Chap007 The Role of Financial Information in Contracting
True/False
[QUESTION]
1. Contract terms can be designed to eliminate or reduce conflicting incentives that arise in
business relationships.
2. Contracts include financial reporting information and create incentives for earnings
management.
3. Debt covenants help guard against conflicts of interest between creditors and bank regulators.
4. Some debt covenants preserve repayment capacity by preventing mergers and acquisitions
unless the debt is first repaid.
5. Negative covenants tend to be less significant than affirmative covenants because they place
direct restrictions on the actions lenders can take.
6. Managers wishing to avoid loan covenant violations may resort to making accounting
changes that increase reported earnings.
7. Potential conflicts of interest between managers and owners can be overcome if compensation
packages are tied to improvement in firm value.
8. Most compensation packages involve a base salary, an annual incentive, and a short-term
incentive.
9. When restricted stock is granted as executive compensation, the recipient must wait for
collecting dividends and exercising voting rights until the restriction period ends.
10. Research shows that managers sometimes use accounting flexibility to evade contract
constraints in order to gain bonus benefits.
11. A factor that can affect managers’ incentives for short-term focus on performance is that a
compensation committee oversees incentive plans and can intervene when circumstances warrant
modification of the scheduled incentive award.
12. Banks and other financial institutions are required by federal and state regulatory agencies to
meet minimum lending requirements.
13. Under RAP, loan charge-offs decrease bank capital and also reduce bank net income.
14. Many managers believe that meeting earnings benchmarks helps to build credibility with
investors.
15. A difference of one penny between reported EPS and analysts’ expectations of EPS matters
a lot to investors.
Multiple Choice
[QUESTION]
16. Loan provisions that are specifically designed to restrict dividend payments to shareholders
are called
a. debt covenants.
b. debt obligations.
c. stock covenants.
d. stock agreements.
17. A lender may be protected from deterioration of the borrower’s creditworthiness if the
commercial lending agreement requires the borrower to maintain a
a. specified return on equity.
b. specified earnings per share (EPS).
c. fixed charge ratio above a certain level.
d. fixed charge ratio below a certain level.
18. A borrower that violates one or more loan covenants but makes all interest and principal
payments timely
a. is in payment default.
b. is in trigger default.
c. is in technical default.
d. is not in default.
19. Which of the following is not a purpose served by debt covenants?
a. Preservation of repayment capacity
b. Protection against credit damaging events
c. Triggers and signals
d. Guarantee of no default by the creditor
20. When one party to a business relationship can make decisions that benefit him or her but
harm another other party in the relationship
a. a lawsuit is automatically filed.
b. a contract arises.
c. a conflict of interest arises.
d. a contingent liability arises.
21. Potential conflicts of interest permeate
a. few business relationships.
b. only relationships between investors and managers.
c. only relationships between borrowers and lenders.
d. many business relationships.
22. Contract terms
a. confer the rights and obligations of the borrower.
b. depend on data in financial statements that are issued before the contract is executed.
c. cannot be designed to eliminate or reduce conflicting incentives.
d. do not use financial accounting numbers to monitor compliance with contract terms.
23. A typical rate formula for a public utility includes
a. revenue, operating costs, and taxes.
b. operating costs, depreciation, and taxes.
c. advertising, depreciation, and taxes.
d. operating costs, bad debt provisions, and depreciation.
24. When agents do not act in the best interest of their principals, the cost is borne by which of
the following?
a. Only the principal
b. Only the agent
c. Both the principal and agent
d. There is no cost of an agent not acting on behalf of their principal.
25. When conflicts of interest exist, lenders generally take all of the following actions at the
creation of a contract except
a. impose higher interest rates to reflect greater default risk.
b. ensure that affirmative covenants are in the contract.
c. accept the risk and set up a reserve for potential future issues.
d. ensure that negative covenants are in the contract.
26. A covenant that specifies a required minimum level of net worth and working capital is a/an
a. compliance covenant.
b. financial covenant.
c. implicit covenant.
d. negative covenant.
27. Affirmative covenants generally would not include which of the following stipulations?
a. The lender has the right to inspect business assets and business contracts.
b. Limits on the borrower’s total indebtedness.
c. The borrower must maintain insurance on business properties.
d. Specific financial covenants and reporting requirements.
28. Many loan agreements have financial covenants that rely on
a. floating GAAP.
b. fixed GAAP.
c. flexible GAAP.
d. regulatory accounting procedures (RAP).
29. What purpose is served by including covenants that place strict limits on new borrowing,
prohibit stock repurchases and dividends without prior lender approval, or ensure that cash
generated both from ongoing operations and from asset sales will not be diverted away from
servicing debt?
a. Signal
b. Protection against credit-damaging events
c. Preservation of repayment capital
d. Trigger
30. Which of the following is not an example of a negative covenant provision?
a. Limits on capital expenditures.
b. Limits on the borrower’s total indebtedness
c. Limits the use of the loan to an agreed-upon purpose
d. Restricts the payment of cash dividends
31. Based on a comprehensive survey of U.S. companies, the most common financial
performance measure used in annual and long-term incentive plans for senior executives is
a. return on equity.
b. economic value added.
c. return on capital.
d. net income or revenues.
32. Which of the following situations does not lead to default of a loan contract?
a. Impairment of capital
b. Failure to abide by a covenant
c. Paying interest and principal when due
d. Failure to pay other debts when due
33. Debt covenants benefit
a. lenders.
b. borrowers.
c. both lenders and borrowers.
d. neither borrowers nor lenders, but are required by the SEC as a condition of issuing debt
securities.
34. Which one of the following is not a broad function served by debt covenants?
a. Debt covenants usually preclude the borrower from being a merger target.
b. Debt covenants serve as both signals and triggers, thereby assuring a steady flow of
information from borrower to lender.
c. Debt covenants are designed to preserve the borrower’s repayment capacity.
d. Debt covenants offer the lender some protection against credit-damaging events affecting the
borrower.
35. A financial covenant would stipulate all of the following except
a. financial statements must be prepared in accordance with GAAP.
b. specific levels of performance to be met.
c. which accounting methods are to be used.
d. conditions that must be met.
36. In the event of a default, lenders may do all of the following except
a. modify the contract terms.
b. take immediate full control of the creditor.
c. initiate bankruptcy proceedings.
d. seize the collateral.
37. In using financial statements to monitor compliance with debt covenants
a. mandatory changes in accounting principles can be ignored in all cases.
b. many loan agreements have financial covenants that rely on the accounting rules in place
when the loan is first granted.
c. the lender is in default if not enforcing the borrower’s compliance with the most recent
accounting principles.
d. the lender must renegotiate the covenants if a new accounting principle harms the borrower’s
compliance.
38. A lender’s requirement for a borrower to maintain a certain level of fixed charge coverage
a. directly enhances the borrower’s ability to pay dividends.
b. indirectly enhances the borrower’s ability to pay dividends.
c. directly limits the borrower’s ability to pay dividends.
d. indirectly limits the borrower’s ability to pay dividends.
[QUESTION]
39. Covenants that place direct restrictions on managerial decisions are called
a. affirmative restrictions.
b. affirmative covenants.
c. negative restrictions.
d. negative covenants.
40. Which one of the following is an example of a negative covenant?
a. Compliance with laws.
b. Maintenance of insurance.
c. Limit on capital expenditures.
d. Rights of inspection.
41. Which of the following is not an example of an affirmative covenant?
a. Allowing the lender to inspect business assets and business contracts.
b. Limiting new business ventures.
c. Complying with laws.
d. Providing periodic, audited financial statements.
42. A requirement that a company maintain a fixed-charge coverage ratio
a. cannot limit the company’s ability to pay dividends.
b. is an example of a negative covenant.
c. is an example of an affirmative covenant.
d. cannot limit the company’s ability to spend replacement capital.
43. The section of a loan agreement that describes circumstances in which the creditor obtains
additional rights is called the
a. events of compliance section.
b. certificate of compliance section.
c. events of termination section.
d. events of default section.
44. The failure of a company to pay other debts, such as payables or other loans, when due is
called
a. routine default.
b. non-default.
c. cross default.
d. compliance default.
45. Which statement below best describes a technical default?
a. The borrower violates one or more loan covenants but has made all interest and principal
payments.
b. The borrower has not violated any covenants but has missed both an interest and principal
payment.
c. The borrower violates one or more loan covenants but has made all principal payments.
d. The borrower violates one or more loan covenants but has made all interest payments.
46. According to the SEC, any breach of a loan covenant that existed at the balance sheet date that
has not subsequently been cured should
a. be recorded as an adjustment to the financial statements.
b. be disclosed in the notes to the financial statements.
c. be disclosed in the audit report.
d. not be disclosed.
47. When a debt covenant is violated, the related debt must be classified as current if it is
a. probable that the borrower will not be able to cure the default within the next twelve months.
b. probable that the borrower will not be able to cure the default within the next fifteen months.
c. probable that the borrower will be able to cure the default in the next twelve months.
d. probable that the borrower will be able to cure the default in the next fifteen months.
48. Company A’s interest ratio has fallen below the level required by its lender. The lender may
not take which action?
a. Gain representation on the company’s board of directors.
b. Replace the CEO of the company.
c. Demand repayment of the loan.
d. Veto payment of a dividend.
49. Which accounting choice would not be used to reduce the likelihood of a technical default?
a. Bad debt provisions.
b. When to sell assets.
c. Inventory valuation method.
d. Management compensation plans.
50. When a borrower is unable to make a scheduled interest payment, the type of default that
occurs is a
a. technical default.
b. covenant default.
c. payment default.
d. transitory default.
51. A study examining how incentives arising out of debt contracts affect managers’ accounting
choices found that the most common violations of accounting-based covenants occurred with
a. net worth and working capital restrictions.
b. mergers and acquisitions restrictions.
c. leveraged buyout restrictions.
d. debt restructures.
52. Discretionary accounting accruals are
a. cash financial statement adjustments, which accrue revenue or expenses.
b. noncash financial statement adjustments, which accrue revenue or expenses.
c. cash financial statement adjustments, which accrue only revenue.
d. noncash financial statement adjustments, which accrue only expenses.
53. A study of discretionary accounting accruals found that abnormal accruals in the year prior
to reporting covenant violations
a. significantly decreased the company’s current ratio but significantly increased the company’s
reported earnings.
b. significantly decreased the company’s net worth.
c. significantly increased reported earnings and increased working capital.
d. significantly increased reported earnings and decreased working capital.
54. Studies seem to suggest that management tends to make accounting changes and/or
manipulate discretionary accruals to
a. enhance technical defaults.
b. eliminate debt covenants.
c. violate debt covenants.
d. avoid violation of debt covenants.
55. Potential conflicts of interest between shareholders and managers may be overcome if
managers are given incentives which cause them to behave as if they were
a. creditors.
b. owners.
c. debtors.
d. vendors.
56. Firms must provide detailed disclosure of three broad executive pay categories. Which of the
following is not one of these categories?
a. Retirement and other postemployment compensation
b. Costs incurred by the corporation for executive travel, entertainment, and other “expense
account” items
c. Compensation for the last fiscal year and the two preceding years
d. Holdings of equity-related interests that relate to compensation