Economic Institutions, Governance and Accounting

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NSC Outstanding Scholar Series. Taiwan March 2005. Top-down Approach. Start with economic institutionsFind key constraints that affect firm structures (ownership, organization, management and governance)Understand the incentives structuresExamine the effects on accounting and auditing. NSC Outs

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Economic Institutions, Governance and Accounting

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1. NSC Outstanding Scholar Series Taiwan March 2005 Economic Institutions, Governance and Accounting Professor T.J. Wong The Chinese University of HK

2. NSC Outstanding Scholar Series Taiwan March 2005 Top-down Approach Start with economic institutions Find key constraints that affect firm structures (ownership, organization, management and governance) Understand the incentives structures Examine the effects on accounting and auditing

3. NSC Outstanding Scholar Series Taiwan March 2005 Developing a Framework Three Steps Descriptive research Fundamental research Build a framework

4. NSC Outstanding Scholar Series Taiwan March 2005 Current Development of Asian Research Bottom-up approach has no future! Two common examples of that: Replicate U.S. research Document a phenomenon but cannot provide good explanations or the explanation is too simple (no academic value)

5. NSC Outstanding Scholar Series Taiwan March 2005 1. Descriptive Research START w/ DATA Understand institutional background Construct a good data sample: data are very hard to get, but they are available Measurement and classification work e.g. Identify ownership types and organization structures Finding some patterns in a chaotic environment

6. NSC Outstanding Scholar Series Taiwan March 2005 2. Fundamental Research To study stakeholder incentives and conflicts among them, we need to first answer some fundamental questions for listed family- or government-owned firms: Ownership and organization structure and incentives What are the property rights allocations among stakeholders? Identify their incentives and conflicts Role of economic institutions, e.g. governments, in ownership and control of firms

7. NSC Outstanding Scholar Series Taiwan March 2005 3. Development of Theoretical Framework Based on theories from economics and finance Transition economics Property rights and transaction cost literature Organization theories e.g. agency framework Use them to guide empirical work that helps develop some descriptive theories

8. NSC Outstanding Scholar Series Taiwan March 2005 Rough Sketch of the Framework

9. NSC Outstanding Scholar Series Taiwan March 2005 Institutional Setting Political economy Govt ownership - SOE Transition economy - lack of markets Govt and private business - rent seeking Law Legal systems and enforcements Culture and social norm Trust Relationship-based dealings

10. NSC Outstanding Scholar Series Taiwan March 2005 How to Go about it? Acquiring the right tools: Organization economics: property rights and transaction cost Ownership and organization costs Government Accounting and agency costs

11. NSC Outstanding Scholar Series Taiwan March 2005 First Step Learn from positive accounting theory Based on organization economics New development in the ownership literature: separation of ownership and control and agency conflict between owners and managers Also based on economics of government regulation research Developing a framework to describe firm’s accounting choices

12. NSC Outstanding Scholar Series Taiwan March 2005 Organization Economics Overview Which productive markets are carried out by markets and which by firms? Formation of firms is an optimal choice (Coase, 1937) Tradeoff between co-ordination and transaction costs How are firms organized optimally to minimize organizational costs? Co-ordination cost Monitoring costs (Alchian and Demsetz, 1972) Monitoring incentives (Karpoff and Rice, 1989) Organization structure (Jensen and Meckling, 1991)

13. NSC Outstanding Scholar Series Taiwan March 2005 The Theory of the Firm I. Underlying ideas Substitution at the margin Formation of firm is not just government fiat, but optimal choice of economic agents (footnote 3, p.398) II. What is the difference between economic planning and price mechanism?

14. NSC Outstanding Scholar Series Taiwan March 2005 Theory of the Firm III. What is the major difference between co-ordination by entrepreneur vs. co-ordination by price mechanisms? Co-ordination determined by changes factor market prices, not entrepreneur’s order

15. NSC Outstanding Scholar Series Taiwan March 2005 Theory of the Firm IV. What is marketing cost? Most obvious one is the cost of discovering what the relevant prices are The cost of carrying out a transaction by means of an exchange on the open market Search and information costs, bargaining and decision costs, policing and enforcement costs

16. NSC Outstanding Scholar Series Taiwan March 2005 Theory of the Firm V. How do the contractual arrangements change when there’s a firm? Several contracts substituted by one Factor agrees to obey entrepreneur within certain limits IV. How do long-term contracts give rise to the formation of firms?

17. NSC Outstanding Scholar Series Taiwan March 2005 Theory of the Firm VI. Main argument in the paper Firms will emerge to organize what would otherwise be market transactions whenever their costs are < costs of carrying out the transactions thru’ the market VII. What is the market? An institution that exists to facilitate exchange, in order to reduce the cost of carrying out exchange transactions

18. NSC Outstanding Scholar Series Taiwan March 2005 Theory of the Firm VIII. Role of law and regulations Reduce transaction costs, not necessarily an attempt to create monopoly rights that aim to reduce competition

19. NSC Outstanding Scholar Series Taiwan March 2005 Production, Information Costs, and Economic Organization by Alchian and Demsetz (1972) The essence of organization It is in a team use of inputs and a centralized position of some party in the contractual arrangements of all other inputs The essence of the classical firm is identified as a contractual structure with: 1. Joint input production

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24. NSC Outstanding Scholar Series Taiwan March 2005 Corporate Management and Property Rights A.Alchian Coase talks about why there is modern firm Alchian and Demsetz analyze how the metering (monitoring) problem shapes the organization structure of a firm This paper focuses on a unique feature in modern firm – separation of ownership and control – affects monitoring problem

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30. NSC Outstanding Scholar Series Taiwan March 2005 Specific and General Knowledge, and Organization Structure Jensen and Meckling, 1991 In Alchian (previous paper), we examine how ownership (separation of ownership and control) affects organization cost - monitoring cost Here, we examine how knowledge affects organization of firms Allocation of decision rights Centralization vs. decentralization within an organization

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35. NSC Outstanding Scholar Series Taiwan March 2005 2. Ownership and Agency Cost

36. NSC Outstanding Scholar Series Taiwan March 2005 Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure – Jensen and Meckling Background Theory of the firm: a black box Before, the firm operated so as to meet the relevant marginal conditions (mc=mr), thereby maximizing profits No theory explains how the conflicting objectives of the individuals are brought into equilibrium to yield the results JM adopts utility max behavior approach to examine how these conflicting incentives shape the equilibrium

37. NSC Outstanding Scholar Series Taiwan March 2005 Background - continued Property rights A very broad term, it includes the rights to the profits generated by the property, the decision rights of the usage of the property, and the rights to transfer the property rights to others For example: a shareholder has cash flow rights, control (voting rights), rights to sell the share This paper studies how contracts are used to allocate property rights among the participants of an organization

38. NSC Outstanding Scholar Series Taiwan March 2005 Background – continued Agency cost Complement property rights literature (study the contractual relationship between principal and agent) Definition of agency costs: a. monitoring expenditures by the principal, b. bonding expenditure by the agent, c. residual loss Similar to shirking and monitoring of team production in Alchian and Demsetz, 1972 Focus is not normative: how to structure contracts to maximize principal’s welfare. Rather, positive: how principal and agents set the contractual relationship by maximizing their respective welfare

39. NSC Outstanding Scholar Series Taiwan March 2005 Background - continued Other issues: Coase (1937): tradeoff between cost of using markets vs. cost of direct authority Alchian and Demsetz (1972): emphasize contractual relationships within a firm (not direct authority); monitoring problem of joint inputs in production process This paper, broader view: firm is a nexus of contracts

40. NSC Outstanding Scholar Series Taiwan March 2005 Agency Cost of Outside Equity Jensen and Meckling (1976) call the contract between shareholders of a firm and owner-manager an agency relationship Owner-manager enjoys money and perks (company cars and business trips) JM analyze how owner-manager’s consumption of perks differs before and after the sale of shares to outsiders

41. NSC Outstanding Scholar Series Taiwan March 2005 Owner-manager with no outside shareholders Perk consumption lowers value of the firm Owner-manager needs to make optimally 3 business trips for a project with net present value of V If owner-manager enjoys business trips and thus makes 4 trips, then the net present value of the project will be V* < V (because business trip is costly Cost of the perk consumption is F* = V - V*

42. NSC Outstanding Scholar Series Taiwan March 2005 Owner-manager with outside shareholders If a fraction of non-voting shares, (1-a) where 0 < a < 1, are sold to outsiders, owner-manager will consume more perks (F’ > F*). Why? Cost of $1 perk consumption drops to $a, outside shareholder shares $(1-a). Firm value drops to V’ = V - F’ < V*. Outside shareholder pays (1-a)V’ for the firm. Why not (1-a)V*?

43. NSC Outstanding Scholar Series Taiwan March 2005 Owner-manager with outside shareholders (cont’d) Rational expectation of investors in market as it is under Efficient Market Hypothesis Outside shareholders are price protected They expect the increase in consumption of perks to F’ and reduction in share value to V’. Owner-manager’s reduction in wealth V* - V’ is the agency cost

44. NSC Outstanding Scholar Series Taiwan March 2005 Contracts for monitoring To the owner-manager, the agency cost of the additional perk consumption after sale of shares to outsiders is V*-V’. However, the benefit of consuming it may be K, K < V*-V’. If the owner-manager can contract for monitoring (hire an auditor) at a cost of M, he will do so if V*-V’ > K+M.

45. NSC Outstanding Scholar Series Taiwan March 2005 Contracting role of accounting Accounting numbers are used in contracts (debt contracts, management compensation contracts, government rules) External auditor as monitors Financial analysts as monitors Stewardship vs. information role of accounting

46. NSC Outstanding Scholar Series Taiwan March 2005 Separation of Ownership and Control – Fama and Jensen Theme: To explain of the survival of organizations characterized by separation of ownership and control, absent of fiat. In such organization, important decision agent do not bear a substantial share of the wealth effects of their decisions

47. NSC Outstanding Scholar Series Taiwan March 2005 Key contractual arrangements in firms The contract that specifies the nature of residual claims and The contract that allocates the steps of the decision process among agents These 2 contracts distinguish organizations from one another and explain why specific organizational forms survives

48. NSC Outstanding Scholar Series Taiwan March 2005 Residual claims Residual claimants or residual risk bearers contract for the rights to net cash flows. The residual risk here is the risk of the difference stochastic inflows of resources and promised payments to agents Having uncertainly borne by ONE group has survival value by reducing monitoring cost Contracts that direct decisions toward the interests of residual claimants add survival value – lower production allows products to be more competitive

49. NSC Outstanding Scholar Series Taiwan March 2005 Residual claims - continued Residual claims may contain restrictions – e.g. state share cannot be traded Least restriction is common stock of a large US corporation (e.g. of an open corporation) Shareholders not required to have any role Residual claims are alienable without restriction This allows unrestricted risk sharing Closed corporation have residual claims largely restricted to internal decision agents – limited risk sharing

50. NSC Outstanding Scholar Series Taiwan March 2005 The decision process The process has four steps Initiation – generation of proposals for resource utilization and structuring of contracts Ratification – choice of the decision initiatives to be implemented Implementation – execution of ratified decisions Monitoring – measurement of the performance of decision agents and implementation of rewards 1 & 3 are decision management and 2 & 4 are decision control

51. NSC Outstanding Scholar Series Taiwan March 2005 Relations between risk-bearing and decision process Define some contractual arrangements Separation of residual risk bearing from decision management leads to decision systems that separate decision management from decision control Combination of decision management and decision control in a few agents lead to residual claims that are largely restricted to these agents

52. NSC Outstanding Scholar Series Taiwan March 2005 Relations between risk-bearing and decision process - continued An interesting question – what determines these two different types of contractual arrangements Decision management, decision control and residual risk bearing: Combination Separation

53. NSC Outstanding Scholar Series Taiwan March 2005 Combination More optimal for small noncomplex organization where specific information relevant to mgmt and control is concentrated in one or a few agents Combining mgmt and controls increases agency cost, thus restrict residual claimants to be decision agents This restriction limits the benefits of unrestricted risk sharing – firms become too risk adverse These problems less serious in small noncomplex organization

54. NSC Outstanding Scholar Series Taiwan March 2005 Separation In complex organizations, specific knowledge relevant to decision management and decision control is diffused among agents, leading to separation of management and control Residual claims are also diffused – allowing unrestricted risk sharing, satisfy their demand for capital Separation increases agency cost but allows valuable knowledge to be used at the point of the decision process, reducing agency cost

55. NSC Outstanding Scholar Series Taiwan March 2005 The Structure of Corporate Ownership: Causes and Consequences – Demsetz and Lehn Motivations Separation of ownership and control increases shirking, lower efficiency There exist advantages of diffuse ownership that counterbalance such externalities Firms that vary ownership concentration is guided by this tradeoff, guided by the goal of value maximization

56. NSC Outstanding Scholar Series Taiwan March 2005 Main theme Two questions What determine ownership structure? Understanding what makes these advantages of diffuse ownership vary in strength from firm to firm Does ownership concentration matter (after controlling for other determinants of profits)

57. NSC Outstanding Scholar Series Taiwan March 2005 Four proposed determinants of ownership concentration Size Control potential Regulation Amenity potential

58. NSC Outstanding Scholar Series Taiwan March 2005 Consequence of diffuse ownership structures Demsetz (1983) predicts no relation. The ownership structure is optimally decided to maximize profits.

59. NSC Outstanding Scholar Series Taiwan March 2005 Management Ownership and Market Valuation: An Empirical Analysis - Morck, Shleifer and Vishny 2 hypotheses: Entrenchment hypothesis – increase ownership can free mgmt from checks on his control. Control of board and free from takeover threat Convergence-of-interest hypothesis – interests of mgmt and outsider investors are aligned, less agency problem

60. NSC Outstanding Scholar Series Taiwan March 2005 Government

61. NSC Outstanding Scholar Series Taiwan March 2005 Outline The theory of economic regulation Political process and wealth transfer Political process and accounting 3 models of government Politician incentives and firm behavior

62. NSC Outstanding Scholar Series Taiwan March 2005 The Theory of Economic Regulation George Stigler Main point: to explain who will receive the benefits or burdens of regulation, what form regulation will take, and its effects on resource allocation Regulation is “acquired” by the industry and is designed for primarily for its benefits

63. NSC Outstanding Scholar Series Taiwan March 2005 Two views of political process Economic/rational view: regulation is instituted primarily for the protection and benefit of the public at large or some large subclass of the public Irrational view: politics are not predictable and cannot be rationalized

64. NSC Outstanding Scholar Series Taiwan March 2005 What benefits can state provide for industry? Direct subsidies Control over entries of rivals Policies that hurt substitutes but promote compliments. e.g. airlines lobby against railway but support govt subsidies to airports Price fixing/control

65. NSC Outstanding Scholar Series Taiwan March 2005 Cost of political process - acquiring regulation Democratic political decision process differ from market process Decisions must be made simultaneously be a large number of persons Decisions must involve all the community Information cost is high compared to market decision - information must be sought on many issues with little or no direct concern to individuals

66. NSC Outstanding Scholar Series Taiwan March 2005 Political process The process is a competition among individuals for wealth transfer Political lobbying e.g. Farmers lobby for import quotas, unions lobby for minimum wages Equilibrium result of 2 opposing forces - those providing the benefit and those receiving the benefit

67. NSC Outstanding Scholar Series Taiwan March 2005 Other costs High information cost and the small benefit in obtaining the information leads to the formation of political party or special interest groups Heterogeneity of interests limit the size of the group Too large a group increases organization costs

68. NSC Outstanding Scholar Series Taiwan March 2005 Political process’s effect on accounting procedure Asymmetric loss function -- conservatism in accounting (explain) It is a result of information costs, why? Manage earnings to avoid large windfall profits during the oil crisis Companies in regulated industries used purchase method instead of pooling to increase asset base, so as to increase revenue (fee based on asset base x fixed rate)

69. NSC Outstanding Scholar Series Taiwan March 2005 Grabbing Hand Shleifer and Vishny 3 models Helping hand assumes government is welfare maximizing; govt intervention is response to market failures Invisible hand; govt intervention bad for economy; build market institutions Grabbing hand model; govt is v. self-interested NOT welfare maximizing; focuses on politics that drive government behavior

70. NSC Outstanding Scholar Series Taiwan March 2005 Helping hand In dealing with a banking crisis - a state bank going bankrupt See advantages of state ownership to address market failures e.g. loan to regionally important projects Bad firms are results of bad governance due to market failures

71. NSC Outstanding Scholar Series Taiwan March 2005 Grabbing hand Not a corporate governance issue Rather a public governance issue Politicians pursue political goals, not economic goals in the bank Privatize the bank and limit the influence of politicians

72. NSC Outstanding Scholar Series Taiwan March 2005 Positive Accounting Theory Phd Seminar Professor TJ Wong 2004

73. NSC Outstanding Scholar Series Taiwan March 2005 Background Study of accounting choice, can be broad Level of disclosure Quality of information reported Accounting methods used Accruals Role of accounting information in an organization Role of auditors, type of auditors hired

74. NSC Outstanding Scholar Series Taiwan March 2005 Positive vs. Normative Positive Descriptive Based on theory with objective goal Refutable Emphasize constraints in market, organizational & human behavior Negative Prescriptive A matter of subjective value Not refutable

75. NSC Outstanding Scholar Series Taiwan March 2005 Evolution Information perspective: info usefulness, relationship between accounting information and stock price (Ball and Brown, 1968) In finance theory underlying the empirical tests of these financial accounting research info is costless and no transaction cost Accounting choice is irrelevant

76. NSC Outstanding Scholar Series Taiwan March 2005 Accounting choice matters It matters when we introduce information and transaction costs Development of the literature Production activity can occur via marketplace or within a firm (Coase) Within a firm, there are organization /contracting costs (Alchian and Demsetz) Agency costs associated with debt and equity (Jensen and Meckling) Firms organize themselves to minimize contracting costs (Fama and Jensen; Demsetz and Lehn)

77. NSC Outstanding Scholar Series Taiwan March 2005 Accounting choice matters Development of the literature Firms choose a optimal portfolio of accounting method to minimize organization cost and maximize chances of survival There are costs of “contracting” in the political process (Stigler, 1971). For example, lobbying cost. The extent of wealth transfers created by the political process are affected by these contracting costs

78. NSC Outstanding Scholar Series Taiwan March 2005 Economic Institutions and Accounting Name some sample research based on US data. Non-US studies: Institutions --> organization --> quality of accounting Cross-country looking at legal system; ownership and corporate structures using Asian data; ownership and corporate structures using China data: private vs. government Quality of earnings can include ERC, cash vs. accruals, related party transactions 2. Roles of auditors and analysts 3. Know more about organization structures and role of accounting 4. Government influences and corporate transparency and choice of auditors Name some sample research based on US data. Non-US studies: Institutions --> organization --> quality of accounting Cross-country looking at legal system; ownership and corporate structures using Asian data; ownership and corporate structures using China data: private vs. government Quality of earnings can include ERC, cash vs. accruals, related party transactions 2. Roles of auditors and analysts 3. Know more about organization structures and role of accounting 4. Government influences and corporate transparency and choice of auditors

79. NSC Outstanding Scholar Series Taiwan March 2005 Corporate Financial Statements, A Product of the Market and Political Process – Watts and Zimmerman Background Use the agency theory to examine the role of audited financial statements in reducing agency cost How can accounting information reduce agency cost?

80. NSC Outstanding Scholar Series Taiwan March 2005 What’s new? The idea that agency relationship can explain accounting practice is not new – the “stewardship” concept in the accounting literature What’s new: formally linking firms’ incentives to reduce agency cost and how they contract to supply monitoring info in FS This framework helps generate consistent, interrelated hypotheses about accounting practices Can we learn from them?

81. NSC Outstanding Scholar Series Taiwan March 2005 Research design Use voluntary FS reporting in the 19th century for testing hypotheses of the unregulated market See how contracting costs affect the level of FS reporting in regulated and unregulated market

82. NSC Outstanding Scholar Series Taiwan March 2005 Role of FS in unregulated economy H1: More bonding covenants, greater likelihood for presentation of FS Possible endogeneity problem H2: Smaller managerial ownership, more FS H3: More outside risky debt, more FS H4: Compensation contracts use profits after renewals, repairs, maintenance or depreciation

83. NSC Outstanding Scholar Series Taiwan March 2005 Role of FS in regulated economy In regulated economy, managers still have incentives to reduce agency cost There exists an income-increasing standard, profits increased by some non-cash accruals H5: Loan agreements made after the new standard would exclude the accruals from the profit

84. NSC Outstanding Scholar Series Taiwan March 2005 Information perspective cannot explain accounting practices in unregulated economies FS convey relatively little info which causes the capital market to change the values of share prices Investors have incentives for private info gathering. Managers cannot hold back leakage of info until publication of FS. They can profit from supplying value-relevant info, whereas they will be rewarded for supply relevant info for contracting purposes, e.g. lower cost of capital

85. NSC Outstanding Scholar Series Taiwan March 2005 Political process and FS Understanding bureaucrats’ incentives Voters don’t pay attention to political process but focus on crises Bureaucrats try to avoid future crises Tend to overreact to past crises (e.g. 1929 crash) Losses due to actions are more apparent than losses due to inactions Bias towards undervaluation of assets

86. NSC Outstanding Scholar Series Taiwan March 2005 Political process and FS Understanding bureaucrats’ incentives H6: the assets are more undervalued in economy in which disclosure regulations set by bureaucrats than unregulated economy Overreact to “crises” lead to the following H7: the larger the size of a corporation whose net income is increased (decreased) by a proposal accounting standard, the greater the likelihood that its managers will lobby against (for) the standard

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