Financial Reporting and Analysis 7th Edition
Financial Reporting and Analysis (7th Ed.)
Chapter 7 Solutions
The Role of Financial Information in Contracting
E7-1. Understanding debt covenants
Debt covenants are restrictive provisions written into loan agreements. They are designed to reduce potential conflicts of interest between the lender and borrower. Typical restrictions include limits on additional debt, dividend payments, mergers, asset sales, as well as the various accounting-based covenants described in the chapter. Lenders include covenants as a form of protection against managerial actions that might reduce the likelihood of debt repayment. Borrowers agree to these restrictions because it reduces the cost of borrowing. Without covenants, lenders would charge a higher interest rate to compensate for the additional default risk. Debt covenants make both borrowers and lenders better off.
E7-2. Tying contracts to accounting numbers
• Low cost: Since the borrower (company) must produce financial statements anyway, there is no added out-of-pocket cost to using these same statements as a basis for loan agreements.
• Accounting numbers are audited: Since the financial statements are audited by independent accounting firms, lenders can be assured that the reported numbers are relatively free from error and material misstatements.
• Management manipulation: Even though the financial statements are audited, management still has some discretion over the reported numbers statements. Opportunistic reporting can never be completely ruled out. Examples include voluntary accounting method changes and changes in accounting estimates.
• Mandatory accounting changes: Accounting-based loan covenants can be influenced by mandatory accounting changes imposed by the FASB or other regulatory group. Lenders may feel that such changes detract from the ability of accounting numbers to accurately portray changes in a borrower’s credit risk. And, mandatory accounting changes may cause borrowers to be in technical violation of debt covenants even though there has been no real change in underlying default risk.
E7-3. Debt covenants and accounting methods
There are several reasons lenders may not want to require borrowers to use specific accounting methods. One important consideration is the cost associated with keeping multiple sets of accounting records. Suppose a company had five loans, each from a different bank, and each bank required the company to prepare financial statements using a different set of accounting methods. This situation could be very costly.
Allowing some discretion also benefits lenders because managers can then adapt their accounting methods to the company’s changing economic circumstances. Example: changing to LIFO inventory accounting when raw material price increases are expected. LIFO accounting can save tax dollars, and this cash flow improvement makes the debt less risky.
Another reason lenders may not want to require “fixed” accounting methods is that GAAP has a built-in tendency for conservatism (i.e., to understate assets and income, and to overstate liabilities).
Despite these reasons, some lenders do stipulate the accounting method(s) to be used in preparing financial data for loan covenant compliance purposes.
E7-4. Sales-based bonus plan
There are two different ways to grow sales at Sunshine Groceries: (i) grow sales at existing stores by increasing customer traffic and/or the amount each customer spends per visit; and (ii) grow sales by opening new stores. The first approach—typically referred to as “organic” growth—yields increased earnings as long as each new sales dollar more than covers incremental costs (e.g., the cost of the item sold plus sales commissions, etc.). The second approach, on the other hand, will not yield increased earnings unless the sales dollars generated from the new store exceed all of the operating costs associated with that store (including store rental, utilities, taxes, etc.).
It makes sense for the company to award bonuses based on sales growth because increased sales can lead to increased profits at the company. However, this compensation policy could also lead to poor business decisions. For example, managers might boost sales (and their bonuses) through the use of extreme price discounts where each sales dollar falls short of covering the cost of the item sold. Or, managers might boost sales by opening new stores in unprofitable locations. Note that this sales bonus approach provides no incentive for managers to reduce expenses.
To encourage managers to increase sales profitably, many companies pay bonuses based on a combination of sales growth and earnings growth.
E7-5. McDonald’s Corporation: Pay disclosure lawsuit
Country club membership is likely to be one of those pay components that shareholders find troublesome. Why? Because the business purpose of the membership is sometimes difficult for management to explain. The question shareholders want answered is: How does country club membership increase the value of the company and thus the value of my stock?
Some companies may be reluctant to disclose pay components of this sort because doing so could attract greater investor (and perhaps regulatory) scrutiny of pay practices even in situations where the pay component has a clear business purpose.