CHAPTER 7

1. FINANCIAL REPORTING & ANALYSIS BY REVSINE – COLLINS – JOHNSON 2nd Edition CHAPTER 7 THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING Slides Authored by Brian Leventhal University of Illinois at Chicago

2. I. Conflicts of Interest in Business Relationships A. Stockholders and lendersdelegateauthority to professional managers, but such delegation can cause conflicts of interest. 1. Conflictsarise when one party to the business relationship can take actions that benefit THEM, but harm the other party.

3. I. Conflicts of Interest in Business Relationships A. Stockholders and lendersdelegateauthority to professional managers, but such delegation can cause conflicts of interest. 2. Contract terms can be designed to eliminate or reduceconflictingincentives that arise in business relationships.

4. I. Conflicts of Interest in Business Relationships The value of financial statement data for contracting purposesdepends on the: accounting methods used by the company and its freedom to change them.

5. I. Conflicts of Interest in Business Relationships C. Contracting partiesunderstand that financial reporting flexibilityaffectshow contracts are written and enforced.

6. 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 createsincentives for managers to take actions that transferpart of the company’s valuefrom creditors to the managers and stockholders.

7. II. Lending Agreements & Debt Covenants A. The interests of creditors and stockholders often diverge, particularly after the lender has handed over the cash. • These incentivesarise because business decisionsaffect 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

8. 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 chargedreflects that low risk, • the value of the businessto owners is increased • —and the value to creditors is reduced—by substitutinghigher risk projects. Assets = Liabilities + SE

9. II. Lending Agreements & Debt Covenants B. Two sources of conflict can arise between creditors and owners: 1. Asset substitution:   • Stockholders of companies with debt financingpreferinvestment projects with high dispersion because: • They receiveall payoffs greater than $M . • While creditorsabsorb the loss associated with payoffs less than $M.

10. 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 itselfless valuable • by substituting a high-risk project that has a lower expected value (or greater market risk).

11. 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.

12. 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 cashbackinto the business. ii. Repay amounts owed to creditors. iii. Pay dividends or buy back shares from stockholders.

13. 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-managershave incentives to distribute cash to stockholders.

14. 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 chargedpresumes the company’s current dividend policy will be maintained, • the value of the business to creditorsis reduced when managers foregoinvestments in positive net present value projects in order to pay (larger) dividends.

15. 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.

16. 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 harmcreditors.

17. II. Lending Agreements & Debt Covenants B. Two sources of conflict can arise between creditors and owners: 2. Repayment: • g. To reduceconflicts of interestbetweencreditors and shareholders : • A written contract that restricts the owner-manager’sability to harm creditors is needed.(Debt Covenants)

18. II. Lending Agreements & Debt Covenants C. The structure of debt covenants: 1. Affirmative covenantsstipulate actions the borrower musttake. These include: a. Using the loan for the agreed-upon purpose in order to guard againstsubstitution.

19. II. Lending Agreements & Debt Covenants C. The structure of debt covenants: 1. Affirmative covenantsstipulate actions the borrower musttake. These include b. Financial covenants and reporting requirements i. These covenants establish minimum financial tests with which a borrowermust comply. ii. These tests can specify dollar amounts or ratios, but do not stipulate the accounting methods to be used when preparingfinancial statements.

20. II. Lending Agreements & Debt Covenants C. The structure of debt covenants: 1. Affirmative covenantsstipulate actions the borrower musttake. These include b. Financial covenants and reporting requirements iii. They are intended to signalfinancial difficulty, and to trigger intervention by the creditorbeforeliquidation or bankruptcybecomes necessary.

21. II. Lending Agreements & Debt Covenants C. The structure of debt covenants: 1. Affirmative covenantsstipulate actions the borrower musttake. These include: • Compliance with laws. • Rights of inspection. • Maintenance of insurance, properties, and records.

22. 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 makeinterest and principal payments, • or to prevent actions that might impair the lender’s claims against the company’s cash flows, earnings, and assets.

23. 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.

24. 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. 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.

25. II. Lending Agreements & Debt Covenants D. Managers’ responses to potentialdebt covenant violations: • Since violating a covenant is costly, • managers have strong incentives to make accounting choices that reduce the likelihood of technical default.

26. II. Lending Agreements & Debt Covenants D. Managers’ responses to potentialdebt 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 borrowerviolates one or more loan covenants, but has madeall interest and principal payments.

27. II. Lending Agreements & Debt Covenants D. Managers’ responses to potentialdebt covenant violations: a. Technical default occurs when the borrowerviolates one or more loan covenants, but has madeall interest and principal payments. i. Net worth and working capital restrictions are the most frequentlyviolatedaccounting-based covenants. ii. “Abnormal” discretionary accounting accruals (i.e., noncash financial statement adj. that accrue revenue or accrue expenses) were found to significantly increasereported earnings in the year prior to technical default.

28. II. Lending Agreements & Debt Covenants D. Managers’ responses to potentialdebt 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 defaultoccurs when the borrower is unable to make the scheduled interest or principal payment.

29. II. Lending Agreements & Debt Covenants D. Managers’ responses to potentialdebt covenant violations: 2. Management tends to makeaccounting changes and/or to manipulate discretionary accruals to avoidviolating debt covenants.

30. III. Management Compensation A. Managers have incentives to usecorporate assets for their personal benefit at the expense of owners. 1. Potentialconflicts of interest can be overcome if managers are given incentives which cause them to behave like owners.

31. III. Management Compensation A. Managers have incentives to usecorporate 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.

32. 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 decisionsclearly affect share prices in the long run, • but short-run share prices could change because of factors that are outside of management’s control.

33. 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 probablyless 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.

34. B. How executives are paid: III. Management Compensation 1. Base salary is typically dictated by industry norms and an executive’s 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 incentivesmotivate and rewardexecutives for the company’s long-term growth and prosperity.

35. B. How executives are paid: III. Management Compensation 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.

36. C. Incentives tied to accounting numbers: III. Management Compensation 1. Figure 7.5 shows that up to 55% of all companiesuseperformance plans, which are tied to accounting numbers, as long-term compensation incentives. 2. For annualbonus plans, accounting numbers become overwhelminglyimportant. 3. Figure 7.6 in the text shows common performance measuresused in annual incentive plans for senior corporate executives.

37. C. Incentives tied to accounting numbers: III. Management Compensation • 1. Figure 7.5 shows that up to 55% of all companiesuseperformance plans, which are tied to accounting numbers, as long-term compensation incentives. • 2. For annualbonus plans, accounting numbers become overwhelminglyimportant. • Figure 7.6 in the text shows common performance measuresused in annual incentive plans for senior corporate executives. • Figure 7.7 shows the performance measures used in long-term incentive plans.

38. C. Incentives tied to accounting numbers: III. Management Compensation 5. Widespread use of accounting-based incentives is controversial for at least three reasons: a. Earnings growthtranslates into shareholder value only when the company earns more on new investments than its incremental cost of capital. b. Accounting-based incentive plans can encouragemanagers to adopt a short-term business focus. c. Executives have discretion over the company’s accounting policies, and they can use that discretion to achieve bonus goals.

39. C. Incentives tied to accounting numbers: III. Management Compensation 6. Research evidence: • When annual earningsexceed the bonus ceiling, managersusediscretionary 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 CEO’s retirement, thereby increasing payouts from bonus contracts. • d. Compensation committeesdo not shieldtop managers from bonus reductions when net income is reduced by nonrecurring losses. But when net income increases by nonrecurring gains, top managementreap the benefits in the form of higher bonus rewards.

40. C. Incentives tied to accounting numbers: III. Management Compensation 7. Long-term incentives can provide protection from short-term focus.

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

42. 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 RAPfinancial 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 company’s GAAP financial statements.

43. 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.

44. 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.

45. 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 GAAPdifferences 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.

46. IV. Regulatory Agencies D. Taxation: 1. Tax accounting rules are just another type of RAP. 2. Many IRS accounting rulesagree with GAAP, but there are situations in which IRS accounting rulesdiffer from GAAP. 3. Tax accounting rules may influence the choice of GAAP accounting methods(LIFO).

47. IV. Regulatory Agencies E. Identifying managed earnings: 1.Uncoveringcore earnings and assessingoverall performance is not easy. Analysts must: a. Adjust for differences in the accounting methods and reporting practicesacross companies—even within the same industry. b. Identifyareas 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.

48. IV. Regulatory Agencies E. Identifying managed earnings: 2. Managers have powerful incentives to hide a company’s 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 statementdistortions are most prevalent when these accounting incentives are especially strong.

49. 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. Evaluatelarge business transactions, especially those that are unusually complex in structure or in their financial statement effects. d. Examinefinancial statement footnotes and other financial disclosures—they should be complete and transparent.