THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING

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CHAPTER 7

• THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING

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Figure 6.1 Significant Contracting Relationships
in Corporate Organizations
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II. Lending Agreements Debt Covenants
B. Two
sources of conflict can arise between creditors
and owners

• 1. Asset substitution  
• a. If a company borrows to engage in low-risk
  investment projects and the interest rate charged
  is commensurate with that low risk, the value of
  the business to owners is increasedand the value
  to creditors is reducedby substituting higher
  risk projects.

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II. Lending Agreements Debt Covenants
B. Two
sources of conflict can arise between creditors
and owners

• 2. Repayment 
• a. This conflict involves how to use the cash
  generated by operating activities.
• b. There are really three choices
• i. Reinvest the cash back into the business. ii.
  Repay amounts owed to creditors.iii. Pay
  dividends or buy back shares from stockholders.

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II. Lending Agreements Debt Covenants

C. The structure of debt covenants1. Affirmative
covenants stipulate actions the borrower must
take. These include

• a. Using the loan for the agreed-upon purpose in
  order to guard against substitution.b. Financial
  covenants and reporting requirements.c. Complianc
  e with laws.
• d. Rights of inspection.
• e. Maintenance of insurance, properties, and
  records.

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II. Lending Agreements Debt Covenants

C. The structure of debt covenants

2. Negative covenants stipulate
actions the borrower must NOT take. These
include

• 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. Paymen
  t of cash dividends.

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II. Lending Agreements Debt Covenants

C. The structure of debt covenants

2. Negative covenants stipulate
actions the borrower must NOT take. These
include

• 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.

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II. Lending Agreements Debt Covenants

C. The structure of debt covenants

• 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. The borrower may be required to provide a
  Certificate of Compliance that affirms management
  has reviewed the financial statements and found
  no violation of any covenant provision.

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II. Lending Agreements Debt Covenants

D. Managers responses to potential debt covenant
violations

• 1. Technical Default and Payment Default
• Net worth and working capital restrictions are
  the most frequently violated accounting-based
  covenants.
• 2. Management tends to make accounting changes
  and/or to manipulate discretionary accruals to
  avoid violating debt covenants.

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Summary of Loan Agreement

• Conflicts in interest
• Bad actions borrowers can take
• Asset substitution
• Failure to pay back
• Lenders response
• Affirmation and Negative Covenants
• Events of Default and Certificate of Compliance
• Default

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III. Management Compensation
A. How
executives are paid

• 1. Base salary is typically dictated by industry
  norms and an executives specialized skills.
• 2. Short-term incentives set financial
  performance goals that must be achieved if the
  executive is to earn various bonus awards.
• 3. Long-term incentives motivate and reward
  executives for the companys long-term growth and
  prosperity.

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Figure 6.4 CEO Total Executive Compensation
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Figure 6.6 Annual Performance Based Plans (1993)
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Figure 6.7 Long-Term Performance Based Plans
(1993)
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III. Management Compensation
C. Incentives tied
to accounting numbers

• Accounting-based incentives is controversial for
  at least three reasons
• a. Earnings growth translates into shareholder
  value only when the company earns more on new
  investments than its incremental cost of capital.
• b. Accounting-based incentive plans can encourage
  managers to adopt a short-term business focus.
• c. Executives have discretion over the companys
  accounting policies, and they can use that
  discretion to achieve bonus goals.

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Figure 6.8 Structure of Annual Performance Bonus
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III. Management Compensation
C. Incentives tied
to accounting numbers

• 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
  CEOs retirement, thereby increasing payouts from
  bonus contracts.

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Figure 6.7 Long-Term Performance Based Plans
(1993)
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Summary of Compensation Agreement

• Conflicts in interest
• Components of executive compensation
• Base Salary
• Bonus (Short term incentive)
• Stock option or stock ownership (Long term
  incentive)
• Pros and cons of using accounting information

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IV. Regulatory AgenciesA. Regulatory accounting
principles (RAP) are the methods and procedures
that must be followed when putting together
financial statements for regulatory agencies.

• 1. RAP tells a company how to account for its
  business transactions.
• 2. RAP sometimes deviates from GAAP.
• 3. However, RAP sometimes show up in the
  companys GAAP financial statements.

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IV. Regulatory Agencies
Capital
requirements in the banking industry

• 1. minimum capital requirements
• 2. Regulatory intervention can be triggered if
  bank capital falls below the minimum allowed.

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IV. Regulatory Agencies
Capital
requirements in the banking industry

• 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 subject to more stringently applied
  dividend restrictions if it has inadequate
  capital.

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IV. Regulatory Agencies
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 thisAllowed Revenue Operating
  costs Depreciation Taxes (ROA ? Asset
  base)Where ROA is the return on assets allowed
  by the regulator.

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IV. Regulatory Agencies
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.
• 3. Tax accounting rules may influence the choice
  of GAAP accounting methods.
• FIFO for financial reporting
• LIFO for tax purpose

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Summary of General Agreements

• RAP
• Three examples
• Banking minimum capital requirement
• Utilities maximum profitability
• Tax the more profitable, the more tax