Economic consequences and positive accounting theory try to explain why managers care about accounting policy choices and to predict how managers will respond to changes in accounting standards. Required: a) Explain the relation between economic consequences and contracting, and between contracting and the moral hazard problem. b) A current debate in accounting practice is whether rules-based or principles-based GAAP (generally accepted accounting principles) is preferable. Which do you think is preferable from the perspective of economic consequences and efficient contracting between investors and managers? Why?
Economic consequences and positive accounting theory try to explain why managers care about accounting policy choices and to predict how managers will respond to changes in accounting standards.
- a) Explain the relation between economic consequences and contracting, and between contracting and the moral hazard problem.
Need a contract to enforce actions that the principal prefers
This is not a problem unless 3 conditions hold:
1 A divergence of interests.
2 A need for the individuals to transact.
3 Observation Problems.
What actions may be unobserved?
- Employee’s effort.
- How much investment a regulated firm is making.
- How carefully individuals are preparing themselves for retirement.
Usually the principal only receives a noisy signal of the effort expended (Output, accounts, profits)
If the agent does not care about risk the principal can give him incentives to behave efficiently (sell him thecompany!).
If the agent does care about risk then it is impossible!
General Conclusions
To solve the moral hazard problem when agents are risk neutral and have unlimited liability is easy – sell them the company.
If they have limited liability (e.g. bank loans) or care about risk its harder to give them incentives.
In limited liability efficiency does not occur some investments that should be made will not. (Second best).
- b) A current debate in accounting practice is whether rules-based or principles-based GAAP (generally accepted accounting principles) is preferable. Which do you think is preferable from the perspective of economic consequences and efficient contracting between investors and managers? Why
GAAP’s objective is to facilitate the efficient allocation of capital within an economy.the theory predicts that GAAP’s principal focus, as shaped by the demand for and supply of financial information, is on the use of the income statement and balance sheet for performance measurement and control (stewardship).
Over the last two decades, the global financial landscape has undergone a significant transformation. These developments have been attributable, in part, to dramatic changes in the business and political climates, increasing global competition, the development of more market-based economies, and rapid technological improvements. At the same time, the world’s financial centers have grown increasingly interconnected.
My decision to adopt the GAAP Standards was based on our conclusion that the standards were of high quality and that their adoption would provide information comparable to the amount and quality of information that U.S. investors receive today
Because of the following reason principles-based GAAP (generally accepted accounting principles) is preferable over rules-based
- effective, independent and high quality accounting and auditing standard setters;
- high quality auditing standards;
- audit firms with effective quality controls worldwide;
- profession-wide quality assurance; and
- active regulatory oversight.
