Solution Manual For Financial Reporting _ Analysis 6Th Edition By Lawrence Revsine

Solution Manual For Financial Reporting _ Analysis 6Th Edition By Lawrence Revsine

CHAPTER 7

THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING

CHAPTER OVERVIEW

A contract is a legally binding exchange of rights and obligations between parties and is best expressed in writing to enhance clarity. Business contracts incorporate financial statement information in their formulation.
Conflicts of interest among managers, shareholders, lenders, or regulators are natural features of business. Contracts and regulations help address these conflicts of interest in ways that are mutually beneficial to the parties involved. Accounting numbers often play an important role in contracts and regulations because they provide useful information about the company’s performance and financial condition, as well as about the management team’s accomplishments.
Accounting-based lending agreements, compensation contracts, and regulations shape managers’ incentives—after all, that is why accounting numbers are included in contracts and regulations. They also help explain the accounting choices that managers make. Understanding why and how managers exercise their GAAP accounting discretion can be extremely helpful to those who are analyzing and interpreting a company’s financial statements.

CHAPTER OUTLINE

I.CONFLICTS OF INTEREST IN BUSINESS RELATIONSHIPS
A. Stockholders and lenders delegate authority to professional managers, but such delegation can cause conflicts of interest. A contract creates a principal-agent relationship where the agent is supposed to act on behalf of the principal. Conflict can arise when the agent will not always act in the principal’s best interests, resulting in an agency cost. These costs are borne by both parties.
1. Conflicts arise when one party to the business relationship can take actions that benefit him or her, but harm the other party.
2. Contract terms can be designed to eliminate or reduce conflicting incentives that arise in business relationships.
3. Stock options, bonuses, and other incentives may be used to motivate management but pose an additional incentive to manipulate the numbers.
B. The value of financial statement data for contracting purposes depends on the accounting methods used by the company and its freedom to change them.
C. Contracting parties understand that financial reporting flexibility affects how contracts are written and enforced.
D. Many contracts use ratios to monitor compliance of terms and conditions. Managers may use Special Purpose Entities and other creative outsourcing arrangements to change the economic substance of transactions without violating the contractual terms.
II. DEBT COVENANTS IN LENDING AGREEMENTS
A. The interests of creditors and stockholders often diverge, particularly after the lender has handed over the cash.
1. This divergence creates incentives for managers to take actions that transfer part of the company’s value from creditors to the managers themselves as well as to other stockholders. These arrangements favor one group of stockholders over another by transferring profits and assets from one related entity to another.
2. These incentives arise because business decisions affect not only the value of the firm, but also the relative share of that value which belongs to owners rather than creditors.
3. Debt covenants are contractual restrictions included in borrowing agreements that serve three broad functions:
a. Preservation of repayment capacity
b. Protection against credit-damaging events
c. Signals and triggers.
4. Debt covenants benefit both creditors and borrowers. Creditors benefit because
covenantsreduce default risk while borrowers benefit because the covenants provide
a way to commit credibly to actions that keep default risk lower, which reduces cost
of capital (credit).
B. Affirmative covenants, Negative Covenants, and Default Provisions:
1. Affirmative covenants stipulate actions the borrower must take. These include:
a. Using the loan for the agreed-upon purpose.
b. Providing periodic, audited financial statements.
c. Complying with financial covenants.
d. Compliance with laws.
e. Allowing the lender to inspect business assets and business contracts.
f. Rights of inspection.
g. Maintenance of insurance, properties, and records.
h. Financial covenants and reporting requirements.
i. These covenants establish minimum financial tests with which a borrower must comply.
ii. These tests can specify dollar amounts or ratios, but generally do not stipulate the accounting methods to be used when preparing financial statements.
iii. They are intended to signal financial difficulty, and to trigger intervention by the creditor before liquidation or bankruptcy becomes necessary.
2. Negative covenants restrict possible managerial decisions in order to better assure that cash will be available to make interest and principal payments, or to prevent actions that might impair the lender’s claims against the company’s cash flows, earnings, and assets. They include limits on:
a. Total indebtedness, stated as a dollar amount or in the form of a ratio.
b. Investment funds.
c. Capital expenditures.
d. Additional leases.
e. Corporate loans and advances.
f. Payment of cash dividends.
g. Share repurchases, to address the repayment problem.
h. Business combinations.
i. Asset sales.
j. The voluntary repayment of other indebtedness.
k. New business ventures.
3. The “events of default” section of the loan agreement describes circumstances in which the creditor has the right to terminate the lending relationship.
4. A common action is to renegotiate the loan agreement.
5. If the covenant violation is insignificant, lenders may give the borrower a grace period to cure the covenant breach.
6. If the violation is significant, lenders my accelerate loan repayment (with interest) and terminate its relationship with the borrower.
C. Mandated Accounting Changes May Trigger Debt Covenant Violation: New
reporting standards are issued to enhance the relevance and representational
faithfulness of financial statements.
1. A new FASB or IFRS standard may trigger a debt covenant violation.
2. Many loan agreements have financial covenants that rely on “fixed GAAP”, the rules
in place when the loan was first granted.
3. When “fixed GAAP” is not permitted, lenders still have the option to waive or
renegotiate the covenants.
D. Managers’ responses to potential debt covenant violations:
1. Since violating a covenant is costly, managers have strong incentives to make accounting choices that reduce the likelihood of technical default.
a. Technical default occurs when the borrower violates one or more loan
covenants, but has made all interest and principal payments.
i. Net worth and working capital restrictions are the most
frequently violated accounting-based covenants.
ii. According to one study, “abnormal” discretionary
accounting accruals
(i.e., noncash financial statement adjustments that accrue
revenue or accrue expenses) were found to significantly
increase reported earnings in the year prior to technical
default.
b. Payment default occurs when the borrower is unable to make the scheduled interest or principal payment.
2. Management tends to make accounting method changes and/or to manipulate discretionary accruals to avoid violating debt covenants.
3. Violating debt covenants may require the corporation to pay penalties, a higher rate of interest, or possibly could cause bankruptcy procedures.
III. MANAGEMENT COMPENSATION
A. Managers have incentives to use company assets for their personal benefit at the expense of owners.
1. Potential conflicts of interest can be overcome if managers are given incentives which cause them to behave like owners.
2. Two ways of aligning managers’ incentives with owners’ interests are to link
compensation to stock returns and/or financial performance measures such as accounting earnings.
a. Managerial strategies and decisions clearly affect share prices in the long run, but short-run share prices could change because of factors that are outside of
management’s control.
b. Earnings are probably less susceptible to the influence of temporary and external economic forces, but earnings can be criticized for its reliance on accruals, deferrals, allocations, and valuations that involve varying degrees of subjectivity and judgment.
B. How executives are paid:
1. Base Salary is typically dictated by industry norms, the size of the company, and the executive’s specialized skills.
2. Annual(Short-term) Incentives set yearly financial performance goals that must be achieved if the executive is to earn various bonus awards.
i. The most common financial performance measure used in bonus plans is GAAP net income or some variation of it.
ii. Compensation committees are comprised of outside directors in order to eliminate (reduce) the conflict of interest inherent in executives setting their own bonus targets. This does not always yield the expected results.
3. Long-Term Incentives motivate and reward executives for the company’s long-term growth and prosperity (typically three to seven years).
4. Figure 7.2 in the text illustrates the compensation mix for CEOs.
a. Long-term incentives (most frequently stock options) comprise a larger portion of total compensation for most CEOs while salaries as a percentage of compensation has decreased between 1985 and 2008.
b. Stock Options as a form of compensation is popular since it gives the holder an incentive to increase shareholder value as measured by stock price.
c. Restricted stock is nontransferable or subject to forfeiture for some years.
d. Performance-based pay plans require the manager to achieve certain multi-year financial performance goals (such as ROE). Payout is in cash or stock.
5. Proxy Statements and Executive Compensation: Information about a
company’s executive compensation can be found in the annual proxy statement.
a.Proxy statements are filed each year with the SEC and includes disclosures of
compensation and awards made to executives.
b. Firms now provide a compensation discussion and analysis (CD&A) in the
proxy statement.
c. In addition to CD&A, three broad executive pay categories are disclosed in
detail:
1. Compensation currently paid or deferred for the current fiscal year and
the two preceding years
2. Holdings of equity-related interests (stock options and restricted stock)
for current and prior period compensation
3. Retirement and other postemployment compensation
6. Figure 7.5 in the text shows common performance measures used in annual and
multi-year cash incentive plans.
1. Widespread use of accounting-based incentives is controversial for at least
three reasons:
a. Sales and earnings growth translate into shareholder value only when the
company earns more on new investments and acquisitions.
b. Accrual accounting process distorts traditional measures of performance.
c. Accounting-based incentive plans can encourage managers to adopt a
short-termbusiness focus.
d. Executives have discretion over the company’s accounting policies, and
they can use that discretion to achieve bonus goals.
7. Research evidence:
a. When annual earnings exceed the bonus ceiling, managers use discretionary accounting options to reduce earnings.
b. When earnings are below the bonus threshold, managers use their financial reporting flexibility to reduce earnings still further, improving their chances of receiving bonuses next year.
c. Research and development expenditures tend to decline during the years immediately prior to a CEO’s retirement, thereby increasing payouts from bonus contracts.
d. Compensation committees apparently shield top managers from bonus reductions when net income is reduced by nonrecurring losses. But when net income increases by nonrecurring gains, top management reaps the benefits in the form of higher bonus rewards.
8. Protection Against Short-Term Focus: Long-term incentives can provide protection from short-term focus.
a. A recent comprehensive research study finds no evidence that CEO equity
incentives contribute to accounting irregularities.
b. Stock options give managers a strong incentive to avoid shortsighted business
decisions and instead create shareholder value. Hence the prevalence of stock
and stock option portfolios as a form of compensation.
c. Multi-year incentive pay plans and compensation committee intervention can
mitigate executives’ short-term focus.
IV. REGULATORY AGENCIES
A. Regulatory accounting principles (RAP) are the methods and procedures that must be followed when putting together financial statements for the regulatory agency responsible for monitoring firm activities.
1. RAP tells a company how to account for its business transactions.
2. Regulators use RAP financial reports to set the prices customers are charged and as a basis for supervisory action.
3. RAP sometimes deviates from GAAP but may show up in the company’s GAAP financial statements.
B. Capital Requirements in the Banking Industry:
1. Banks and other financial institutions are required to meet minimum capital requirements to ensure that the institution remains financially sound and can meet its obligations to creditors.
2. Regulatory intervention can be triggered if bank capital falls below the minimum allowed.
3. A noncomplying bank:
a. Is required to submit a comprehensive plan describing how and when its capital will be increased.
b. Can be examined more frequently by the regulator.
c. Can be denied a request to merge, open new branches, or expand its services.
d. Can be prohibited from paying any dividends.
C. Rate Regulation in the Electric Utilities Industry:
1. Electric utility companies have their prices set by public utility commissions.
2. A typical rate formula for an electric utility looks like this:
Allowed Revenue = Operating costs + Depreciation + Taxes + (ROA x Asset base) where “Allowed Revenue” determines the rates customers are charged and ROA is the return on assets allowed by the regulator.
3. Public utility RAP and GAAP differences can affect utility rates and the costs that a utility can recover.
4. Rate regulation creates incentives for public utility managers to artificially increase the asset base.
D. Taxation:
1. Tax accounting rules are just another type of RAP.
2. Many IRS accounting rules agree with GAAP, but there are situations in which IRS accounting rules differ from GAAP.
a. Deferring Costs that would otherwise be charged to expense by nonregulated companies.
b. Capitalizing equity costs on construction projects whereas interest alone can be capitalized by nonregulated companies.
3. Deferred taxes (Chapter 13) may be a strong indicator of “Quality of Earnings.”
a. Deferred tax assets indicate that a company has higher tax earnings in relation to
book earnings.
b. Deferred tax liabilities indicate that a company has higher book earnings in
relation to tax earnings.
4. Taxation rules may influence the choice of GAAP accounting methods. Many tax rules are the same as GAAP rules except in some cases:
a. Depreciation expense – GAAP spreads it out; tax rules require the use of schedule using MACRS.
b. U.S. firms are not required to use the same accounting methods for financial statements and on their tax returns except for inventory accounting using LIFO.