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ACCT3321 – Tute discussion

Application of accounting theory

Group discussion questions

A) What is an agency relationship? Explain how monitoring costs, bonding costs and residual loss arise in agency relationships.

An agency relationship occurs when one party, who is referred to as the principal, employs another party, the agent, to undertake some activity on their behalf. Costs incurred by the principal to observe, evaluate and control the agent’s behaviour are referred to as monitoring costs. Examples of monitoring activities incurred by shareholders to monitor management include having the financial statements audited. Bonding costs are those costs incurred by the agents to provide assurance to the principal that they are acting in the principal’s best interests. The time and effort expended in producing and providing quarterly accounting reports to lenders is an example of bonding costs. Residual loss is the reduction in value of the firm that results from the separation of ownership of control, when the marginal cost of additional monitoring or bonding exceeds the expected benefit.  

B) Take a look at Wesfarmers 2021 Remuneration report in their Annual report (in week 1 folder).

Discuss in groups:

What performance measures determine the bonuses of executives?

· How does the remuneration contracts used by Wesfarmers help overcome agency problems?

· What theories help us to understand  management behaviour in relation to remuneration?

Case study 2.2

During the year ended 30 June, City Retail Ltd launched a new logo and spent $1 000 000 on new signage for all its premises. The expenditure on signage was originally accounted for as part of property, plant and equipment. It was recognised as a depreciable asset with a useful life of 10 years.

Tony has been engaged as the new accountant for City Retail Ltd. Tony believes that the expenditure for signage should be recognised as an expense because it is in the nature of advertising and the signage has no resale value. Eager to impress the senior managers, Tony gave a presentation on how he would ‘improve’ the forthcoming financial statements, by expensing signage costs. An extract from his presentation is provided below:

Tony was puzzled by the senior managers’ response: ‘You don’t understand our business. What might look like an improvement for your financial statements, looks like devastating economic consequences for us.’

Additional information

· Managers receive a bonus, subject to profit exceeding 10% of total assets.

· The long term debt agreement restricts borrowing to a maximum of 65% of total assets.

Required

For simplicity, assume that the change in accounting treatment has no implications on tax or tax expense.

1. Describe and quantify the effects of recognising the signage costs as an expense in City Retail Ltd’s financial statement for the year ended 30 June.

2. How would agency theory explain why the managers of City Retail Ltd did not welcome Tony’s accounting treatment for the expenditure on signage?

1. Ignoring tax, if the signage costs were recognised as an expense for the year ended 30 June, profit would decrease by a net amount of $900,000, comprising an increase in signage expense of $1,000,000 and a decrease in depreciation expense of $100,000. This would flow through to a reduction in equity of $900,000. Thus profit for the period would be $300,000 and shareholders’ equity would be $2,500,000 at 30 June. Assets would decrease by $900,000, being the carrying amount of the signage, to $7,500,000 at 30 June if the signage were expensed. The accounting treatment of the signage costs has no effect on liabilities.

2. Agency theory suggests that managers with bonus plans linking remuneration to accounting profit are more likely to prefer accounting policies that increase profit. City Retail Ltd has a remuneration scheme that links the managers’ bonus to profit. The change of accounting policy reduces profit to $300,000 and assets to $7,500,000. Profit would be only 4% of total assets, which is below the hurdle of 10% of total assets. Accordingly, the managers would not be eligible for a bonus for current period.

Agency theory suggests that management of firms with high leverage, or in close proximity to leverage constraints, are more likely to prefer accounting policies that increase reported profit so as to avoid breaching restrictive debt covenants. Management of City Retail Ltd would prefer to account for  the expenditure on signage as an asset because expensing it would reduce assets and thus increase the firm’s leverage ratio to 67% (i.e., $5,00,000/$ 7,500,000), which exceeds the maximum leverage ratio of 65% permitted by its long-term debt contract. Management would be keen to avoid the breach of the debt covenant because it might cause the lender to demand repayment in full, resulting in costly refinancing.

Exercise 2.7

Mechanistic hypothesis and efficient market hypothesis

Hudson Ltd had always classified interest paid as an operating cash flow. In 2024 Hudson Ltd changed its accounting policy and classified interest paid of $50  000 as a financing cash flow in its statement of cash flows. The reported amounts are summarised below.

Required

1. Describe the mechanistic hypothesis. What does the mechanistic hypothesis predict about how investors and, therefore, share prices will respond to the increase in operating cash flows reported in Hudson Ltd’s 2024 financial statements?

2. Describe the semi-strong form of market efficiency. What does the efficient market hypothesis predict about how investors and, therefore, share prices will respond to the increase in operating cash flows reported in Hudson Ltd’s 2024 financial statements?

(LO5)

1. The mechanistic hypothesis predicts that investors will focus on the reported numbers and ignore the underlying methods and classifications used to calculate them. Accordingly, in the absence of other news, the mechanistic hypothesis predicts that the share price would respond favourably to the increase in operating cash flows.

2. The semi-strong form of market efficiency assumes the rapid and unbiased adjustment of prices in response to all publicly available information. Accordingly, if a securities market is efficient in the semi-strong form, security prices reflect all publicly available information. Assuming the market is efficient in the semi-strong form, the efficient market hypothesis predicts that investors would respond to all the information contained in Hudson Ltd’s financial statements, including the composition of numbers reported in its statement of cash flows. As this is a cosmetic change in accounting policy, merely impacting on the classification of cash flows rather than the amount of cash generated or used, it would not be expected to have any effect on share prices.