978-0078025679 Chapter 7 Lecture Note

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

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.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

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

covenants reduce 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.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

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

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

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. Performan ce–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 pr ovide 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-term business 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.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

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 proh ibited fro m 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.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

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.

E. FAIR VALUE ACCOUNTING AND THE FINANCIAL CRISIS:

1. Fair value (or mark-to-market) accounting is the practice of revaluing an asset

according to the price it would bring if sold regardless of what was actually paid

(historical cost) for the asset (or received for the liability).

2. Fair value rules came under criticism in late 2008 when the global housing

bubble triggered the failure of financial institutions.

3. Fair value rules forced banks blamed FASB and IASB fair value accounting

standards because of the accounting-based minimum capital requirements imposed by

regulators on the financial services

1. The Meltdown: A robust economy, low interest rates, and large inflows of

foreign investment funds created a climate of easy credit in the U.S. in the mid

1990s. Use of mortgage-backed securities and collateralized debt obligations

greatly increased during the housing and credit booms and this drove up home

prices and created mortgage defaults.

2. Mortgage-backed securities (MBS) and collateralized debt obligations (CDO)

greatly increased during the housing and credit booms.

3. Packaged bundled MBSs and CDOs for sale to third-party-investors, originators

could convert loans into immediate up-front cash rather than waiting for payments to

flow in from borrowers. The cash was then used to make new loans.

4. Because the supply of mortgages originated at traditional lending standards had

been exhausted, originators started offering nontraditional loans to high-risk

(subprime) borrowers.

5. The increased supply increased housing demand that drove up home prices. This

speculative bubble proved unsustainable.

6. Housing prices started declining, interest rates escalated, MBSs and CDOs

yielded losses and this combination pushed financial institutions to near failure.

7. The Controversy:

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

a. Financial services firms complained that fair value rules contributed to

further depletion of regulatory capital.

b. Securities regulators and accounting standards setters argued that the

primary purpose of accounting is to report the financial condition and

performance of a company – necessitating fair value rules.

c. Regulatory accounting principles serve a different purpose.

4. Political pressure led to several changes in accounting rules.

8. FASB and IASB continue seeking ways to improve the fair value rules.

E. ANALYTICAL INSIGHTS: INCENTIVES TO “MANAGE” EARNINGS:

1. Managers have powerful incentives to hide a company’s true economic

performance and financial condition.

a. These incentives are motivated by loan covenants, compensation

contracts, regulatory agency oversight, and tax avoidance efforts.

b. Financial statement distortions are likely to be most prevalent when these

accounting incentives are especially strong.

CHAPTER QUIZ

1. Which of the following situations best characterizes the agency costs associated with

diverse ownership?

a. Managers have incentives to substitute low-risk projects for high-risk projects.

b. Managers have incentives to reduce the dividend payout ratio in order to accelerate

debt repayment.

c. Managers that own shares of the firm they manage have incentives to consume

perquisites

d. All of the above.

2. Asset substitution pertains to the conflicting incentives of creditors and owners. Which

of the following is true?

a. Even though asset substitution transfers wealth from creditors to shareholders, the total

value of the business generally increases.

b. Creditors have limited “downside” exposure since they have preferences over

common shareholders in bankruptcy proceedings.

c. Creditors have limited “upside” potential because of their fixed claims.

d. Debt covenants eliminate creditors’ concerns from asset substitution.

3. Which of the following is an example of a negative covenant?

a. The borrower will at all times maintain a ratio of current assets to current liabilities that

is greater than 2.0 to 1.0.

b. The borrower will use the proceeds of the loan in accordance with the loan purposes set

forth in the loan agreement.

c. The borrower shall prepare financial statements in accordance with GAAP.

d. The borrower agrees that it will not repurchase its stock using the proceeds of this loan,

either directly or indirectly.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

4. A technical default occurs when the borrower violates one or more of the loan covenants, but

has made all principal and interest payments. Which of the following is true?

a. Loan covenants prohibit managers from making choices that reduce the likelihood of

technical default.

b. Technical defaults that have not been cured should be disclosed in the financial

statements.

c. Technical defaults are not likely to change an analyst’s assessment of liquidity.

c. Discretionary accounting accruals are not likely to provide managers enough room to

avoid technical default.

5. Executive compensation packages often include a base salary, an annual incentive, and a

long-term incentive. What role do accounting numbers have on these incentives?

a. Nearly all companies use performance plans that are tied to accounting numbers.

b. Return on equity and earnings per share are the most common accounting measures used

in both annual and long-term performance-based plans.

c. Earnings growth translates into increased shareholder value, increasing the value of

stock options to managers.

d. All of the above.

6. Illinois Power & Light just spent $5 million repairing one of its electrical generating

stations that was damaged by a tornado. The loss was uninsured. Management has asked the

public service commission for approval to treat the $5 million as an asset for rate-making

purposes rather than as an allowed expense. Assume the public utility commission sets

ROA at 10%. What difference will this make to customers?

a. This request makes no difference to customers.

b. Customers will pay an additional $5 million in higher electricity costs under both

plans.

c. Customers will pay $5.5 million in higher electricity costs if the repair costs are an

allowed operating cost for rate-making purposes.

d. Customers will pay $5.5 million in higher electricity costs if the repair costs are treated

as an asset for rate-making purposes.

7. Consolidated Corp. must choose between two projects, both of which require an initial

investment of $100,000. Project A has a 0.5 probability of generating a net payoff of

$100,000 and a 0.5 probability of generating a net payoff of $200,000. Project B has a 0.5

probability of generating a net payoff of $40,000 and a 0.5 probability of generating a net

payoff of $260,000. Which project would shareholders prefer?

a. Project B since it offers the highest potential outcome.

b. Project A since its worst-case outcome ensures recoverability of the amount invested.

c. Shareholders would be indifferent between the two projects since the expected values of

both payoffs are the same.

d. Project A since it has a lower variance in its possible payoffs.

8. Why might it make sense to change a CEO’s incentive pay plan as the CEO nears

retirement?

a. There should be increased emphasis on annual performance plans since a CEO

nearing retirement has a shorter management horizon.

b. There should be increased emphasis on long-term performance plans in order to

encourage the CEO nearing retirement to act in the best long-term interests of the

shareholders.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

c. There should be a change in the nature of the performance plans to reduce the short-

term, self-interested, focus of the CEO nearing retirement.

d. The CEO nearing retirement should be given increased discretion over accruals and

deferrals.

9. Do you think that institutional investors favor or oppose significant managerial stock

ownership?

a. Favor, since it aligns the interests of the managers with those of the institutional

investors.

b. Favor, since it more likely translates into higher future shareholder returns.

c. Oppose, since it increases the direct competition between managers and the

institutional investors for board seats.

d. Oppose, since higher managerial ownership is likely to result in lower quality of

earnings.

10. Why may outside board members not strengthen corporate governance?

a. They may be long-time personal friends of the CEO.

b. They may own stock in the company, making it more likely that they will follow the lead

of the CEO.

c. They may only sit on this one board, weakening corporate governance because of their

lack of experience.

d. They sit on key board committees, such as the audit, nominating, and

compensation committees.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

QUIZ ANSWERS:

1. c. Delegation of authority can cause conflicts of interest. Conflicts arise when managers can

take actions that benefit themselves, but hurt other parties. In this case, managers have

incentives to consume perquisites since they receive all of the benefit but bear only part of

the costs. In other words, managers that own 35% of the stock receive 100% of the benefit of

the perks, but only “pay” 35% of the cost (their share of lower earnings). Asset substitution

encourages managers to substitute high-risk projects for low-risk projects. The repayment

problem encourages managers to pay dividends out of loan proceeds.

Financial Reporting and Analysis 6e The Role of Financial Information in Contracting

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be ineffective for a CEO with a short management horizon.

9. a. Higher ownership interest by managers is likely to align the interests of the managers

with those of the institutional investors.

10. a. Factors related to outside board members that may weaken corporate governance

include board members that are long-time friends of the CEO, those that own no company

stock, and those that serve on numerous boards and earn substantial fees from doing so.

However, those directors that are truly “independent” may strengthen corporate governance

by sitting on key “board” committees.

RECOMMENDED EXHIBITS

Figure 7.2—CEO Compensation Mix.

Figure 7.4—Long-Term Incentive Mix.

Figure 7.5 – Performance Measures Used in Annual and Multiyear Cash Incentive Plans.

Figure 7.6 – Typical Structure of Annual Performance Bonuses

Figure 7.7 – Why Meet Earnings Benchmarks?