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Law and Economics Agency theory is a good explanation for costs of capital. Agency theory defines contracts as under which one party called principal engages another party called the agent to perform service on the principals behalf. Concluding, the principal delegates decision-making authority to the agent. Both sides of the contract are utility maximises and the agent will not necessarily act in the principals best interests. This leads to the rise of agency costs. Agency costs are the welfare reduction by the principal due to the divergence of the interest.
There are three agency costs: monitoring costs, bonding costs, and residual loss. Monitoring costs are the costs of monitoring agents behavior. They are expenses of the principal to measure, observe, and control the agents behavior. Good examples for monitoring costs are auditing costs. To protect themselves of huge monitoring costs principals are bearing the costs to agents. An example can be given in lending: A high-risk company has high monitoring costs, which leads to a high interest rate.
Another example would be the reputation of the manager: Has he got a bad reputation, than his salary would be lower than usual. Agents try to reduce monitoring costs by installing mechanisms to guarantee that they will behave in the interest of the principal or by proposing to compensate principals for their losses. The mechanisms mentioned above are bonding costs, because they are the costs of bonding the agents interest to the principals. Quarterly financial reports are bonding costs, namely the time and effort invested to generate the financial report. Agents will normally weigh bonding costs with monitoring costs and chose the cheaper alternative.
Despite bonding and monitoring costs, it is still likely that agents interests will not correspond exactly with the principals. If the manager is not motivated and does not invest his whole efforts, than his actual work output is lower than it would be, if his interests were exactly the same as principals interests. The fundamental prerequisite for understanding and evaluating the quote now, it is necessary to mention that it is not possible to measure the true financial performance of a company. Accounting is a social science and cannot be objective: Accounting as a social science is bidirectional and does not have an objective and separate existence from accountants (Godfrey-Jayne et al; 1997, p. 395). Accounting deals with measurements and should as good as possible enable users to determine the fair value: The amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arms length transaction. This leads to the principle of presenting a true and fair view of the company.
If this aim could be achieved, than investors should gain full confidence in the integrity of markets, reducing their monitoring and bonding costs, which should result into a reduction of the cost of capital. But the production of accurate information is tricky, because accuracy is defined as relevant and reliable, but both criteria are based on each other. Their reasoning is circular. Then, comparability of information needs an explanation. This leads into either one standard for accounting procedures or different standards with firms obliged to mention which standard they have chosen. In the past, business fought constantly against imposing uniformities on standards and the problem of the latter suggestion is that it needs skilled users to evaluate the impact of the different standards on the financial statement.
As only a limited group will be able to do this, the number of possible finance is reduced. Capital could become more expensive since in free market systems a broader supply of capital should result into lower prices for capital and the reverse effect is true. Further, accounting has difficulties to clearly measure performance and the value of assets. Therefore, many different methods exist as historical cost, present value, current replacement costs, net realizable value, and deprived value accounting and all are reasonable in their approaches. Trust of the public means more trust in managements behavior. This is reflected in less monitoring and reduced bonding costs.
The former reduction is obvious and with good experience in more trustworthy relationships the monitoring mechanisms should decrease. As these costs decrease, so should the costs of capital decrease caused by a decrease of interest expense or dividend payout. A capital markets development is dependent from investors trust into the information given by the investments. Capital markets can only develop if investors are willing to take risks and accept new financial instruments.
To raise the trust of investors they must receive comparable information. Users have to be enabled to disarm and evaluate similarities and differences between the nature and effects of transactions and events, at one time over another time. For new financial instruments this is not possible, but a solid and regularly stated accounting policy should nurture enough confidence. Therefore, the regular disclosure of accounting policies is very important. Then, the innovators of new financial instruments, which develop the capital market, have to know that there is a reward for their efforts. Unless the market honors their creativeness with extraordinary revenues, they will not be as innovative as they could be.
Since the benefits of developing financial instruments will not equal the costs. The conceptual framework defines concepts as costs, liabilities, and revenues. This definition decreases the further need for standards and leads to fewer standards. The conceptual framework is a frame of reference for all users of accounting in their decision-making. It is used to solve current issues in accounting.
A current, positive tendency is the outlawing of abuse of flexible accounting. Creative accounting and weak accounting standard setting led to bad experience in the mid- 80 s. Both conspired to erode significantly the integrity of financial reports. This demonstrates how insufficient standards lower the trust in accounting and its integrity. Further, creative accounting raises monitoring costs. Debt holder could require more often certain accounting methods (ex ante approach) and regular reports (ex post).
This is the reason, why even not ethically orientated managers should be interested in integer standards. Users are able to discover certain accounting alternatives to reduce agency costs. They discover differences due to the depreciation method but cannot recognize small-scale alternatives. This takes them too much time, costs exceed benefits; instead, They expect accountants to provide comparable standards. (Anthony; 1983; p. 14) Even financial analysts state that it is difficult to compare net income across companies because of the variety of methods and creative accounting. If even the experts cannot gain enough useful information from financial statements, the market instead has to demand more monitoring mechanisms to determine the methods used by a firm.
This increases costs of capital further. Lack of confidence in the pricing efficiency of the market tends to focus the attention of both investors and raisers of capital on potentially wasteful techniques of exploiting perceived inefficiencies, and away from a more positive recognition of the messages contained in the market price. (Keans; 1983; p. 3) According to EMH more information leads to fairer prices and better decisions. The economic forecasts will be closer to reality, raise trust, making the future more calculable and ultimately reducing agency cost. Better information allows a better resource allocation. However, since we do not have a strongly efficient market only a small group of users will benefit from the better information.
The given more useful information do not reach all users. A lot of the mentioned arguments work in theory but not in practice. Not all users are skilled in accounting and do not know how to make information more relevant. More information raises production expenses but derives no equal benefits. Further, we can already speak of an information overload. A potential investor cannot analyze the financial statements of all companies that are listed on the domestic stock exchange, not to speak of international companies or derivatives like currency swaps.
Furthermore, studies have shown that shareholders prefer steady growth, instead of abrupt changes in income even if the sum of income is equal. Regarding to this, companies need creative accounting. Then, future opportunities and expectations normally influence the share prices not historical results presented in financial statements. In addition, the agency costs will only decrease if capital is too expensive at the moment. If this issue could be solved, accounting would have made a great step towards more accurate financial reports and performance evaluations, and would receive more trust by the public.
Firstly, the benefits of the newly introduced accounting standards must at least equal the costs. Secondly, the consensus process must not be time consuming because of the fast-changing environment, which continuously produces new issues. Lastly, the influence of historical (accounting) information on share prices and interest rates must be determined, how strongly it influences agency costs. Sources: Anthony, R. V. (1983), Tell it like is was: A conceptual framework for financial accounting, Richard D.
Irwin Inc. , Homewood, Illinois. Blonde, J. , (1997), Brand New World, cited Financial Accounting III (Second Semester 1998), Ed. Phil Hancock, pp. 309 - 311, Murdoch University, Perth, Western Australia. Godfrey, J. , Hodgson, A. , and Holmes, S. (1997), Accounting Theory, 3 rd Edition, Jacaranda Wiley Ltd, Milton, Queensland. Griffiths, I. (1995), Creative accounting: How to make your profits what you want them to be, Macmillan Press, London. Henderson, S. (1998), Issues in financial accounting, 8 th Edition, Longman, South Melbourne.
Keans, S. M. (1983) Stock market efficiency: Theory, evidence and implications, P. Allan, D eddington. McGregor, W. , (1990), The Conceptual Framework for General Purpose Financial Reporting: Its Nature and Implications, cited Financial Accounting III (Second Semester 1998), Ed. Phil Hancock, pp. 104 - 107, Murdoch University, Perth, Western Australia.
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Research essay sample on Conceptual Framework Financial Accounting
