SUFE 2005

Accounting Phd Seminars

Economic Institutions and Financial Accounting Reporting

Professor TJ Wong

Summer 2006

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Twelve Topics• Organization economics• Corporate ownership and agency costs• Government, regulations and accounting• Positive accounting theory• Corporate ownership and governance around the world• Economic institutions and corporate governance in China• Accounting conservatism• Accounting properties• Financial analysts• Executive compensation• Earnings management• Auditing

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Where have we come from in China accounting research?

• Moving away from normative research– Know how the world actually works– Know how it works in China

• Moving to descriptive research: documenting phenomena, e.g. earnings management

• Can we always explain what we find?

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A New Approach in Research

• Build a framework to understand how the institutions in China affect the role of accounting information

• With this framework, you can – come up with new research topics– Provide more complete explanations of certain

market phenomena and firm/managerial behaviors

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Value of the Research

• Academic value– China offers a natural laboratory for accounting research

because of her rich and unique institutional setting

– Recent trend in international research in economics, finance and accounting started by Andrei Shleifer

– Our research on listed companies (micro approach) would interest many economists and other social scientists who do research on China economic reform

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Value of the Research• Social Impact

– Understand better the organization structure of a listed SOE

– For policy setters, they would know how different involving parties (shareholders/owners, banks, bureaucrats, managers) in a firm and the market react to a new standard or regulation

– Help identify constraints to improve corporate governance transparency

– Not limited to accounting issues

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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

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Organization Economics

OverviewWhich 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)

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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?

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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

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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

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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 limitsIV. How do long-term contracts give rise to the

formation of firms?See p.392

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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

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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

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Production, Information Costs, and Economic Organizationby 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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2. Several input owners

3. One party who is common to all the contracts of the joint inputs

4. Who has rights to renegotiate any input’s contract

independently of contracts with other input owners

5. Who holds the residual claim

6. Who has the right to sell his central contractual

residual status

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I. The metering problem

•A study of the relation between metering inputs and rewards•Metering problems sometimes can be resolved in markets. Market exchange yields a high correlation between rewards and productivity•Classical relationship in economics assume the existence of an organization, that allocates rewards to resources in accord with productivity•This paper looks at a reverse causality. It is the specific system of rewarding that shapes a particular productivity response

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II. Team production

Team productionSeveral types of resources are used•The product is not a sum of separable outputs of each cooperating resources•Not all resources used in team production belong to one person

Costs of metering the marginal products of the team’s membersand shirking incentives •If net productivity increases after metering costs, we observe teamWork

Ways to reduce shirking – market competition•Costs for investigating where and how much shirking•New team workers also shirk

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III. Prelude to agency problem One method to reduce shirking: monitor•Who monitors the monitor

•Competition•Offer the monitor the residual claim in the firm

•How the residual claimant (owner) monitor other inputs•Measure outputs•Apportion rewards•Observe inputs’ behavior•Giving assignments and instructions

•Rights for owner•Residual claimant•Observe inputs•Central party to all contracts of inputs•Alter membership in team•Sell rights to others

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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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1. Motivation

What is separation of ownership and control in the Berle and Means context? High degree of stock ownership dispersion.  What is the problem? A manager’s diversions from stockholders’ interests are less likely to be “policed.” Is this claim true? Is dispersion of ownership always bad? Would it destroy wealth?Some considerations before answering these questions:• Increase number of shareholders, more specialization in a variety of knowledge. • Managerial labor market could align interests between managers and dispersed owners

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2. Theory a. Compensation contractsRelying on reputation and efficient managerial labor market. Efficient means good manager, based on his track records, command a higher salary. “Via a contract, in the context of competition for his services, an amount commensurate with the most optimistic employer’s belief of what his is expected to produce.” Note: these managers don’t have to share in profits and be co-owners.

b. Is dispersed ownership wealth destroying?Dispersion of owners increases policing cost. It increases managers’ ability to engage in diversionary tactics. The forms but not value of managerial behavior and of rewards in the dispersed ownership corporation are different and more costly (inefficient), but the managers would reap no extra gain! 

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Consumers would pay a higher price than otherwise would (if there’s no diversionary activities – first best result) but this is still cheaper than if there were no dispersed ownership corporations).*  Shareholders will price protect up to the competitive return level. *He’s silent here about why there’s dispersed ownership and the real benefits of such ownership structure. In analyzing agency cost of an organization, we need to understand the “benefit” side of such organization structure that gives rise to the agency cost. Questions: What are the benefits of dispersed ownership in US and UK? What are the benefits of dispersed ownership in Europe and East Asia?

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Implications – (1) dispersed ownership, for-profit organization, we should expect different types of managerial and employee behavior and rewards than in small and closely held corporations. (2) These corporations may have greater cost of policing and revising delegated authority, but not necessarily lower wealth for stockholders than concentrated ownership. NOTE: a big underlying assumption is there are relative efficient markets for labor, consumer products and equity capital. 

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3. Property rights and not-for-profit organizations Power of for-profit organizations that gives shareholder rights voting rights, cash flow rights and the ability to transfer these two rights: the capitalization of future effects into present value (stock price is the PV of discounted future cash flows) combined with the ability to capture that market wealth by selling to a second party, provides an effective stimulus to the control of actions that affectpresent capital values.  Absence of these rights in not-for-profit organizations or heavily regulated industries (can fully share profits because of press control) would encourage diversionary activities by managers.

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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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1. Introduction

Specific knowledge is costly to transfer among agents and generalknowledge is inexpensive to transmit.

Two problems when we have knowledge transfer cost:•Rights assignment problem – Who should receive the decisionrights?•Control or agency problem – How to ensure that self-interesteddecision agents not to abuse power

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2. Knowledge

•Limited knowledge of decision-makers•Transfer knowledge or decision rights in order to get collocation•Cost of transferring knowledge (different between specific andgeneral knowledge

3. Rights systems

•Decision right – the right to make decision and take actions•Alienable rights – right to sell the resource and right to capture the proceeds of the sale•Assignment of rights is largely a matter of law•Weak enforcement of property rights - the alienable decision rights – will result in waste of specific knowledge and lack of control

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4.In the market place, the function of alienability of decision rights

•Solves the rights assignment problem•Voluntary exchange creates a process in which the purchase sale of rights b maximizing individuals collocates knowledge and decision rights.

•Solves the control problem•They provide a measure of the performance of the parties w/the rights•They provide the reward or punishment that accrues to theowners of the rights as a result of their decisions

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5. The organizational problems of the firm

•Without alienable rights, agency cost becomes more acute•Tradeoff – decentralization increases collocation of knowledgeand decisions but also increase agency problem•Improvements in control technology such as communicationand measurement techniques, will tend to increase Decentralization in an organization•Creation of a control system is important (Alchian and Demsetz)

•Measures of performance•Specifies the relation between rewards/punishments andmeasures of performance

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Organization Form, Share Transferability, and Firm Performance: Evidence from the

ANCSA Corporations – Karpoff and Rice

Theme: How organization form (share transferability – related to the alienability in JM) affects monitoring problem (Alchian and Demsetz), which in turns affects firm’s operating efficiency and performance

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1. Firm characteristics

•Shares are not transferable (imposed by govt)•Ownership is diffuse•Managerial monitoring is unsophisticated

2. Theory

The restriction in share transfer has resulted in poor monitoring of mgmt•No market for corporate control •No good managerial labor market’s evaluation – no security analystsand market price that can measure managers’ performance•Stock-related compensation contracts cannot be effective incentives

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3. Performance test

Alternative hypotheses•Non-profit purpose•False poor performance•Section 7(i) incentives•Legal cost problem

4. Other evidence•Control contests, board member turnover, CEO turnover•Costly monitoring mechanisms•Diversification in operations•Operations versus passive investment•General and administrative expenses •Compensation