The Role of Financial Information in Contracting

1. The Role of Financial Information in Contracting Revsine/Collins/Johnson: Chapter 7

2. Learning objectives • What conflicts of interest arise between managers and shareholders, lenders, or regulators. • How and why accounting numbers are used in debt agreements, in compensation contracts, and for regulatory purposes. • How managerial incentives are influenced by accounting-based contracts and regulations. • What role contracts and regulations play in shaping managers’ accounting choices. • What accounting “gimmicks” are sometimes used to hide a company’s true performance, and how to spot them.

3. Business contracts • Financial data are used in various business contracts and agreements: • Contracting parties understand that financial reporting flexibility affects how business contracts are written and enforced. Significant contracting relationships in corporate organization Accounting methods and estimates used by the company and its freedom to change them

4. Conflicts of interest • Conflicts arise when one party can take actions for his or her own benefit that harm other parties to the relationship. • Contract terms are designed to eliminate or reduce conflicting incentives that arise in business relationships. Use loan proceeds to buy a lottery ticket Close the store to join a friend for lunch Substitute low quality materials when high quality materials were promised

5. The interest of creditors and stockholders often diverge. Suppose a bank loans the firm $75,000, but the owner then pays himself a $75,000 dividend. The dividend payment benefits the owner but harms the bank. Creditors protect themselves from conflicts of interest in several ways. One way is to charge a higher rate of interest on the loan to compensate for risky actions. Another way is to write contracts that restrict the borrower’s ability to harm the lender. The loan agreement might: Require a personal guarantee of loan payment. Prohibit dividend payments unless approved by the lender. Limit dividend payment to some fraction (say 50%) of net income. Debt covenants help guard against conflicts of interest. Loans and debt covenants

6. 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.

7. Loan agreements:Affirmative financial covenants • These covenants establish minimum financial tests with which the borrower must comply. • Examples from the TCBY loan agreement: • Financial statements must comply with GAAP and be audited. • Maintain: • a ratio of Current Assets to Current Liabilities that is greater than 2.0 to 1.0; • a Profitability Ratio greater than 1.5 to 1.0; • a Fixed Charge Coverage Ratio greater than 1.0 to 1.0 Management has flexibility As defined by GAAP As defined by the loan agreement

8. Notice how this covenant limits dividend payouts. Dividends in excess of $15 will violate the covenant Loan agreements:How financial covenants limit risky actions • Fixed-charge coverage ratio must be greater than 1.0 e.g. depreciation and amortization As defined by the loan agreement

9. Loan agreements:Negative covenants • These covenants place direct restrictions on the actions borrowers 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 approval by the lender.

10. Loans, advances, and credit extensions ≤ 0.25 Tangible net worth Loan agreements:Negative financial covenants • Restrictions on total indebtedness are sometimes stated as a ratio: • Total debt to assets cannot exceed 0.5 to 1.0. • Current debt to working capital cannot exceed 1.0 to 1.0. • Here is one example from the TCBY loan agreement:

11. When a covenant is violated, the lender can: Initiate bankruptcy Waive violation Seize collateral Renegotiate debt covenant Minor Extreme Severity of violation Loan agreements:Events of default • This section of the loan agreement describes circumstances in which the lender can terminate the loan agreement, such as: Inaccuracy in representations Failure to pay interest or principal when due Failure to pay other debts when due Covenant violation

12. How managers sometimes respond to potential covenant violations • Debt covenant violations are costly. • So managers have strong incentives to reduce the likelihood of default using: • These maneuvers may increase earnings or improve balance sheets in the short-run, but they can mask deteriorating economic fundamentals. Accounting choices Discretionary accruals • Accounting methods • Accounting estimates • Transaction timing • Non-cash financial • statement adjustments

13. Management compensation:How executives are paid • Base salary is usually dictated by industry norms. • Annual incentive is a yearly performance-based bonus award. • Long-term incentive is a yearly award in cash, stock, or stock options for multi-year performance. CEO compensation mix

14. Management compensation:Annual (short-term) incentives 1 2 3 4 5

15. Management compensation:How the annual bonus formula works Bonus payout is capped Bonus payout increases with performance No bonus payout Computer Associates International

16. Management compensation:Long-term incentives Prevalence of long-term incentives

17. Management compensation:Proxy statement information • Officers must defer 25% of their bonus and invest it in restricted stock. • New long-term performance-based incentive plan adopted (see page 348) in response to 1993 change in the Internal Revenue Code. • Compensation committee will establish yearly performance goals based on one or more of several measures (e.g., earnings per share, total shareholder return). • Compensation committee may reduce or eliminate any calculated award, but not increase the award.

18. Management compensation:Incentives tied to accounting numbers The use of accounting-based incentives is controversial because: • Earnings growth does not always translate into increased shareholder value. • Accrual accounting can sometimes distort traditional performance measures like ROA. • Managers may be encouraged to adopt a short-term business focus. • Managers may use their accounting discretion to achieve bonus goals. Performance measures used in annual and multi-year cash incentive plans

19. Management compensation:Accounting incentives and short-term focus • Stock options and stock ownership give managers strong incentives to avoid shortsighted business decisions. • Compensation committees can intervene when circumstances warrant modification of the scheduled incentive award (e.g., when the payout is influenced by an accounting method or estimate change). Structure of annual performance bonuses Stockpile for next year Exceed minimum performance Big bath

20. Regulatory accounting principles • RAP refers to the accounting methods and procedures that must be followed when assembling financial statements for regulatory agencies. • RAP accounting sometimes differs from GAAP accounting. • RAP sometimes shows up in the company’s GAAP financial statements (SFAS No. 71). • Banks • Insurance companies • Public utilities RAP Are they the same or different? • Retailers • Manufacturers • Other non-regulated firms GAAP

21. Regulatory accounting:Banking industry • Banks are required to meet minimum capital requirements, and violation is costly. • To avoid these regulatory compliance costs, banks can: • Operate profitably and invest wisely so that the bank remains financially sound. • Choose accounting policies that RAP invested capital or decrease RAP gross assets.

22. Allowed revenue = Operating costs + Depreciation + Taxes + (ROA x Asset base) = $300 million + (10% x $500 million) = $300 million + $50 million = $350 million Regulatory accounting:Electric utilities industry • Utilities have their prices set by regulators. • The rate formulas use accounting-determined costs and assets values. • Because of SFAS No. 71, RAP gets included in the financial statements that utility companies prepare for shareholders and creditors. Rate formula illustration The rate per KWH is then set equal to : Allowed revenue Rate = Estimated total KWH

23. Regulatory accounting:Taxation • All companies are “regulated” by state and federal tax agencies. • IRS rules (another type of RAP) govern the computation of net income 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 GAAP accounting methods (e.g., LIFO inventory accounting).

24. Identifying “managed” earnings Methods Estimates Trends Large accruals Transaction timing

25. Summary • Conflicts of interest among managers and shareholders, lenders, or regulators are a natural feature of business. • Contracts and regulations help address these conflicts of interest. • Accounting numbers often play an important role in contracts and regulations—and they help shape managers’ incentives, and help explain the accounting choices managers make.