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Financial Reporting and Analysis (7th Ed.)
Chapter 7 Solutions
The Role of Financial Information in Contracting
Exercises
Exercises
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
Advantages:
Low cost: Since the borrower (company) must produce financial
Accounting numbers are audited: Since the financial
statements are audited by independent accounting firms, lenders
Disadvantages:
Management manipulation: Even though the financial
can never be completely ruled out. Examples include voluntary
Mandatory accounting changes: Accounting-based loan
covenants can be influenced by mandatory accounting changes
imposed by the FASB or other regulatory group. Lenders may
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
Allowing some discretion also benefits lenders because managers
can then adapt their accounting methods to the company’s
Another reason lenders may not want to require “fixed” accounting
Despite these reasons, some lenders do stipulate the accounting
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
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
To encourage managers to increase sales profitably, many
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
Some companies may be reluctant to disclose pay components of
this sort because doing so could attract greater investor (and
E7-6. Regulatory costs
Taxes and regulations can transfer wealth from companies and their
stockholders to other groups or individuals. Consider, for example,
local property taxes paid by a company. These taxes represent a
Electricity rate regulation provides another example. State utility
regulators set the price of electricity so that stockholders can earn a
“fair” rate of return on their investment. If they earn too small a
Regulatory costs are important for understanding a company’s
financial reporting choices because financial statement data are
used by regulators to justify taxes and to set rates charged by utility
E7-7. Regulatory accounting principles
When “construction in progress” costs are included in the rate base,
regulators are allowing the company and its shareholders to earn a
($ in millions) CIP included CIP excluded
Allowed operating costs
$1,120
$1,120
Assets in service $3,200 $3,200
Construction in progress 500 0
Allowed assets 3 ,700 3 ,200
Allowed return on assets (8%)
296
256
1This is the amount of revenue needed to cover all operating expenses and still
earn net income equal to the “allowed” amount.
In this case, including CIP in the rate base allows the company to
set electricity prices so that it receives $1,416 million in revenue
rather than only $1,376 million. As a result, customers pay 10.11
Note that including CIP costs in the rate base may actually benefit
customers if it results in earlier construction of additional and more
E7-8. Equipment repairs and rate regulation
The answer depends on when rates will be adjusted as well as how
the tornado loss is classified for rate-making purposes. Let’s
Rates Set in Loss Year Rates Set One Year Later
($ in millions) Expense Capitalize Expense Capitalize
1The revenue requirement is the sum of allowed operating costs (with or
without tornado damage) and the allowed returns.
If electricity rates are set in the loss year, it is better for shareholders
to have the company treat the repairs as an expense. That’s
If electricity rates are set in the loss year and the repairs are
capitalized, customers may still pay the full cost of the repairs—but
If rates are to be set one year after the tornado loss (but not the loss
year), it is better for customers (but worse for shareholders) if the
If the repairs are capitalized, and rates are set in the year after the
represents depreciation of the capitalized repair costs (over a 5-year
Also note that if rates are set both years, it is still better for
shareholders (but worse for customers) to expense the repairs
E7-9. Maintaining capital adequacy
Requirement:
Banks and insurance companies are required to maintain minimum
levels of investor capital for two reasons. First, it provides a cushion
Minimum capital requirements affect the financial statements that
There’s expanded disclosure regarding a company’s capital
Certain “exotic” financial instruments that count as investor
capital for regulatory purposes (and are shown as capital in the
E7-10. Identifying conflicts of interest and agency costs
An agency relationship: whenever someone hires another person
(the agent) to act on his or her behalf. Jensen and Meckling (p. 308)
define an agency relationship as “a [formal or informal] contract
under which one or more individuals (principals) engage another
In the oil and gas drilling partnership, the general partner—Huge
Gamble—makes all the operating decisions. Huge Gamble is the
agent for the investor group (you and your friend). Is there any
agency conflict here? Yes, because Huge Gamble gets paid
See: M.C. Jensen and W.H. Meckling, “Theory of the Firm:
Managerial Behavior, Agency Costs and Ownership Structure,”
Journal of Financial Economics (October 1976), pp. 305–360; and
Financial Reporting and Analysis (7th Ed.)
Chapter 7 Solutions
The Role of Financial Information in Contracting
Problems
Problems
P7-1. Krispy Kreme’s bonus plan
Requirement 1:
Shareholders benefit when Krispy Kreme opens new doughnut
shops that earn a rate of return on invested capital (ROIC) that
exceeds the company’s cost of capital. The bonus plan rewards
Requirement 2:
Using the same profit performance definition (EBITDA) in the
company’s loan covenants as the profit performance definition in the
bonus plan helps ensure that managers pay incentives are aligned
Requirement 3:
A variety of accounting alternatives can be used to enhance
managers’ bonuses when those bonuses are based on accrual
accrual machinations discussed throughout the book. These
Requirement 4:
Krispy Kreme paid off most of its debt in the year ended February 2,
2014. In that year, total debt fell from $25.7 million to $2.0 million.
EBITDA is a pre-interest measure of income, so it is unaffected by
the degree of leverage or changes in it. While the company was
leveraged, EBITDA provided a purer measure of operating
P7-2. Krispy Kreme’s compensation recovery plan
Requirement 1:
Annual and long-term compensation plans can contribute to agency
problems by encouraging managers to take actions that enhance
their pay (and thus personal wealth) to the detriment of
shareholders. These actions may involve real transactions such as
Requirement 2:
Here are two examples:
Overstating revenue for the quarter by forcing retail franchises
Understating expenses for the quarter by recording certain
Both examples are taken from the company’s description of the
Requirement 3:
The pay recovery plan is aimed at reducing managers’ incentives to
inflate reported financial statement results and thus their annual
P7-3. Medical malprofits
When doctors own the hospitals where they work, they may be
tempted to overprescribe or overdiagnose medical treatments
and procedures. That’s because hospital profits flow to the doctors
P7-4. Foot Locker, Inc.: Anticipating covenant violation
Requirement 1:
A minimum fixed charge coverage ratio covenant limits the
company’s ability to pay dividends or make capital expenditures by
requiring that fixed charges—current maturities on debt, dividends,
Requirement 2:
By agreeing to this restriction, Foot Locker promises to keep more
Requirement 3:
Suppose the numerator of the fixed charge coverage ratio is defined
by the loan agreement to be net income plus depreciation and
amortization. Management has an incentive to make the numerator
as large as possible because this creates slack in the covenant and
Requirement 4:
Lenders have several options available to them when a loan
covenant is violated. These options include waiving the violation,
P7-5. Frisby Technologies: Violating a covenant
Requirement 1:
A minimum tangible net worth covenant requires the company to
maintain a balance of at least a certain amount of contractually
defined “tangible net worth”—stockholders’ equity minus the book
value of intangible assets. There are two related purposes served
by this covenant. First, it provides a contractual incentive for
management to profitably operate the company because
Requirement 2:
Lenders are reluctant to waive a covenant violation when the
circumstances of the violation indicate a true deterioration in
borrower credit worthiness. If credit risk has increased, lenders will
Requirement 3:
Lenders often prefer to avoid foreclosure because the cash
proceeds obtained from liquidating a company are often quite small
in comparison to loan amounts. Lenders often structure a “work
