AK0040

ACCOUNTING THEORY
The Efficient Contracting
Approach to Decision
Usefulness

ACCOUNTING PROGRAM
Contents
• What Is Efficient Contracting Theory?
• Sources of Efficient Contracting Demand for Financial
Accounting Information
• Accounting Policies for Efficient Contracting
• Contract Rigidity
• Employee Stock Options
• Distinguishing Efficiency and Opportunism in
Contracting
• Summary of Efficient Contracting for Debt and
Stewardship
• Implicit Contracts
What Is The Efficient Contracting
Theory?
• Efficient contracting theory studies the role of financial
accounting information in moderating information
asymmety between contracting parties, thereby
contributing to efficient contracting and stewardship and
efficient corporate governance.
• It is an important component of the firm’s activities with
the interests of its investors and society.
• It assumes that managers, like investors, are rational and
studies how the conflict between them.
• It believes in markets, because it assert that, ideally,
demands for financial accounting information should met
by market forces, with the role of standard setting to
provide general principles within wich accounting practices
can develop based on laws of supply and demand.
Sources of Efficient Contracting Demand for
Financial Accounting Information
Sources of efficient contracting demand for financial
accounting information can be described with this
two sources, such as:
1. Lenders
2. Shareholders
Sources of Efficient Contracting Demand for
Financial Accounting Information
1. Lenders
• Debt contract are an important source of financing for
most firms. While the ultimate security for lenders,
like shareholders, is the firm’s future performance,
two aspects of debt contracts dhould be noted.
First, it is management that has the best
information about the state of the firm.
Lenders are concerned about this information
asymmetry because management may not share
their information with them and, indeed, mau
choose accounting policies to hide performance
that threatens lender intersts.
Lenders thus demand protection againts this
possibility. (continued...)
Sources of Efficient Contracting Demand for
Financial Accounting Information
1. Lenders (...continued)
Second, lenders face payoff asymmetry. Like
equity investors, they stand to lose if the firm
performs poorly.
However, unlike equity investors, their gains
are limited if the firm performs well.
Consequently, lenders are crucially concerned
about protecting themselves on the downside
– that is, protection againts financial distress.
For this reason, they demand financial
accounting policies that help prevent financial
distress and provide an “early warning system”
if distress threatens.
Sources of Efficient Contracting Demand for
Financial Accounting Information
2. Shareholders
• An efficient contracting source of demand for
accounting policies also arises from shareholders (and
boards of directors operating on shareholders’
behalf), to protect themselves from exploitation by
management.
• To some extent, exploitation is controlled by basing
manager compensation on some measure of manager
performance, such as net income.
• Also, the confirmatory role of financial statements
helps to prevent managers from overstating their
inside infromation during the year, which could result
in share price overvaluation by the market.
(continued...)
Sources of Efficient Contracting Demand for
Financial Accounting Information
2. Shareholders (...continued)
• However, since managers are assumed to act in
their own interest, and since information
asymmetry prevents shareholders from directly
observing managers’ effort in running the firm (a
moral hazard problem), managers may shirk on
effort and cover up overstatements and lower
profit through opportunitic behaviour such as
overvaluation of assets and managing earnings
upward.
• This creates a demand for financial accounting
policies that encourage responsible manager
effort and limit opportunitic manager actions.
Accounting Policies for Efficient Contracting
Accounting policies for efficient contrating, consist of:
• Reliability
To be reliable, accounting information for efficient
contracting should be based on realized market
transactions, and be veriable by third parties.
• Conservatism
The efficient contracting rationale for conditional
conservatism extends beyond legal liability. As
mentioned, it provides an early warning system of
impending financial distress. Also, conditional
conservatism, by creating a systematic understatement
of net asset value, provides lenders with a lower bound
on net assets to help them evaluate their loan security.
Contract Rigidity
• Contracts, by their nature, can be hard to change.
In other words, contracts are rigid.
• Also, many contract, such as debt contracts, are
long term.
• Given contract rigidity, the firm faces a corporate
gevernance tradeoff. The optimal set of accounting
policies for the firm represents a compromise.
Employee Stock Options
• We now examine an area where management concern
aboutn accounting policy was particularly apparent.
• This is the accopunting for stock options issued to
management and, in some cases, to other employees,
giving them the right to buy company stock over some
time period.
• We will refer to these options as EOS’s
• Management’s concern about accounting policies does
not contradict efficient securities market theory. Even id
securities markets are efficient, and managers believe
this, management concern about the effects of
accounting policies on contracts remain.
Distinguishing Efficiency And
Opportunism In Contracting
• We conclude that both efficient contracting and
opportunism exist in the real world of accounting.
• This puts accountants and auditors on notice that while
the borderline between these two types of behaviour is
imprecise, some manager accounting policy choice, even
if within GAAP, may be opportunistic. This represents a
failure of corporate governance.
• If managers cannot be dissuaded from such policy choices,
the onus is on the accountant fo full disclosure so that
investors are not misled.
• Otherwise, the firm faces the likehood of financial
statement restatements, lawsuits, and possible securities
commision investigation, all of which damage the
reputations of the accountants as well as management.
Summary of Efficient Contracting
for Debt and Stewardship
• Efficient contracting theory studies the role of financial
accounting information in moderating information
assymetry between contracting parties.
• It predict that reporting to lenders and reporting on
manager stewardship are important sources of demand
for dinancial accounting information as a protection
againts managers’ inside information advantage and
possible shirking.
• At it most general level, the story asserts that accounting
policy choice is part of the firm’s overall need to attain
efficient contracting and corporate governance.
• To attain efficient contracting, financial information
should be reliable and (conditionally) conservative.
Summary of Efficient Contracting
for Debt and Stewardship
• A significant implication of efficient contracting
theory is that accounting policies have economic
concequences. That is, they matter to managers.
• To the extent that managers have flexibility to
choose accounting policies, they may change these
policies to offset the effect of new accounting
standards on debt and compensation contracts.
Lacking sufficient policy flecibility, they may change
operating policies.
Summary of Efficient Contracting
for Debt and Stewardship
• Firms face a tradeoff in the accounting policy flexibility to
managers.
• Too little flexibility leads to contract inefficiency when
accounting standards change.
• Too much flexibility opens up the possibility of manager
opportunism.
• A reasonable compromise is to allow managers to choose
accounting policies within GAAP.
• Contract theory has led to a rich body of empirical
literatur. Some studies suggest managers opportunism.
Others suggest efficient contracting.
• Accountants should be allert to the possibility of manager
opportunism, since they are usually caught up in the
lawsuits that follow.
Implicit Contracts
• Non-cooperative game theory enables us to model
the conflict situation that often exists between
different constituencies of financial statement
users.
• Even a very simple game-theoretic model shows
that an accounting standard-setting body that fails
to consident the interests of all constituencies
affected by accounting policy choice is in danger of
making policy recommendations that are difficult
to implement.
Questions and Answers