Business

Increasing costs and interest group theory of regulation

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The costs have gone up after the new regulations have been implemented! What may have happened? This can be viewed through the lens of interest group theory of regulation (Ezelle, 2011). Per previous narrative, verbatim:

Scott (2006, pp. 383-403) indicates information asymmetry is a reason for the creation of various rules and regulations governing the production of information to protect owners who are at an information disadvantage to improve the capital markets and increase the public confidence of fairness. Regulation of the professions as well as the firms and the information to be disclosed to the owners has a cost benefit trade off since the costs of regulation include enforcement as well as ill informed decisions made by the regulators. The benefits of the increased regulation are in the perception of the market success following the perceived notion of a market failure.

Interest group theory of regulation, as developed, modified and discussed by others, (Becker, 1983; Posner, 1974; Scott, 2006, pp. 415-416; Stigler 1971) contends that the formation of groups by individuals will lobby to protect their interests. Some interest groups demand regulation and legislatures supply regulations. The legislature is also an interest group and is interested in retaining its’ position by supplying the regulations to the demanders of regulation in order to retain their position. The regulatory bodies which are formed as a result of legislative action engage in compromise in an effort to create an environment of cooperation between the various interests groups by using due process to create standards. In effect, the setting of standards is political as well as economic since the demand for information to ameliorate the information asymmetry by the owners is not equivalent to the information which is provided willingly by the management of the firm. Thus, there is a demand for regulation of information. Due process is a part of the determination of standards which is characterized by conflict and compromise and acceptance by a greater than majority with the acceptance dependent upon the extent to which the conflicted parties believe their concerns were considered. The setting of standards require an increase in the information of usefulness of information a firm provides to its’ owners such as there will be a reduction in information asymmetry wherein there is not an overbearing increase in costs to society. A concern of the creation of new standards is the costs involved to the firm and management. When the costs are too great, management may engage in due process efforts to reduce the information provision requirements which are being forced by the owners.

In the event market forces are unable to control information asymmetry, resolution of issues between owners or potential owners and management of the firm are subjected to regulatory standards which provide the economic consequence of costs. Conflict between owners and management has necessitated the use of auditors to control for information asymmetry which represents a cost to the firm as well as the owners (Khalil & Lawarree, 1995).

Over time various rules and regulations have been implemented by due process through private, quasi-governmental, and governmental regulatory bodies to address issues of concern pertaining to the conflict which exists between owners and managers. The passage and implementation of the Sarbanes Oxley Act is an additional burden placed on owners and management which is instrumental in the potential for an increase in the fees charged by auditing firms.

Sir Isaac Newton actually covered this several centuries ago in his axioms of motion!

References

Becker, G. S. (1983). A theory of competition among pressure groups for political influence. The Quarterly Journal of Economics, 98(3), 371-400.

Ezelle, Jr., R. W. (2011). The impact of the Sarbanes Oxley Act on auditing fees: An empirical study of the oil and gas industry (3483923) (Doctoral dissertation). Retrieved from ProQuest Dissertations and Theses database. (3483923)

Khalil, F., & Lawarree, J. (1995). Collusive auditors. American Economic Review, 85(2), 442-446.

Posner, R. A. (1974). Theories of economic regulation. The Bell Journal of Economics and Management Science, 5(2), 335-358.

Scott, W. R. (2006). Financial Accounting Theory (4 ed.). Toronto: Pearson Prentice Hall.

Stigler, G. J. (1971). The theory of economic regulation. The Bell Journal of Economics and Management Science, 2(1), 3-21.

Uncategorized

Wealth maximization, profit maximization, agency theory

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Wealth is the long term view for the benefit of the owners of the corporation. Conversely, profit maximization is a short term view, which could indicate problems or potential problems. In light of the aforementioned, I thought about something I wrote several years ago (Ezelle, 2011) and provide parts of it verbatim:

In a perfect and complete market where there is a lack of information asymmetry and other barriers to a fair and efficient market operation, the asset and liability valuation of a firm is based on the expected present value of future cash flows. Under this ideal scenario the owners of a firm and the managers of a firm will have no conflict over the roles of financial reporting and no need for regulations (Scott, 2006, p. 14). However, ideal conditions do not exist in practice as the relationship between shareholders, principals, and corporate management, agents, is contentious with respect to conflicting interests (Jensen, 1986).

Scott (2006, p. 261) explains that owners of the firm are not able to directly observe the actions of management. Although management has in its’ possession the requisite skills necessary to direct the economic activities of a firm, the concern of owners is the preservation and growth of the firm with incipient returns they deem adequate. The concern for management is the preservation of the personal benefits contracted to them by the owners to be the caretakers of the firm. The conflict between management and owners results in the posturing of each party in an effort to gain a rational mutually beneficial economic outcome. The interaction between the owners and management is within the realm of an economic theory of games where there is a presence of uncertainty and information asymmetry wherein each party is desirous of gaining the maximum potential for their expected utility (Jensen & Meckling, 1976; Ross, 1973). The choices made by management may be difficult to determine since the action chosen by management will depend upon what action the owners think management may take. Likewise, the opposite exists when considering actions of the owners and what management may think the owners actions may be.

The owners of the firm will want relevant and reliable financial information to aid them in the determination of the risks and expected values of their investment. Management, however, may not necessarily provide the information to the owners or potential owners’ for a variety of reasons, including but not limited to; not reporting all liabilities on the balance sheet to be able to raise additional capital, not revealing the accounting policies used in order to manage profits, or not releasing information for fear of competitive reasons. In effect, the financial statements of the firm as released by management may be biased towards efficient contracting or for opportunistic purposes. The owner or investor considers the possibility of management actions and will react accordingly with their investment decision. In turn, management is aware of the investor considerations when the financial statements are prepared.

Management is generally viewed as having an information advantage as it is directly involved in the day to day operations of the firm, knowledge or information may not readily available to the owners. This information asymmetry may lead to two primary agency problems; moral hazard, and adverse selection (Subramaniam, 2006, p. 59). Moral hazard is concerned with the agent’s shirking or consuming perquisites due to the principal having restricted abilities to observe the manager directly and being only able to assess the manager’s performance outcome. Adverse selection occurs when the principal is able to observe the manager but is unable to discern if appropriate behavior is extended by the agent. Examples of adverse selection would include a manager choosing an accounting policy to maximize reported net income in order to increase bonuses, investors not receiving full disclosure of the firm where there is a beneficial gain to the managers, or the principal not being able to verify the agent’s abilities at the time of engagement or while working.

Lessening the effect of agency problems can be accomplished by offering incentives to the agent to align actions comparable to what is desired by the principal or by monitoring the behavior of the agent. Either effort to mitigate the agency problem has agency costs which are classified as bonding costs, agency costs, or residual costs (Eisenhardt, 1989; Jensen & Meckling, 1976; Ross, 1973). Monitoring costs would include those activities owners or lenders consider necessary to oversee the agent behaviors and control agent costs by means of auditing, implementation of internal controls, creation of various policies and procedures, and implementing budgeting so as to protect their investment. Bonding costs are those agency costs which provide the owners some form of security to curtail the agent acquiring benefits from the firm by auditing, requiring agent insurance, and contractually limiting the agent’s authority. The residual costs are the losses which will occur when incentives exist for the agent to consume perquisites of the firm which benefit the agent to the detriment of the principal.

The conflict between the owner as principal, and manager as agent, can be framed in a branch of the economic theory of games, agency theory. Agency theory is concerned with the design of contracts which are used in the motivation of rational agents to act on the behalf of the principal when the interests of the agent would conflict with that of the principal. In effect the modeling of a firm composed of a large number of owners and managers with conflicting interests is analogous to the separation of ownership and control of a firm which is composed of a single owner and a single manager.

 

References

Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of Management Review, 14(1), 57-74.

Ezelle, Jr., R. W. (2011). The impact of the Sarbanes Oxley Act on auditing fees: An empirical study of the oil and gas industry (3483923) (Doctoral dissertation). Retrieved from ProQuest Dissertations and Theses database. (3483923)

Jensen, M. C. (1986). Agency cost of free cash flow, corporate finance, and takeovers. The American Economic Review, 76(2), 323-329.

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.

Ross, S. A. (1973). The economic theory of agency: The principal’s problem. The American Economic Review, 63(2), 134-139.

Scott, W. R. (2006). Financial Accounting Theory (4 ed.). Toronto: Pearson Prentice Hall.

Subramaniam, N. (2006). Agency theory and accounting research: An overview of some conceptual and empirical issues. In Z. Hoque (Ed.), Methodological Issues in Accounting Research: Theories and Methods (pp. 55-81). London: Spiramus Press Ltd.

Ethics

Questionable Ethics

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More years ago than I like to think about, I worked for a oil service company in Alabama. I, as well as others working for the company, routinely visited drilling well sites to perform services for the oil companies operating the wells being drilled. Broadly speaking, due to costs and risk mitigation, there are many owners of a well being drilled in search of oil and gas. Because of the fractionated interests, one of the owners is designated, by mutual agreement, to be the operator of the well. The owners of the well have an ownership which is simply referred to as a working interest. As this is not meant to be a discourse on ownership interests, I will dispense with further elaboration.

On one occasion, around a holiday, two of the working interest owner employees, both being geologist, and a geological consultant were having a conversation concerning the well, what had transpired, and what was anticipated to occur. This discussion was Each working interest owner geologist represented their respective company and the geological consultant was engaged by one of the working interest owners and received direction from one of the geologists at the well site. The geologist was planning to return home for the holiday. That geologist was providing the consulting geologist with information concerning what had to be done in his absence. Obviously, the other geologist was present during the conversation and must have been a bit envious of his peer’s consulting arrangement since he approached the consulting geologist to contract for the the same services on the same well.

The consulting geologist told the second geologist he would provide the services and quoted his daily rate and expenses. This arrangement was immediately agreed upon. Following the verbal agreement, the two company geologist and the consulting geologist laughed about the amount of money the consultant would be making per day plus the double expenses. With the consultants new found contract, one of the company geologist suggested they memorialize the event with dinner and drinks, at the consultants expense, of course. The three of them left the drill site shortly thereafter.

Out of curiosity several weeks later I did ask one of the company geologist about the arrangement which was the consummated at the well, of which he confirmed. Being young and naive, I was absolutely amazed at how business was so loosely and quickly conducted. But, more importantly, I was confused. The actions of the consultant double dipping had a bad odor, at least to me. The actions of the two company geologist was confusing as well since, they found humor in spending their company’s money so readily to help their “friend” out with a few extra dollars. Although not the sharpest tack in the box, everything that was done by the three geologist did not seem right, at least to me.

Upon becoming a member of a professional organization for geologist, I reviewed the amazing amount of technical material provided. I also found the organization’s code of ethics. It appeared my observation of the actions taken by the three geologist, though legal, was not ethical. Many years later, I spoke with the geological consultant for that well and in jest asked about the consulting and the double dipping, to which be replied, while laughing, he made a small fortune doing work that way. He was also proud of having accomplished triple dipping. Further disappointment was had on my part when finding that the consultant was certified in his field of interest and a member of other professional organizations which tout the integrity and ethics of their members.

In the more than thirty years since this occurred, the memory of these individuals, their decisions, and actions have never left me. I have taken several ethics courses when working on my MBA, PhD, and in continuing education hours for my professional registration and always, I think of what I witnessed. I continually ponder the “why”, and have yet to come to any semblance of an answer which I consider to be satisfactory. Each of the individuals was well paid. Each party lived within their means and did not “hot dog”. And, each party did very well, monetarily, through their careers. Perhaps, they did well in their careers because they continued to take care of their business as when I first met them or possibly because they were very good in their profession.

I did cross paths with all three of the individuals, at one time or another over the ensuing years. I never spoke of what I witnessed to anyone other than in ethics courses. I never mentioned their names and never spoke poorly of any of them to anyone. I approached dealing with them, individually, with caution and paid particular attention to every detail in any discussion. I did transact two deals with one party and, sadly, there were problems which required outside intervention to resolve the issues. Would I ever do business with that individual again? No.

Even though I was not knowledgeable as to how infractions of this nature should be addressed at the time or even for some period afterwards, I did learn a valuable lesson, if it smells, even in the least bit, it is best to step away.

Ethics

Geology is Highly Interpretive

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An oil company was in need of a new CEO and the board of directors made a decision to promote within the company for their search. After a great deal of effort, the board had whittled its choices to three candidates; a geologist, a petroleum engineer, and an attorney. The three candidates were called to the meeting and asked to remain outside the board room. The first candidate called into the meeting was the geologist.ﾠTheﾠ geologist…well… looked like a geologist; khaki pants, wrinkled shirt with the tail not fully tucked, and all else that goes with an outdoors kind of person, even to the scuffed shoes. Being invited to have a seat at the conference table, the geologist reclined on the back legs of the chair to listen. The presiding board member explained the view of the board wanting to promote within and that he was one of three candidates identified. The board member then told the geologist they have only one question, “What is two plus two?” The geologist looked at each board members as if sizing them up for a fight. He then leaned his chair forward, stood up, and slowly walked to the floor to ceiling window to survey the city from the rarified elevation. After having taken stock in the outside world, the geologist slowly turned, ambled to his chair and returned to his reclined position. Running the fingers of his right hand through the mane of hair, he mustered a professorial voice, “You know…geology is highly interpretive…I’m gonna say it’s somewhere between three and five”.

Geology can be highly interpretive, depending on the amount of data which is available. I had the pleasure of reviewing a drilling prospect in the Breton Sound area of Louisiana. the beautifully colored geological structure maps showed several prospective horizons. As explained, there were several billion cubic feet of natural gas which were narrowly missed by many wells drilled over many years by many operators. The maps showed one large regional fault but, the prospective horizons were not trapped by the large down to the south growth fault as portrayed. Instead, each of the mapped prospective horizons was a four way closure with numerous downdip wells setting up the play.

Wanting to understand the prospective geological structure, I started from scratch with a new base map and clean well logs, there was no geophysical data. After correlating the well logs and posting the data, the horizons of interest were interpreted. Sadly, the prospective geological structure disappeared, at least with the interpretation I constructed. I reviewed the data; again and again. And, perhaps because of the bias of my original interpretation, my results from subsequent remapping was very similar to my original interpretation.

The objective of reviewing the geology is to support the originators geological interpretation. However, if it cannot be confirmed, the objective becomes reoriented with a direction taken of what can be done to assure a reasonable re-interpretation. Unfortunately neither I nor a third party could confirm or agree with the original geological prospect maps. So, there was a pass on the deal.

Approximately two years later I met the originator of the deal while dining in a restaurant. In playing “catch up”, I asked what happened with his Breton Sound deal. He told me it was a dry hole and the well was plugged and abandoned. I asked about oil and gas shows, of which the response was the well had no shows and came in low and wet. I expressed my disappointment in his not having a discovery. His response was surprising. He told me that since the well came in low, it set up two plays, one to the east and one to the west. The play can be very easily visualized or recreated while taking a bath. A large soap bubble floating on the surface of the water is the gas prospect. If a finger is used to slice through the soap bubble, two bubbles are “created”. Now there are two gas prospects.

In short, this well drilled for the original prospective horizons turned out to not have been drilled in an optimum structural position and narrowly missed the “two” prospects, just like all of the other wells in the past. When I returned to my office the next day I pulled my files and maps of the area which showed the prospect should have been low and no plays to be made.

Strange things happen. The originator sold the “two” prospects. One prospect was drilled, resulting in a dry hole. THe horizons were low and wet. The operator that took the deal would not drill the second play. You know, geology is highly interpretive, especially when chasing soap bubbles.

Business, Efficiency

Production Efficiency

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A toothpaste factory had a problem. They sometimes shipped empty boxes without the tube inside. This challenged their perceived quality with the buyers and distributors. Understanding how important the relationship with them was, the CEO of the company assembled his top people. They decided to hire an external engineering company to solve their empty boxes problem. The project followed the usual process: budget and project sponsor allocated, RFP, and third-parties selected. Six months (and $8 million) later they had a fantastic solution – on time, on budget, and high quality. Everyone in the project was pleased.

They solved the problem by using a high-tech precision scale that would sound a bell and flash lights whenever a toothpaste box weighed less than it should. The line would stop, someone would walk over, remove the defective box, and then press another button to re-start the line. As a result of the new package monitoring process, no empty boxes were being shipped out of the factory.

With no more customer complaints, the CEO felt the $8 million was well spent. He then reviewed the line statistics report and discovered the number of empty boxes picked up by the scale in the first week was consistent with projections, however, the next three weeks were zero! The estimated rate should have been at least a dozen boxes a day. He had the engineers check the equipment, they verified the report as accurate.

Puzzled, the CEO traveled down to the factory, viewed the part of the line where the precision scale was installed, and observed just ahead of the new $8 million dollar solution sat a $20 desk fan blowing the empty boxes off the belt and into a bin. He asked the line supervisor what that was about.

“Oh, that,” the supervisor replied, “Bert, the kid from maintenance, put it there because he was tired of walking over, removing the box and re-starting the line every time the bell rang.”

Teaching a MBA course concerning management accounting, I received the aforementioned while covering activity based costing. It really makes one wonder if too much time is spent in the towers of power as opposed to walking the floor and hearing a bit of common sense. The aforementioned “story” is very much in line with the experiences I had when working in a foundry. It always seemed the geniuses in the office were two steps behind those of us in the midst of the action. Sometimes a little common sense works best.

Ethics

Academic Integrity and Plagiarism

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Cornell University (2005) states, at 60 percent of all their academic integrity violations, plagiarism is the most common problem they experience.

Plagiarism is a form of dishonesty as it uses and presents the intellectual work effort performed by another yet, it is presented as the work of one’s own doing (Cornell University, 2005; Trident University International, 2011). Although a traditional sense would lead one to believe plagiarism exists only when someone copies word for word an encyclopedia article for a school assignment, the depth of plagiarism is much deeper when considering the inclusions which seem to be better defined within a university setting. Not only are writings, conversations, words and ideas included as copied works falling under the plagiarized domain but, any form of media are, as well (University of Southern Mississippi, n.d.). Trident University International (2011) also includes for clarification; the engagement of contract cheating, copy and pasting, direct duplication, paraphrasing, and submitting one’s prior work.

Texas A&M University (n.d.) clarifies part of the reasoning for academic integrity by addressing the issues surrounding individual reputation, personal integrity, professional competence, and the status or standing of the institution.

Plagiarism charges can be levied by anyone, inclusive of professors, administrators, students, or co-workers (Trident International University, 2011). Trident further states that in addition to the plagiarist, the assistance or attempt thereof, even if not a benefit to the facilitator is a violation of the university academic policy. The Aggie Honor System (n.d.) has a simple but very profound and in depth code of which adherence is practiced, “An Aggie does not lie, cheat or steal, or tolerate those who do”.

Cornell University (2005) cites penalties of plagiarism to include grade penalty, failure of the course, and suspension or expulsion from the university. Trident University International (2011) in addition to Cornell penalties adds “imposition of appropriate education and academic sanctions”. Trident further notes that plagiarism may also attract civil and criminal penalties if the actions are in violation of U.S. copyright law.

The avoidance of plagiarism can be summed; 1) use your own words when referring to ideas or concepts of others, and 2) give due credit to the rightful author and source (Trident University International, 2011). The University of Southern Mississippi (n.d.) among others promotes the use of in-text citations to credit the words or ideas of others within the document and providing a reference listing of all of the work which is cited. Several referencing styles are available for properly quoting, citing, and listing the sources of information. The choices; whether APA, MLA, Chicago or others depend, on the department and the university.

University of Southern Mississippi (n.d.) refers to Harris (2001) in developing a pre and post test concerning plagiarism which helps one to understand what may and what may not be plagiarism.

References

Cornell University (2005). Recognizing and avoiding plagiarism, Retrieved from http://plagiarism.arts.cornell.edu/tutorial/index.cfm
Harris, R.A. (2001). The Plagiarism Handbook: Strategies for Preventing, Detecting, and Dealing with Plagiarism. Los Angeles, CA: Pyrczak Publishing.

Aggie Honor System Office (n.d.). 20.1.2 Honor System Rules, Texas A&M University, Retrieved from http://aggiehonor.tamu.edu/RulesAndProcedures/HonorSystemRules.asp

Texas A&M University (n.d.). Academic integrity and plagiarism. Retrieved from http://library.tamu.edu/help/help-yourself/using-materials-services/online-tutorials/academic-integrity/index.html

Trident University International (n.d.). Student guide to writing a high-quality academic paper [PDF]. Retrieved from http://www.trident.edu/files/Well-Written-Paper.pdf

Trident University International (2011). Academic integrity policy. In Fall 2011 University Catalog [PDF]. Retrieved from http://www.trident.edu/Media/Default/Catalogs/Fall-2011/University_Catalog_Fall_2011.pdf

University of Southern Mississippi (n.d.). Welcome to plagiarism tutorial. Retrieved from http://lib.usm.edu/legacy/plag/plagiarismtutorial.php#ti