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CHAPTER 7

CHAPTER 7. THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING. Figure 6.1 Significant Contracting Relationships in Corporate Organizations. II. Lending Agreements & Debt Covenants B. Two sources of conflict can arise between creditors and owners:. 1. Asset substitution :  

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CHAPTER 7

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  1. CHAPTER 7 THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING

  2. Figure 6.1 Significant Contracting Relationships in Corporate Organizations

  3. II. Lending Agreements & Debt CovenantsB. 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 increased—and the value to creditors is reduced—by substituting higher risk projects.

  4. II. Lending Agreements & Debt CovenantsB. 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.

  5. II. Lending Agreements & Debt CovenantsC. 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.b. Financial covenants and reporting requirements.c. Compliance with laws. • d. Rights of inspection. • e. Maintenance of insurance, properties, and records.

  6. II. Lending Agreements & Debt CovenantsC. 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. Payment of cash dividends.

  7. II. Lending Agreements & Debt CovenantsC. 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.

  8. II. Lending Agreements & Debt CovenantsC. 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.

  9. II. Lending Agreements & Debt CovenantsD. 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.

  10. 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

  11. III. Management CompensationA. How executives are paid: • 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 incentives motivate and reward executives for the company’s long-term growth and prosperity.

  12. Figure 6.4 CEO Total Executive Compensation

  13. Figure 6.6 Annual Performance Based Plans (1993)

  14. Figure 6.7 Long-Term Performance Based Plans (1993)

  15. III. Management CompensationC. 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 company’s accounting policies, and they can use that discretion to achieve bonus goals.

  16. Figure 6.8 Structure of Annual Performance Bonus

  17. III. Management CompensationC. 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 CEO’s retirement, thereby increasing payouts from bonus contracts.

  18. Figure 6.7 Long-Term Performance Based Plans (1993)

  19. 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

  20. 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 company’s GAAP financial statements.

  21. IV. Regulatory AgenciesCapital requirements in the banking industry: • 1. minimum capital requirements • 2. Regulatory intervention can be triggered if bank capital falls below the minimum allowed.

  22. IV. Regulatory AgenciesCapital 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.

  23. IV. Regulatory AgenciesRate 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 Revenue = Operating costs + Depreciation + Taxes + (ROA  Asset base)Where ROA is the return on assets allowed by the regulator.

  24. IV. Regulatory AgenciesTaxation: • 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

  25. Summary of General Agreements • RAP • Three examples • Banking: minimum capital requirement • Utilities: maximum profitability • Tax: the more profitable, the more tax

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