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P7-6. Tying bonus to EPS performance
Requirement 1:
According to the bonus formula, Mr. Brincat would receive a bonus of
$500,000 if the company reported net after-tax earnings of $50 million and
the EPS increase was 10 percent.
Requirement 2:
According to the bonus formula, Mr. Brincat would receive a bonus of
$846,140 if the company reports net after-tax earnings of $50 million and the
EPS increase is 30 percent.
Assuming the company has not issued or repurchased stock during the
So, earnings last year must equal $50 / (1.30) or $38.462 million.
Requirement 3:
Most shareholders would not feel very comfortable if managers had this type
of compensation package. Consider, for example, the incentive bonus. It is
based on annual increases in EPS, and the larger the EPS increase, the
The combination of annual bonuses and stock options tied to EPS growth
sends a clear signal to management: EPS is all that matters. Shareholders,
P7-7. Earnings quality and pay
Requirement 1:
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The first thing to note about the suggested adjustments is that there is no
mention of the nonoperating income items and gains. The list provided by
company managers is one-sided: It identifies nonoperating items that
Consider the three income-reducing special items:
a) Loss on early retirement of debt
The compensation committee could determine that the bonus should be paid
solely on the basis of reported net income and that no adjustment is
On the other hand, a reasonable argument can be made for excluding (a)
from the bonus calculation. Here, changes in the company’s optimal financial
A similar argument can be made to exclude (b) and (c) from the bonus
calculation. Changes in the company’s economic environment may have
contributed to the need for a restructuring and the discontinued operations.
Requirement 2:
(a) Income from continuing operations. The rationale here is to exclude
(b) Income from continuing operations, adjusted for all nonrecurring
items. The idea is to exclude nonrecurring losses so that managers have an
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Education.
(c) Income from continuing operations, adjusted for nonrecurring
losses only. As in (b), the rationale here is to provide managers with an
P7-8. Avoiding debt covenant violations
Requirement 1:
For most companies, the fixed charges ratio is a variation of the interest
coverage ratio. With only two weeks until the books are closed, the company
Accelerate the recognition of revenue from the first few days of next year
Delay the recognition of expenses from the last few days of this year until
Postpone discretionary expenses like maintenance, research and
Change one or more accounting methods to increase reported earnings. For
Change one or more accounting estimates. For instance, increase the
Requirements 2 and 3:
Some actions that could be taken to avoid violating the tangible net worth
ratio are:
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Education.
To reduce the ratio of consolidated debt to total capitalization (i.e., to total
Requirement 4:
Answers to this question will vary from student to student. The dilemma
confronting the banker involves a trade-off between (a) using covenants to
P7-9. Accounting in regulated industries
Requirement 1:
Duke Energy is alerting readers of its financial statements that certain
reported asset and liability items are unique to the rate-making process, and
Requirement 2:
In this particular instance, Duke Energy is reminding readers that some
interest costs are assigned to the balance sheet, and thus are not included in
Duke Energy is also reminding financial statement readers that certain
(implicit) equity costs are also assigned to the balance sheet as part of
Requirement 3:
The chapter provides several examples of regulatory expense shifting where
firms have incentives to classify a cost (e.g., corporate advertising) as an
allowed operating cost rather than a cost not allowed for rate determination.
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Education.
P7-10. Understanding rate regulation and accounting choices
Requirement 1:
The following table shows the impact of the proposed accounting changes on
2017’s revenue requirement and rate per kilowatt hour:
Requirement 2:
The bad debt increase is plausible as long as the revised estimate (1.5% of
The inventory write-up to current replacement value makes economic
sense. Investors should be allowed to earn a fair return (8.75%) on their
current investment in the company, not on an outdated historical measure of
The plant life extension would be allowed, but not the $175 million increase
Regulators would disallow amortization of the hostile takeover cost
incurred last year. This is nothing more than a bold attempt to get one of last
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Education.
that too is likely to be rejected because the outlay was of little benefit to
customers.
Financial Reporting and Analysis (7th Ed.)
Chapter 7 Solutions
The Role of Financial Information in Contracting
Cases
Cases
C7-1. Maxcor Manufacturing: Compensation and earnings quality
Requirement:
There are several reasons why Ms. Magee should feel uneasy about
Maxcor’s computation of 2017 operating profits:
Some research and development (R&D) expenses are shown above the
operating profit line (in cost of goods sold) and some are below the line (as
research and development expense). The classification decision may allow
Plant closing costs lowered net income for the year. The issue here is
whether management should be penalized (or rewarded) for this business
Should the 100% bonus payout for 2017 be approved? Probably not. Sales
are down nearly 12%. Operating costs fell by a similar percentage, but much
Here are some possible changes to the bonus formula:
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Education.
Use a “bonus bank” that spans several years to guard against the
Charge for the capital used in the company so that bonus payments reflect
Use stock options, phantom shares, or stock purchases to make managers
C7-2. Whole Foods Market: EVA-based compensation
Requirement 1:1
Whole Foods Market describes its EVA performance metric as “equivalent to
net operating profits after taxes minus a charge for the cost of capital
First, performance is based on a measure of operating profits, which means
that non-operating gains and losses that might otherwise flow through GAAP
Second, EVA subtracts a cost of capital charge that is omitted from GAAP
earnings. To see why this capital charge can be important to companies such
as Whole Foods Market, put yourself in the shoes of a regional manager and
assume that your incentive compensation is based on GAAP operating
earnings. You could grow earnings—and increase your incentive pay—in any
1 EVA® is a trademark held by Stern Stewart & Company, a consulting firm that has developed a proprietary
approach to the use of economic value added as business management and analysis tool. Whole Foods
Market does not associate the trademark symbol (®) with EVA in its narrative discussion, and we follow that
same practice here.
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Education.
Requirement 2:
The company says that “stock price performance has not been a factor in
determining annual compensation because the price of the Company’s
Whole Foods Market grants stock options and restricted stock to managers
and executives. These pay mechanisms presumably help align the interests
Requirement 3:
At Whole Foods Market, EVA is based on GAAP operating earnings so
managers still have incentives to use accounting discretion to boost the
earnings component of EVA. At other firms, it is common for the EVA
Requirement 4:
The annual EVA bonus for a particular Team Member is first deposited in a
“pool”, and then a portion of the pool balance is paid out annually. The
payout amount is 100% of the pool “up to certain job-specific dollar amounts
To understand how the EVA bonus pool can help overcome the tendency of
management to focus on the short term, consider the bonus pool of one
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Education.
year. The remaining $15,000 of the bonus stays in the pool for possible
payout next period. And that’s the rub! The advertising curtailment this
period may harm sales next period thus reducing future EVA and bonus
Requirement 5:
When an average of several metrics is used, it is more difficult for managers
to “game the system” by maximizing a single metric when doing so is not
optimal. For example, if a single metric of sales growth is used, managers
have an incentive to seek all avenues of increasing sales, even when doing
so is not profitable due to thin or even negative operating margins. In
C7-3 Duke Power Corp: Rate regulation and earnings management
Requirement 1:
Utility companies that fall short of their regulatory rate-of-return profit goals
can appeal to state utility commissions for rate relief—an increase in the
Requirement 2:
If the $10 million consulting fee is considered by regulators to be “above the
line,” it will be included among the operating expenses that are used to
determine the prices charged customers (i.e., the company’s allowed utility
rates). On the other hand, if the fee is viewed by regulators as “below the
Requirement 3:
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Regulated firms such as banks, insurance companies, and Duke Power use
regulatory accounting practices (RAP) when preparing the financial
statements they submit to their regulatory agencies. The GAAP used by
C7-4. Computer Associates International: Compensation and accounting
irregularities
Requirement 1:
Two features of the plan may have contributed to illegal backdating of sales
contracts. The plan has a minimum performance threshold below which no
bonus is awarded. The bonus award jumps from zero to 50% of salary if the
Once the minimum earnings threshold is exceeded, managers receive larger
bonuses as performance increases (up to a maximum of 200% of salary). As
Requirement 2:
When executives have a large fraction of the personal wealth tied to stock
options, they have incentives to cater to Wall Street (e.g., analysts, investors,
and the financial press) and thereby maintain or increase the company’s
Requirement 3:
Auditors routinely look for an unusual clustering transactions at the end of a
quarter or year, particular if the amounts involved are large and help the
company just meet or beat Wall Street sales or earnings expectations,
achieve management bonus targets, or comply with loan covenants.
However, the business model at Computer Associates created a natural
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Education.
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