. Shareholders do not pay the management based on the expected monitoring cost. For instance, Matang do not have strong-form efficient managerial and shareholder information.

Since there is no efficient price protection, agent do not bear the monitoring cost and hence it is likely for them to behave contrary to the manner of shareholders (principal) (Bonding cost is borne by Agent). For example, Matang do not have quarterly reports.
Residual cost is ultimately high due to (monitoring cost not borne by agents) (low bonding cost) make it easier and more profitable to not act at the best interest of principals.
Summary
Horizon Problem
Arises due to the time horizon interest of shareholders and managers.

Matang shareholders are worried that the merger between Matang and Scope would significantly reduce the earnings and also cash flow of Matang.

However, BOD decided to continue the merger as being listed means the director’s resume and salary would significantly increase.

THANK YOU!
Q&A SESSION

Example
When an investor buys shares of an index fund, he is the principal and the fund manager will become his agent. The fund manager, as an agent, he/she must manage the fund which consists of many principals' assets, in a way that will maximize returns for a given level of risk in accordance with the fund's prospectus.
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