Chap007 Financial Reporting Analysis

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The Role of FinancialInformation inContracting

Revsine/Collins/Johnson/Mittelstaedt: Chapter 7

Copyright 2009 by The McGraw-Hill Companies, All Rights Reserved.McGraw-Hill/Irwin


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RCJM: Chapter 7 2009 2

Learning objectives

1. What conflicts of interest arise between managers andshareholders, lenders, or regulators.

2. How and why accounting numbers are used in debt agreements,in compensation contracts, and for regulatory purposes.

3. How managerial incentives are influenced by accounting-basedcontracts and regulations.

4. What role contracts and regulations play in shaping managersaccounting choices.


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Business contracts

Financial data are used in various business contracts andagreements:

Contracting parties understand that financial reporting flexibilityaffects how business contracts are written and enforced.

Significant contracting relationships in corporate organization

Accounting methods and estimatesused by the company and its

freedom to change them


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Loans and debt covenants

The interest of creditors and stockholdersoften diverge.

Suppose a bank loans the firm $75,000,but the owner then pays himself a $75,000dividend.

The dividend payment benefits the ownerbut harms the bank.

Creditors protect themselves fromconflicts of interest in several ways.

One way is to charge a higher rate ofinterest on the loan to compensate forrisky actions.

Another way is to write contracts that

restrict the borrowers ability to harm thelender. The loan agreement might:

1. Require a personal guarantee ofloan payment.

2. Prohibit dividend payments unlessapproved by the lender.

3. Limit dividend payment to some

fraction (say 50%) of net income.Debt covenants:

1. Preserve repayment capacity

2. Protect against credit damagingevents

3. Provide signals and triggers


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Loan agreements:Affirmative covenants

These covenants stipulate actions the borrower must take.

Examples:

Use the loan for the agreed-upon purpose.

Provide financial reports to the lender in a timely manner.

Comply with commercial and environmental laws.

Allow the lender to inspect business assets and contracts.

Maintain business records and properties, and carrying insurance.


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Loan agreements:Negative covenants

These covenants place direct restrictions on the actionsborrowers can take.

Typical restrictions include limits on:

Total indebtedness (including perhaps leases). How funds are used.

Payment of cash dividends.

Stock repurchases.

Mergers, asset sales, voluntary prepayment of debt.

Sometimes the actions are permitted, but only with prior approvalby the lender.


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Loan agreements:Events of default

This section of the loan agreement describes circumstances inwhich the lender can terminate the loan agreement, such as:

Failure to pay interestor principal when due

Inaccuracy inrepresentations

Covenant violationFailure to pay other

debts when due

Waiveviolation

Renegotiatedebt covenant

Seizecollateral

Initiate

bankruptcy

Severity of violationMinor Extreme

When a covenant is violated, the lender can:


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How managers sometimes respondto potential covenant violations

Debt covenant violations are costly.

So managers have strong incentives to reduce the likelihood ofdefault using:

These maneuvers may increase earnings or improve balancesheets in the short-run, but they can mask deteriorating economicfundamentals.

Accounting choices Discretionary accruals

Accounting methods Accounting estimates Transaction timing

Non-cash financialstatement adjustments


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Management compensation:How executives are paid

Base salary is usuallydictated by industrynorms.

Annual incentive is ayearly performance-based bonus award.

Long-term incentive isa yearly award in cash,stock, or stock options

for multi-yearperformance.

CEO compensation mix


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Management compensation:Incentives tied to accounting numbers

The use of accounting-basedincentives is controversialbecause:

Earnings growth does not always

translate into increased shareholdervalue.

Accrual accounting can sometimesdistort traditional performancemeasures like ROA.

Managers may be encouraged toadopt a short-term business focus.

Managers may use their accountingdiscretion to achieve bonus goals.

Performance measures used in annual andmulti-year cash incentive plans


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Regulatory accounting principles

RAP refers to the accountingmethods and procedures thatmust be followed whenassembling financial statementsfor regulatory agencies.

RAP accounting sometimesdiffers from GAAP accounting.

RAP sometimes shows up in the

companys GAAP financialstatements (SFAS No. 71).

RAP

GAAP

Banks Insurance companies Public utilities

Retailers Manufacturers

Other non-regulated firms

Are they the sameor different?


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Regulatory accounting:Banking industry

Banks are required to meet minimum capital requirements, andviolation is costly.

To avoid these regulatory compliance costs, banks can:

Operate profitably and invest wisely so that the bank remainsfinancially sound.

Choose accounting policies that RAP invested capital or decreaseRAP gross assets.


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Regulatory accounting:Electric utilities industry

Utilities have their prices set byregulators.

The rate formulas use

accounting-determined costs andassets values.

Because ofSFAS No. 71, RAPgets included in the financialstatements that utility companies

prepare for shareholders andcreditors.

Rate formula illustration

Allowed revenue

= Operating costs + Depreciation

+ Taxes + (ROA x Asset base)

= $300 million + (10% x $500 million)

= $300 million + $50 million = $350 million

The rate per KWH is then setequal to :

Rate = Allowed revenue

Estimated total KWH


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Regulatory accounting:Taxation

All companies are regulated by state and federal tax agencies.

IRS rules (another type of RAP) govern the computation of netincome for tax purposes.

There are situations where IRS accounting rules differ from GAAP(e.g., depreciation expense).

Sometimes IRS rules require firms to use identical tax and GAAPaccounting methods (e.g., LIFO inventory accounting).


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Summary

Conflicts of interest among managers and shareholders, lenders, orregulators are a natural feature of business.

Contracts and regulations help address these conflicts of interest.

Accounting numbers often play an important role in contracts andregulationsand they help shape managers incentives, and help explainthe accounting choices managers make.

Understanding why and how managers exercise discretion in implementingGAAP is helpful to the analysis and interpretation of financial statements.

Documents

Chap007 Financial Reporting Analysis