Theory of the firm
• What is the “nexus of contracts?” some scholars have defined a firm as this; labor and
purchase contracts
• Define agency
o What is the agency relationship? Trusting somebody else to put your interests
first; delegating decision making authority to someone else; a contract under
which one or more individuals engage another person to perform some service
on their behalf which involves delegating some decision-making authority to the
agent
o What is the subsequent agency problem?
▪ What forms can this problem take?
o How can we structure compensation to adjust for these issues? Real estate
commission, stock options, ESPP (employee stock purchase plan) → helps tie
them to the fate of the company, employees want to see the company succeed
o How do these structures relate to agency costs?
▪ What are the components of agency costs?
• Four kinds of agency costs: monitoring (make sure people are
doing the right thing can be physically or more theoretical),
incentives (commissions, profit-sharing, stock options- issue
them at a higher price than the open market→ your effort
determines your reward), bonding (insuring) → use when you
cannot properly monitor or incentivize, residual loss (the cost is
too great, cost isn’t worth it given how unlikely the event is
o How does accounting reduce agency costs? Accounting itself is one form of
agency costs that can reduces others; it is a type of monitoring cost if performed
correctly; if I know that I am being watched, I am less likely to act in my own
self-interest; if done badly, residual cost is the loss from the fallout
• Talk about internal controls: something designed to make sure a particular process
works as intended
o What are the goals of IC? Designed by management to provide reasonable
assurance regarding the reliability of financial reporting; basically a mechanism
to make sure that financial statements conform with GAAP; maintain records
that accurately reflect the company’s transactions, provide reasonable
assurance that receipts and expenditures were authorized, prevent
unauthorized transactions
▪ Do they directly enhance profitability? No; unprofitable firms can have
solid internal control systems
o Who is responsible for implementing and assuring IC? Management issues an
annual assertion assuming responsibility for establishing and maintaining an
adequate financial reporting internal control process, documents and tests IC
over financial reporting, and provides an assessment of the internal control
process; external auditors determine the nature, timing, and extent of testing,
review the work performed by management and perform independent tests of
controls, and issue and opinion on management’s assessment of internal control
over financial reporting
o What have the provisions of SOX done to IC? Increase the accountability of
management, improve corporate governance, increase the oversight of public
accounting firms, restore investor confidence in the capital markets, created
PCAOB, more defined auditor and independence rules
▪ What are its costs? Expensive to implement, fear of risk taking, and
fewer public companies
▪ What are its benefits? Increased trust in capital markets through more
transparency, better management decisions through analysis of
business processes, and better disclosure can lead to reductions in cost
of capital
▪ What were the unintended consequences in the market? Big wave of
merger activity, new technologies, foreign expansions, better defined
job descriptions, standardizing processes, reducing complexities, and
minimizing human error
Processes
