Lecture – Organization form
Class 1
Course Objective
• Sophisticated user of accounting information
• What types of users?
– Managers use accounting information in making investment
decisions
– Investors use accounting information in valuing stocks and
choosing among different stocks
– Bankers rely on accounting information in lending
– Crucial in evaluating the performance of employees at various
levels in an organization
World of a Sophisticated Financial Statement User
Financial Accounting = translates events
into financial statements
Events
Rules
&
Management
choice
Financial Statements
Generally
Accepted
Accounting
Principles (GAAP)
Management selects
from alternative rules
and from allowable
estimates under GAAP
Sole Proprietorship - 1
• Characteristics
– Single owner also the manager of the business
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Incentives of owner and manager are the same.
Maximize the value of the business
Owner has to provide all the capital
Managerial talent restricted to the owner
Sole Proprietorship - II
• Single owner who is not the manager of the
business
• Incentives of the owner and the manager are different .
Agency problem
• Owner wants manager to work hard
• Pay manager enough to stay
• Manager wants to maximize pay, minimize risk and effort
Shirking problem
• Owner has an incentive to monitor the manager Monitoring
incentive
Partnership - I
• Characteristics
– Partners – Friends and acquaintances.
– Partners contribute capital, managerial talent.
• Unlimited (Limited) partnerships
– To pay off debts of partnership
• Personal wealth liable Unlimited
• Personal wealth not liable Limited
– What is the limit to the liability of the partner?
Partnership - II
• Advantage compared with sole proprietorship
– More capital providers
– More possible managers
• Disadvantage compared with sole proprietorship
– Majority partners can steal from business: minority
partners suffer. Agency problem
– Each partner feels the other partners would monitor the
managing partner. Free riding problem
– Examples: Law and accounting firms
Private Limited Company
• Characteristics
– Owners – friends and acquaintances
– Maximum number of owners is specified by law
– Limited liability
• Advantage compared with partnership
– More capital providers
– More potential managers
• Disadvantage compared with partnership
– More owners: Greater agency problems
– Reporting requirements
Public Company
• Characteristics
– Limited liability
• How much is the limit to the liability?
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Shares issued to the general public
No limit on the number of owners
Professional managers manage the firm. Agency cost
Stocks listed on recognized national stock exchanges
Stockholders have no direct control over day-to-day
operations
How to mitigate the impact of the
different incentives in an organization
• Between managers and owners
• Between majority and minority owners
Agency cost between owners and
managers
• Compensation
• Monitoring
• Disclosure
– Quality
– Quantity
• Bonding
Lecture – Capital providers
Class 1
Owners
• Characteristics of owners (shareholders)
– Highest risk capital – Equity capital
– All the profits earned by the firm belong to the
owners – Retained earnings
– Upon bankruptcy: Shareholders are paid last
– Shares traded
– Easy to transfer ownership
– Listed on stock exchange – Liquidity.
Characteristics of a stock
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Perpetual till the firm dies
Usually carries voting rights
Firm can pay dividend to shareholders
Stock can be repurchased by the firm
Freely transferable and traded if listed on a
stock exchange
Lenders
• Trade credit from suppliers
• Bank loans (short term and long term)
• Bonds are long term and are usually traded
– Public
– Private
Characteristics of a bond
• On a particular date for a particular period maturity period
• Pays interest at a particular rate at regular
intervals - coupon rate
• Repays the principal - face value, at the end of
the maturity period
• Collateral attached to the bond
• Covenants attached to the bond
Derivative securities – Call options
• Call options and Put options
– Call option is a piece of paper that gives the holder
• The right to buy a share
• At a specified price (exercise or strike price)
• On a specified date (exercise date)
– Say A Inc. issues a call option on 1st January 2022 with
an exercise price of $15 and an exercise date of 31st
March 2022.
When to exercise the call option?
• If stock price on 31/3/2022 is $16
– Exercise the option.
• Pay $15 to firm sell stock in market for $16.
• If stock price on 31/3/2022 is $14
– Do not exercise the option.
Derivative securities – Put options
• Put options
– Put option is a piece of paper that gives the holder
• The right to sell a share
• At a specified price (exercise or strike price)
• On a specified date (exercise date)
– Say A Inc. issues a put option on 1st January 2022 with
an exercise price of $15 and an exercise date of 31st
March 2022.
When to exercise the put option?
• If stock price on 31/3/2022 is $12
– Exercise the option.
• Pay $12 to buy the stock in the market and sell
it for $15 to the firm.
• If stock price on 31/3/2022 is $17
– Do not exercise the option.
What is the return received by capital
providers?
• Equity holders:
– The dividend they receive
– The capital appreciation of their shares
• Debt holders:
– The interest that they are paid periodically
Lecture – compensation contracts
Class 1
Compensation contracts
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Align incentives of owners and managers
Owner wants to maximize returns.
Owner wants manager to maximize returns.
Managers will maximize returns if they are
also owners
Types of compensation contracts
• Managers earn flat cash salary regardless of
performance
– Incentive to work less and take less risk
• Managers paid only based on performance
– Take high risk
• Mix of cash pay and performance pay
– Leads to incentive compatibility.
Example - Alibaba Inc. 2020
• Bonus Plan: 425 Individuals based on pre-tax profits
• Equity incentive plans for employees, etc.,
– Granted options or Restricted Stock Units to acquire shares.
• Share-based awards attract, incentivize and retain employees
– 523,671,696 ordinary shares as RSUs
– 51,146,424 as options
– 265, 848,704 authorised for issuance
• RSUs and options subject to a four-year vesting schedule.
• Share based awards: align interests of Alibaba and employees.
Example – Sheng Siong
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2020 Revenue: S$1.39 Billion (39% increase in revenue with Covid)
Board does not use independent remuneration consultants
Chairman of Board and CEO are brothers
Insiders Own 58.43% of shares: S$46.6 Dividend to insiders of the firm
Bonus: Increased from S$3.1 Million to S$5.4 Million
Disclosure on Remunerations (S$’ 000)
– 5 Non-executive directors: Fixed Pay S$60
– 5 Executive directors
Salary
Bonus
Dir Fee
Benefits
Total
Lim Hock Eng
294
5,430
20
48
5,792
Lim Hock Chee
368
5,430
20
40
5,858
Lim Hock Leng
295
5,430
20
44
5,793
Tan Ling San
285
5,430
20
77
5,812
Lin Ruiwen
311
20
15
346
Bonus – Typical For Executives
• Executive Remuneration
高管薪酬
– fixed component,
– a variable cash component
– a share-based component and
– market-related benefits:
Components of bonus
• A. Fixed Component:
– base salary, fixed allowances, contribution to CPF
• B. Variable Cash Component based on:
– Operating Profit
– Economic Value-Added (EVA)
Bands in compensation plans
• Compensation between upper and lower
benchmarks.
• Firm A’s CEO is awarded
– no bonus if ROE is less than 2%.
– Increasing bonus between ROE of 2% to 10%
– No additional bonus if ROE higher than 10%
• ROE: Return on shareholders equity
Singapore Airlines Compensation
• Performance Conditions:
• At both Company and Group level
• Profit Sharing Bonus (PSB)
– Capped at 3X monthly salary
– (0% – 150%) based on pre-set performance targets.
• Transformation Shareholder Award (TSA)
– Senior Mgrs
– Over and Above target comp levels
– Right to shares with vesting requirement
Role of information
Class 1
What is the role of the capital market
• To allocate capital to its best use
• That means a good firm should get capital and
a bad firm should not get capital
• How to distinguish between good firms and
bad firms?
• This is called an identification problem
A
B
Uncertainty about quality – One seller
owns both boxes
• There are two boxes A and B
• Box A and Box B have a value of either $1 or $3
• You do not know which box has how much
money
• You have $10 to buy one of the two boxes.
• How much will you pay for one box
if it’s a repeated game?
A
B
Uncertainty about quality – Two sellers
each owns one box
• There are two boxes A and B owned by seller 1 and
seller 2 respectively
• Box A and Box B have a value of either $1 or $3
• You do not know which box has how much money
• You have $10 to buy one of the two boxes.
• The seller can choose to sell you the box or not.
• How much will you pay for one box?
A
B
Disclosure by Managers – 2 managers
in the game
• There are two boxes A and B owned by manager 1 and 2
respectively.
• One box is worth $1 and the other box $3.
• You have $10 to buy one of the two boxes.
• The Managers of the boxes will announce the value of their
box publicly to you
• What should the manager disclose as the value of the box
• How much will you pay for one box
Disclosure by Managers when Auditors
are paid by Managers
There are two boxes A and B
A box is worth between $0 and $3.
You have $10 to buy one of the two boxes.
Auditor audits the box and certifies the value of the
box and is paid by the owner
• The Managers announce the value of their box
• What value will the Managers announce?
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• How much will you pay for a box?
Disclosure by Managers when Auditors
are paid by Buyers
There are two boxes A and B
A box is worth between $0 and $3.
You have $10 to buy one of the two boxes.
Auditor signs separate contracts with buyers to audit the box
and publicly certifies the value of the box and is paid by each
buyer
• The Manager announces the value of their box
• What value will the manager announce?
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• How much will you pay for a box?
Ideal situation - separating equilibrium
• The $1 box and the $3 box are identified by buyers
• When the good firms and bad firms are separated and
identified and their true value disclosed.
• Why is it not easy in the real world to reach separating
equilibrium?
• Who sets the value?
• How do they set value?
• What information do they need to set value?
• What are the incentives of the providers of information?
Lecture – Accounting Information
Class 1
Who and how do they set value
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Capital provider sets the value
First decide on a valuation model.
– Discounted cash flows / earnings
• P = CF
(k – g)
• P= price; CF = Cash flow; k = discount rate; g = growth rate
– Earnings multiples
Forecast future values of the variables involved in the valuation model
Gather information to forecast future values of the variables
Sources of Uncertainty
– Future cash flows easier to estimate if already pay dividends
– Firms with high growth rates difficult – how long they last?
– Discount rate or cost of capital depends on risk profile – how likely changes?
Value Investing (Warren Buffet): Favor low P/E firms; stable earnings; reduce
valuation errors
Information required by capital
providers
• Equity capital providers
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Profits of the firm
Cash flows of the firm
Risk factors of the firm
Market value of assets of the firm
Market value of the liabilities of the firm
• Debt capital providers
– Profits of the firm
– Cash flow patterns of the firm
– Value of assets of the firm compared with liabilities
Information from inside the firm - I
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Managers:
Mandatory
Annual report: Financial statements
Grab Press release: Voluntary and Mandatory
– https://investors.grab.com/news-releases/newsrelease-details/grab-reports-first-quarter-2022-results
– https://investors.grab.com/static-files/807863c69358-46b4-af8d-7f3bfe1505c9
Grab Press Release: May 19 2022
• Lists of Accomplishments:
– Rev increased 6%
– Gross Merchandise value of $4.8 Billion, grew 32%
– Lots of positive voluntary disclosures with self
defined numbers
• Accounting Numbers
– Revenue: $228 million
– Earnings: - $435 million
Information from outside the firm - I
• Analysts : Recommendations/forecasts/target
price
– Sell side
– Buy side
– Tesla Example
– https://finance.yahoo.com/quote/TSLA/analysis/
Information from outside the firm - II
• Rating agencies
– https://www.moodys.com/credit-ratings/Tesla-Inc-creditrating-823642219
• Fund managers
– Mutual Fund / Hedge fund Managers
• Media
– CNBC/Bloomberg/Yahoo etc
Rating Agencies
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AAA – 0.38%
AA – 0.72%
A – 1.02%
BBB – 1.60%
BB – 3.27%
B – 4.47%
C > 7.0%
Practice Problems
• Chapter 2
– Exercises: #4, #5, #9, #17, #22
– Problems: 5B
– Reporting in Action: BTN 1; BTN 2; BTN 8