Table of content:
2. Accounting information in financial contracting: The incomplete contract theory perspective
(Christensen, Nikolaev, Wittenberg-Moerman, 2016)
3. Is More Always Better? Disclosures in the Expanded Audit Report and Their Impact on Loan
Contracting (Porumb, et al 2019)
3. How does earnings management influence investor’s perceptions of firm value? Survey evidence
from financial analysts (de Jong, Mertens, van der Poel, van Dijk, 2014)
4. The Unintended Effect of Corporate Social Responsibility Performance on Investors’ Estimates of
Fundamental Value (Elliot, Jackson, Peecher, White, 2014)
5. A control framework: Insights from evidence on lean accounting (Kennedy, Widener, 2008)
5. Exploring how the Balanced Scorecard Engages and Unfolds: Articulating the Visual Power of
Accounting Inscriptions (Busco, Quattrone, 2015)
,2. Accounting information in financial contracting: The incomplete contract theory perspective
(Christensen, Nikolaev, Wittenberg-Moerman, 2016)
Central question in accounting literature; how accounting information facilitates transactions
between capital providers and firms.
Role of accounting information is at hearth of positive accounting theory posits that use of
accounting information enhances efficiency of contracting by minimizing contracting cost (agency
cost). Jensen & Meckling role of accounting information is to reduce agency costs associated with
outside financing (equity and debt) which arise from firm managers acting on behalf of stakeholders
taking inefficient actions that expropriate wealth from firm creditors: increasing riskiness of firm
(asset substitution), diluting value of existing debt claims (claim dilution) or failing to take advantage
of investment opportunities (debt overhang). It reduces contract efficiency and gives limits to
opportunistic actions (incentives), protecting creditors’ interest can be done by including
covenants restricting actions of management or ensuring sufficient alignment limit dividend
payouts, CAPEX, asset sales or issuance of additional debt. Agency perspective implies that contract
efficiency role of accounting information is driven by its ability to limit or provide incentives against
opportunistic behavior by the borrower.
Accounting literature on debt contracting;
- Widespread use of accounting measures in formulating contractual provisions
- Significant effect of accounting information properties on debt contract design
- Influence debt contracts have on accounting choice
- Associations between accounting-based contract contingencies, as covenants and
performance pricing provisions, and cost of debt
Theory of incomplete contracts helps broaden perspective on role of accounting information in debt
contracting and on mechanisms through which the efficiency gains take place. Central tenet;
contracts are inherently incomplete because contracting parties cannot anticipate or explicitly
describe all future states of the world postcontractual opportunisms and hold-up problems that
adversely affect incentives of the contracting parties to enter contracts will lead to contract
renegotiations where one party can behave opportunistic. Theory says; mechanism that alleviates
hold-ups is ex ante allocation of decision power (control rights) in contractual relationships
determines status quo in future renegotiations and affect division of surplus between parties has
efficiency implications. Control should be given to those who will contribute more to the joint surplus
(value created by entering contract) debt contracting; borrowers and creditors will agree to
allocate control to the party that has incentives to make value-maximizing decisions as future
unfolds.
Optimal allocation of control rights is contingent on a contractible signal reflecting underlying
economics of borrower accounting system produces summary measures of performance
accounting signals primary candidates for governing state0contingent allocation improves
contracting efficiency by enhancing allocation of control rights.
Agency perspective and incomplete contracting are not mutually exclusive, but complementary
both address conflicts of interest between contracting parties and scope for opportunistic behavior
but have distinction in way of addressing conflicts. Agency not viewing accounting-based
covenants as tool for allocating decision power always rests with management. Incomplete
contract different parties may make different decisions why lenders play active role in
corporate governance and why relying on accounting-based covenants.
, 3. Is More Always Better? Disclosures in the Expanded Audit Report and Their Impact on Loan
Contracting (Porumb, et al 2019)
Literature on debt contracting posits that debt market is characterized by imperfect information and
strong adverse selection problems (from pool of lenders, choose the good ones) while lenders only
provide positive information on projects. Auditing plays crucial role in reducing information
asymmetry and shapes loan contracting terms helps more accurately assess borrower’s risk as it
provides credible information about quality of numbers, reduces uncertainty about cash flows and
transmits auditors’ private information about creditworthiness of borrowers. In attempt to enhance
information content of audit disclosures expanded audit report beyond pass-or-fail would be
useful for debt markets. Given the perceived relevance and credibility will reduce adverse
selection by assisting in credit risk assessments. UK Financial Reporting Council (FRC) first to require
listed firms of expanded audit report following International Standard on Accounting (ISA) 700. They
are mandated to report disclosures on audit procedures, significant risks of material misstatements
(RMMs) and materiality thresholds. This research; examining new disclosures in the expanded audit
report, going beyond the fact of modified auditor opinion or unqualified audit opinion on debt
contracting terms.
Syndicated lending set-up one lead lender and several participating lenders funding one
borrowing firm accounting information is important to reduce information asymmetry between
borrowing firm and lead lender and lead lender and participating lenders. Lead lender decides initial
contract terms after assessing creditworthiness of borrower with high pressure of the speed of
setting up, negotiating and contracting syndicated loans using third party information for initial
screening of borrowers to determine level of effort require in due diligence process. As expanded
audit reports signals provided by credible third parties lenders will use this to indicate riskiness.
Second, due diligence efforts of lead lenders are not observable by others, ensuing information
asymmetry could lead to concerns regarding potential lead lenders’ sub-optimal screening efforts
if borrower if opaque in terms of publicly available information lenders refuse financing. Lead
lender has incentives to justify loan contracting terms to others by referring to observable
information. Information is likely coming from extended audit report.
Contribution;
- Extents economic conseque3nces of expanded audit report; studies focus on equity market,
while this is the debt perspective as the role of auditing is limited, this is important while
debt is a major source of capital.
- Previous studies show that quality of financial reporting and auditing quality are associated
with loan terms, this focus; usefulness of disclosures in expanded audit report for setting
loan terms, this means also contributing to studies focusing on the impact of the presence or
nature of traditional pass-or-fail audit reports on debt contracting.
Main function of statutory audit report is communicating results of auditor’s assessment of whether
a company’s financial statements are fairly presented highly standardized. Financial crisis and
scandals question whether it’s still informative as there is little company-specific information
believe that auditors possess private information that may be relevant if disclosed expanded audit
report include information regarding auditor’s responsibilities and procedures applied during
audit, central element of proposals mandate auditors to disclose RMMs; those matters that, in the
auditor’s professional judgment, were of most significance in the audit of the financial statements of
the current period. ISA 701 auditors not only have to explain why the matter was significant, but
also how it was addressed. Number of RMMs is dependent on the company, but IAASB expects at
least one. UK extended model is obligatory with ISA 700 requiring an explanatory paragraph of how
the auditor applied the concept of materiality and a discussion of audit scope. Last review; investors
greatly value enhanced information where descriptions become less general. US implements it from
2019 and 2020 onwards.
2. Accounting information in financial contracting: The incomplete contract theory perspective
(Christensen, Nikolaev, Wittenberg-Moerman, 2016)
3. Is More Always Better? Disclosures in the Expanded Audit Report and Their Impact on Loan
Contracting (Porumb, et al 2019)
3. How does earnings management influence investor’s perceptions of firm value? Survey evidence
from financial analysts (de Jong, Mertens, van der Poel, van Dijk, 2014)
4. The Unintended Effect of Corporate Social Responsibility Performance on Investors’ Estimates of
Fundamental Value (Elliot, Jackson, Peecher, White, 2014)
5. A control framework: Insights from evidence on lean accounting (Kennedy, Widener, 2008)
5. Exploring how the Balanced Scorecard Engages and Unfolds: Articulating the Visual Power of
Accounting Inscriptions (Busco, Quattrone, 2015)
,2. Accounting information in financial contracting: The incomplete contract theory perspective
(Christensen, Nikolaev, Wittenberg-Moerman, 2016)
Central question in accounting literature; how accounting information facilitates transactions
between capital providers and firms.
Role of accounting information is at hearth of positive accounting theory posits that use of
accounting information enhances efficiency of contracting by minimizing contracting cost (agency
cost). Jensen & Meckling role of accounting information is to reduce agency costs associated with
outside financing (equity and debt) which arise from firm managers acting on behalf of stakeholders
taking inefficient actions that expropriate wealth from firm creditors: increasing riskiness of firm
(asset substitution), diluting value of existing debt claims (claim dilution) or failing to take advantage
of investment opportunities (debt overhang). It reduces contract efficiency and gives limits to
opportunistic actions (incentives), protecting creditors’ interest can be done by including
covenants restricting actions of management or ensuring sufficient alignment limit dividend
payouts, CAPEX, asset sales or issuance of additional debt. Agency perspective implies that contract
efficiency role of accounting information is driven by its ability to limit or provide incentives against
opportunistic behavior by the borrower.
Accounting literature on debt contracting;
- Widespread use of accounting measures in formulating contractual provisions
- Significant effect of accounting information properties on debt contract design
- Influence debt contracts have on accounting choice
- Associations between accounting-based contract contingencies, as covenants and
performance pricing provisions, and cost of debt
Theory of incomplete contracts helps broaden perspective on role of accounting information in debt
contracting and on mechanisms through which the efficiency gains take place. Central tenet;
contracts are inherently incomplete because contracting parties cannot anticipate or explicitly
describe all future states of the world postcontractual opportunisms and hold-up problems that
adversely affect incentives of the contracting parties to enter contracts will lead to contract
renegotiations where one party can behave opportunistic. Theory says; mechanism that alleviates
hold-ups is ex ante allocation of decision power (control rights) in contractual relationships
determines status quo in future renegotiations and affect division of surplus between parties has
efficiency implications. Control should be given to those who will contribute more to the joint surplus
(value created by entering contract) debt contracting; borrowers and creditors will agree to
allocate control to the party that has incentives to make value-maximizing decisions as future
unfolds.
Optimal allocation of control rights is contingent on a contractible signal reflecting underlying
economics of borrower accounting system produces summary measures of performance
accounting signals primary candidates for governing state0contingent allocation improves
contracting efficiency by enhancing allocation of control rights.
Agency perspective and incomplete contracting are not mutually exclusive, but complementary
both address conflicts of interest between contracting parties and scope for opportunistic behavior
but have distinction in way of addressing conflicts. Agency not viewing accounting-based
covenants as tool for allocating decision power always rests with management. Incomplete
contract different parties may make different decisions why lenders play active role in
corporate governance and why relying on accounting-based covenants.
, 3. Is More Always Better? Disclosures in the Expanded Audit Report and Their Impact on Loan
Contracting (Porumb, et al 2019)
Literature on debt contracting posits that debt market is characterized by imperfect information and
strong adverse selection problems (from pool of lenders, choose the good ones) while lenders only
provide positive information on projects. Auditing plays crucial role in reducing information
asymmetry and shapes loan contracting terms helps more accurately assess borrower’s risk as it
provides credible information about quality of numbers, reduces uncertainty about cash flows and
transmits auditors’ private information about creditworthiness of borrowers. In attempt to enhance
information content of audit disclosures expanded audit report beyond pass-or-fail would be
useful for debt markets. Given the perceived relevance and credibility will reduce adverse
selection by assisting in credit risk assessments. UK Financial Reporting Council (FRC) first to require
listed firms of expanded audit report following International Standard on Accounting (ISA) 700. They
are mandated to report disclosures on audit procedures, significant risks of material misstatements
(RMMs) and materiality thresholds. This research; examining new disclosures in the expanded audit
report, going beyond the fact of modified auditor opinion or unqualified audit opinion on debt
contracting terms.
Syndicated lending set-up one lead lender and several participating lenders funding one
borrowing firm accounting information is important to reduce information asymmetry between
borrowing firm and lead lender and lead lender and participating lenders. Lead lender decides initial
contract terms after assessing creditworthiness of borrower with high pressure of the speed of
setting up, negotiating and contracting syndicated loans using third party information for initial
screening of borrowers to determine level of effort require in due diligence process. As expanded
audit reports signals provided by credible third parties lenders will use this to indicate riskiness.
Second, due diligence efforts of lead lenders are not observable by others, ensuing information
asymmetry could lead to concerns regarding potential lead lenders’ sub-optimal screening efforts
if borrower if opaque in terms of publicly available information lenders refuse financing. Lead
lender has incentives to justify loan contracting terms to others by referring to observable
information. Information is likely coming from extended audit report.
Contribution;
- Extents economic conseque3nces of expanded audit report; studies focus on equity market,
while this is the debt perspective as the role of auditing is limited, this is important while
debt is a major source of capital.
- Previous studies show that quality of financial reporting and auditing quality are associated
with loan terms, this focus; usefulness of disclosures in expanded audit report for setting
loan terms, this means also contributing to studies focusing on the impact of the presence or
nature of traditional pass-or-fail audit reports on debt contracting.
Main function of statutory audit report is communicating results of auditor’s assessment of whether
a company’s financial statements are fairly presented highly standardized. Financial crisis and
scandals question whether it’s still informative as there is little company-specific information
believe that auditors possess private information that may be relevant if disclosed expanded audit
report include information regarding auditor’s responsibilities and procedures applied during
audit, central element of proposals mandate auditors to disclose RMMs; those matters that, in the
auditor’s professional judgment, were of most significance in the audit of the financial statements of
the current period. ISA 701 auditors not only have to explain why the matter was significant, but
also how it was addressed. Number of RMMs is dependent on the company, but IAASB expects at
least one. UK extended model is obligatory with ISA 700 requiring an explanatory paragraph of how
the auditor applied the concept of materiality and a discussion of audit scope. Last review; investors
greatly value enhanced information where descriptions become less general. US implements it from
2019 and 2020 onwards.
