Part 1: General Questions

QUESTION 1: Explain the efficiency perspective and the opportunistic perspective of positive accounting theory. Why is one perspective ex ante and the other ex post?

Efficiency Perspective: This perspective suggests that managers choose accounting policies that best reflect the company's economic situation. This selection is efficient as it helps reduce agency costs by aligning managers' actions with the interests of shareholders. The efficiency perspective is considered ex ante (before the fact) because it is based on the idea that managers will choose optimal policies that are in the best interest of all stakeholders from the outset.

Opportunistic Perspective: In contrast, this perspective posits that managers may use their discretion in choosing accounting methods to serve their own interests, possibly at the expense of shareholders. This includes actions such as income smoothing or manipulating earnings to meet bonus thresholds. The opportunistic perspective is ex post (after the fact) because it involves actions taken by managers after events have occurred, potentially to influence outcomes or perceptions retrospectively.

QUESTION 2: If a company pays its senior managers under accounting-based bonus plans, would the managers or the shareholders (or both) prefer using conservative accounting methods? Explain the reasons for your answer.

Managers: They might prefer conservative accounting methods if the bonus plan is structured to reward long-term performance and sustainability, as conservative accounting can lead to more stable and predictable financial results. However, if bonuses are tied to short-term earnings, managers might prefer less conservative methods to boost earnings and reach bonus thresholds.

Shareholders: They typically favor conservative accounting methods because it reduces the risk of financial statement manipulation and provides a more accurate picture of the company's long-term financial health. Conservative accounting can also lead to better governance and lower the risk of legal and regulatory issues.

QUESTION 3: If a large company subject to a high degree of political scrutiny has a choice between expensing and capitalising an item of expenditure, what does the political cost hypothesis of Positive Accounting Theory predict will be the preferred choice? Explain your answer.

• The political cost hypothesis suggests that companies under political scrutiny may prefer accounting policies that reduce reported profits to avoid attracting negative attention or regulatory intervention. Therefore, such a company would likely prefer expensing the item of expenditure rather than capitalizing it. Expensing reduces current period profits, which can help avoid political costs like unfavorable legislation or additional taxes.

QUESTION 4: In January 2020, the IASB issued an amendment to IAS 1 Presentation of Financial Statements (effective date January 2023). The amendment requires companies to classify loans as current liabilities if the right to defer settlement beyond 12 months is (1) subject to debt covenants with testing dates after year-end and (2) they would have breached the covenants if the testing date had been at year-end. Following complaints by financial statement preparers, in September 2021, The IASB issued exposure draft ED/2021/9 Non-current Liabilities with Covenants that proposes to reverse the January 2020 amendment. Why do you think companies were so unhappy with the 2020 amendment to IAS 1? If the IASB had not reversed the amendment, what do you think managers would do? Use the debt hypothesis to draw your conclusion.

Unhappiness with the Amendment: Companies were likely unhappy with the 2020 amendment because it required them to classify certain loans as current liabilities if debt covenants were not met at year-end. This could have affected their liquidity ratios, potentially leading to covenant breaches and higher borrowing costs. Additionally, it could have created a perception of financial instability.

Debt Hypothesis: The debt hypothesis suggests that managers will choose accounting policies to minimize the cost of debt. If the IASB had not reversed the amendment, managers might have sought to renegotiate debt covenants or modify financial practices to ensure compliance with covenant terms. This could include reclassifying certain debts, managing financial ratios more conservatively, or even restructuring debt agreements to avoid unfavorable classifications and the associated costs.

Part 2: Decision Case

Executive compensation has been a focal point of criticism, especially in the context of the global financial crisis. The central issue revolves around the principal-agent problem, where executives (agents) may have different incentives than shareholders (principals). A well-structured compensation package aims to align these incentives, ensuring that executives work towards maximizing shareholder wealth. However, the high levels of pay awarded to Australian CEOs have sparked debates about whether these packages effectively align with shareholder interests.

Argument by Student A:

Student A contends that executive remuneration should primarily align executives' interests with those of shareholders. From this perspective, the significant bonuses paid to employees of Australia Post and NBN, amounting to nearly $300 million, appear excessive, particularly during a period marked by widespread financial strain due to the COVID-19 pandemic. The argument is that such substantial payouts could be seen as a misallocation of resources, potentially detracting from shareholder value, especially in taxpayer-owned entities. Moreover, these bonuses might not be justifiable if they do not correlate with an equivalent enhancement in the company's performance or shareholder returns.

Argument by Student B:

Conversely, Student B defends the high executive pay by emphasizing the importance of retaining top talent in a competitive global market. The directors of Australia Post and NBN might argue that substantial bonuses are necessary to attract and retain skilled executives who can navigate the companies through challenging times, such as the economic downturn caused by the pandemic. The rationale is that without competitive compensation, these organizations risk losing key executives to private sector competitors, potentially jeopardizing the company's stability and future performance. Bonuses, in this view, serve as a motivation tool, ensuring that executives work diligently to benefit the principals, even in difficult circumstances.

Analysis:

Both arguments highlight critical aspects of the debate over executive compensation. On one hand, there is a concern about the potential disconnect between executive pay and shareholder value, especially in public or taxpayer-owned entities where public scrutiny is high. On the other hand, the need to retain capable executives and incentivize them to perform in the best interest of the company cannot be overlooked.

Conclusion:

The controversy surrounding executive compensation often boils down to the challenge of designing pay structures that appropriately balance these competing interests. For taxpayer-owned businesses like Australia Post and NBN, the scrutiny is even more pronounced. Therefore, it is crucial to establish transparent criteria for bonus payouts, ensuring they are closely tied to performance metrics that align with long-term shareholder value and public expectations. This balance can help mitigate criticism and ensure that executive compensation serves its intended purpose without appearing excessive or unjustifiable.