THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING

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CHAPTER 7
FINANCIAL REPORTING ANALYSIS BY REVSINE
COLLINS JOHNSON 2nd Edition

• THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING

Slides Authored by Brian Leventhal University
of Illinois at Chicago
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I. Conflicts of Interest in Business Relationships

• A. Stockholders and lenders delegate authority to
  professional managers, but such delegation can
  cause conflicts of interest.

1. Conflicts arise when one party to the business
relationship can take actions that benefit THEM,
but harm the other party.
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I. Conflicts of Interest in Business Relationships

• A. Stockholders and lenders delegate authority to
  professional managers, but such delegation can
  cause conflicts of interest.

2. Contract terms can be designed to eliminate or
reduce conflicting incentives that arise in
business relationships.
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I. Conflicts of Interest in Business Relationships

• The value of financial statement data for
  contracting purposes depends on the
• accounting methods used by the company
• and its freedom to change them.

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I. Conflicts of Interest in Business Relationships

• C. Contracting parties understand that financial
  reporting flexibility affects how contracts are
  written and enforced.

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II. Lending Agreements Debt Covenants

• A. The interests of creditors and stockholders
  often diverge, particularly after the lender has
  handed over the cash. 

1. This creates incentives for managers to take
actions that transfer part of the companys value
from creditors to the managers and stockholders.
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II. Lending Agreements Debt Covenants

• A. The interests of creditors and stockholders
  often diverge, particularly after the lender has
  handed over the cash. 

• 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.

Assets Liabilities SE
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II. Lending Agreements Debt Covenants

• B. Two sources of conflict can arise between
  creditors and owners

1. Asset substitution  

• If a company borrows to engage in low-risk
  investment projects and the interest rate charged
  reflects that low risk,
• the value of the business to owners is increased
• and the value to creditors is reducedby
  substituting higher risk projects.

Assets Liabilities SE
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II. Lending Agreements Debt Covenants

• B. Two sources of conflict can arise between
  creditors and owners

1. Asset substitution  

• Stockholders of companies with debt financing
  prefer investment projects with high dispersion
  because
• They receive all payoffs greater than M .
• While creditors absorb the loss associated with
  payoffs less than M.

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II. Lending Agreements Debt Covenants

• B. Two sources of conflict can arise between
  creditors and owners

1. Asset substitution  

• A more serious problem for creditors is when
• owners gain (and creditors lose) by making the
  company itself less valuable
• by substituting a high-risk project that has a
  lower expected value (or greater market risk).

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II. Lending Agreements Debt Covenants

• B. Two sources of conflict can arise between
  creditors and owners

2. Repayment

• This conflict involves how to use the cash
  generated by operating activities.

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II. Lending Agreements Debt Covenants

• B. Two sources of conflict can arise between
  creditors and owners

2. Repayment
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
B. Two sources of conflict can arise between
creditors and owners
2. Repayment
c. When companies are financed partially with
debt, owner-managers have incentives to
distribute cash to stockholders.
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II. Lending Agreements Debt Covenants
B. Two sources of conflict can arise between
creditors and owners
2. Repayment

• If a company borrows money for a new project and
  the interest rate charged presumes the companys
  current dividend policy will be maintained,
• the value of the business to creditors is reduced
  when managers forego investments in positive net
  present value projects in order to pay (larger)
  dividends.

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

• At the extreme, if the company sells all its
  assets and pays owners a liquidating dividend,
• creditors are left with a worthless business.

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

• Creditors can obtain price
  protection against the possibility that
  owner-managers
  
• will take actions that benefit shareholders,
  but harm creditors.

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

• g. To reduce conflicts of interest between
  creditors and shareholders
• A written contract that restricts the
  owner-managers ability to harm creditors is
  needed.(Debt Covenants)

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II. Lending Agreements Debt Covenants
C. The structure of debt covenants
1. 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.
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II. Lending Agreements Debt Covenants
C. The structure of debt covenants
1. Affirmative covenants stipulate actions the
borrower must take. These include
b. 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 do not stipulate the accounting
methods to be used when preparing financial
statements.
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II. Lending Agreements Debt Covenants
C. The structure of debt covenants
1. Affirmative covenants stipulate actions the
borrower must take. These include
b. Financial covenants and reporting requirements
iii. They are intended to signal financial
difficulty, and to trigger intervention by the
creditor before liquidation or bankruptcy becomes
necessary.
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II. Lending Agreements Debt Covenants
C. The structure of debt covenants
1. Affirmative covenants stipulate actions the
borrower must take. These include

• Compliance with laws.
• Rights of inspection.
• Maintenance of insurance, properties, and records.

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II. Lending Agreements Debt Covenants
C. The structure of debt covenants

• Negative covenants place direct restrictions on
  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
  lenders claims against the companys cash flows,
  earnings, and assets.

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II. Lending Agreements Debt Covenants
C. The structure of debt covenants

• Negative covenants
• They include limits on

• Total indebtedness, as a dollar amount or in the
  form of a ratio.
• Investment funds.
• c. Capital expenditures.
• d. Additional leases.
• 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.

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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

• Since violating a covenant is costly,
• managers have strong incentives to make
  accounting choices that reduce the likelihood of
  technical default.

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II. Lending Agreements Debt Covenants
D. Managers responses to potential debt covenant
violations

• 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.
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II. Lending Agreements Debt Covenants
D. Managers responses to potential debt covenant
violations
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. Abnormal discretionary accounting accruals
(i.e., noncash financial statement adj. that
accrue revenue or accrue expenses) were found to
significantly increase reported earnings in the
year prior to technical default.
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II. Lending Agreements Debt Covenants

D. Managers responses to potential debt covenant
violations

• Since violating a covenant is costly, managers
  have strong incentives to make accounting choices
  that reduce the likelihood of technical default.

b. Payment default occurs when the borrower is
unable to make the scheduled interest or
principal payment.
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II. Lending Agreements Debt Covenants

D. Managers responses to potential debt covenant
violations
2. Management tends to make accounting changes
and/or to manipulate discretionary accruals to
avoid violating debt covenants.
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III. Management Compensation

• A. Managers have incentives to use corporate
  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.
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III. Management Compensation

• A. Managers have incentives to use corporate
  assets for their personal benefit at the expense
  of owners.

• 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.

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III. Management Compensation

• 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.

• 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 managements
  control.

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III. Management Compensation
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.

• 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
  subjectivity and judgment.

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III. Management Compensation

• B. 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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III. Management Compensation

• B. How executives are paid

4. Figure 7.4 in the text shows the size and mix
of compensation for CEOs based on a recent survey
of pay practices at 500 industrial companies.
a. Long-term incentives (most frequently stock
options) comprise large portions of total
compensation for most CEOs.
b. Figure 7.5 in the text shows the
prevalence of long-term incentives
by type.
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III. Management Compensation

• C. Incentives tied to accounting numbers

1. Figure 7.5 shows that up to 55 of all
companies use performance plans, which are tied
to accounting numbers, as long-term compensation
incentives. 2. For annual bonus plans,
accounting numbers become overwhelmingly
important. 3. Figure 7.6 in the text shows
common performance measures used in annual
incentive plans for senior corporate executives.
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III. Management Compensation

• C. Incentives tied to accounting numbers

• 1. Figure 7.5 shows that up to 55 of all
  companies use performance plans, which are tied
  to accounting numbers, as long-term compensation
  incentives.
• 2. For annual bonus plans, accounting numbers
  become overwhelmingly important.
• Figure 7.6 in the text shows common performance
  measures used in annual incentive plans for
  senior corporate executives.
• Figure 7.7 shows the performance measures used in
  long-term incentive plans.

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III. Management Compensation

• C. Incentives tied to accounting
  numbers

5. Widespread use of 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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III. Management Compensation

• C. Incentives tied to accounting
  numbers 

6. Research evidence

• When annual earnings exceed the bonus ceiling,
  managers use discretionary accounting options to
  reduce earnings.
• 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. R D expenditures tend to decline during the
  years immediately prior to a CEOs retirement,
  thereby increasing payouts from bonus contracts.
• d. Compensation committees do not shield top
  managers from bonus reductions when net income is
  reduced by nonrecurring losses. But when net
  income increases by nonrecurring gains, top
  management reap the benefits in the form of
  higher bonus rewards.

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III. Management Compensation

• C. Incentives tied to accounting
  
• numbers 

7. Long-term incentives can provide protection
from short-term focus.
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IV. Regulatory Agencies

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

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IV. Regulatory Agencies

• A. 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. 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. 4. RAP sometimes shows up in the companys
GAAP financial statements.
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IV. Regulatory Agencies

• 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.
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IV. Regulatory Agencies

• B. 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

• 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 Rev. Operating costs Depr. Taxes
(ROA ? Asset base)Where ROA is the allowed by
the regulator. 3. Public utility RAP and GAAP
differences can affect utility rates and the
costs that a utility can recover. 4. Rate
regulation creates incentives for public utility
managers to artificially increase the asset base.
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IV. Regulatory Agencies

• 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. 3. Tax
accounting rules may
influence the choice of GAAP accounting
methods(LIFO).
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IV. Regulatory Agencies

• E. Identifying managed earnings

1.Uncovering core earnings and assessing
overall performance is not easy. Analysts must
a. Adjust for differences in the accounting
methods and reporting practices across
companieseven within the same industry. b.
Identify areas where choices can hide potential
earnings surprises. c. Assess the degree to
which earnings have been managed. d. Adjust the
reported financial statements to eliminate the
impact of these potential accounting differences.
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IV. Regulatory Agencies

• E. Identifying managed earnings

2. Managers have powerful incentives to
hide a companys 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 most prevalent when these
accounting incentives are especially
strong.
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IV. Regulatory Agencies

• E. Identifying managed earnings

3. What to look for and where to look?
a. Look to areas where subjective judgments or
estimates have a significant impact on the
financial statements. b. Look at areas where
authoritative standards are lacking or
established practices are controversial. c.
Evaluate large business transactions, especially
those that are unusually complex in structure or
in their financial statement effects. d. Examine
financial statement footnotes and other financial
disclosuresthey should be complete and
transparent.