The Role of Financial Information in Contracting Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 7 Copyright © 2015 McGraw-Hill Education. All rights.

The Role of Financial Information in

Contracting

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 7

Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Learning objectives

1. What conflicts of interest arise between managers and shareholders, 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-based contracts and regulations.

4. What role contracts and regulations play in shaping managers’ accounting choices.

5. How and why managers cater to Wall Street

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Conflicts of interest

Contract terms are designed to eliminate or reduce conflicting incentives that arise in business relationships.

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Conflicts of interest arise when one party can take actions for his or her own benefit that harm other parties to the relationship.

Loans and debt covenants

The interest of creditors and stockholders often diverge.

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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.

Loans and debt covenants Creditors protect themselves from conflicts of interest in

several ways:

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One way is to charge a higher rate of interest on the loan to compensate for risky actions.

Debt covenants:1. Preserve repayment capacity2. Protect against credit damaging events3. Provide signals and triggers

Another way is to write contracts that restrict the borrower’s ability to harm the lender. The loan agreement might:

1. Require a personal guarantee of loan payment.2. Prohibit dividend payments unless approved by the

lender.3. Limit dividend payment to some fraction (say 50%)

of net income.

Loan agreements:Affirmative covenants

These covenants stipulate actions the borrower must take and serve three broad functions:

Preservation or repayment capacity Protection against credit-damaging events Signals and triggers

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: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 Fixed Charge Coverage Ratio greater than 1.0 to 1.0

Management has flexibility

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Loan agreements:How financial covenants limit risky actions

Fixed-charge coverage ratio must be greater than 1.0

As defined by the loan agreement

e.g. depreciation and amortization

Dividends in excess of $15 will violate the covenant

Notice how this covenant limits dividend payouts.

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Loan agreements:Negative covenants

These covenants restrict 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.

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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’s one example from the TCBY loan agreement:

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Loan agreements:Events of default

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

Failure to pay interest or principal when due

Inaccuracy inrepresentations

Covenant violationFailure to pay other

debts when due

Waive violation

Renegotiate debt covenant

Seize collateral

Initiate bankruptcy

Severity of violationMinor Extreme

When a covenant is violated, the lender can:

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Mandated Accounting ChangesElectronic Data Systems (EDS)

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In compliance!!

17% higher than the covenantSafety Margin = $1,092 million ($7,512 - $6,420)

But, if EDS adopted the newly mandated pension accounting rules…

…net worth could drop by as much as $1,060 million eliminating most of the safety margin

Safety Margin

As a result many loan agreements rely on fixed GAAP, that is, accounting rules in place when the loan is first granted

Managers’ Responses to Potential Debt Covenant Violations

Violating a covenant = $$

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Readers of financial statements must be able to recognize and

understand these incentives and their affect on these choices

Managers have strong incentives to make accounting

choices that reduce the likelihood of technical default

Occurs when the borrower violates one or more loan

covenants but has made all interest and principal payments

These maneuvers may increase earnings or improve balance sheets in the short-run, but they can mask deteriorating economic fundamentals.

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

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Management compensation:Annual (short-term) incentives

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Annual Incentive Plan

Incentive based on two performance

measures

Executive pay Plan

Management compensation:How the annual bonus formula works

Computer Associates International

No bonus payout

Bonus payout increases with performance

Bonus payout is capped

Figure 7.3

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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

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Management compensation:Accounting incentives and short-term focus

Stock options and stock ownership give managers strong incentives to avoid shortsighted business decisions.

Structure of annual performance bonuses

Big bath

Exceed minimum performance

Stockpile for next year

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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).

Why meet earnings goals?Meeting benchmarks helps us:

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Regulatory accounting principles (RAP)

RAP - refers to the accounting methods and procedures that must be followed when assembling financial statements for regulatory agencies.

RAP• Banks• Insurance companies• Public utilities

GAAP• Retailers• Manufacturers• Other non-regulated firms

Are they the same or different?

Knowing how a company accounts for its business transactions – GAAP or RAP – is essential to gaining a clear

understanding of its financial performance

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RAP accounting sometimes differs from GAAP accounting.

RAP sometimes shows up in the company’s GAAP financial statements.

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.

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Regulatory accounting:Banking industry

Regulators have a powerful weapon to encourage compliance with minimum capital guidelines. For example, a noncomplying bank:

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Is required to submit a comprehensive plan

Can be examined more frequently

Can be denied a request to merge, open new branches or expand services

Can be prohibited from paying dividends

Regulatory accounting:Electric utilities industry

Utilities have their prices set by regulators.

The rate formulas use accounting-determined costs and assets values.

Because of GAAP for regulated companies, RAP gets included in the financial statements that utility companies prepare for shareholders and creditors.

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 equal to :

Rate =Allowed revenue

Estimated total KWH

Note: Different types of customers are charged different rates

Note: Different types of customers are charged different rates

Change the contract

Change the accounting

rules

Same result – adding more $ to the asset base increases the

allowed revenue stream for a rate-

regulated company

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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 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).

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Fair value accounting and the financial crisis

Fair value (or mark to market) accounting has been around for decades.

Banks and other financial services firms were content with the fair value rules when markets were going up

But those rules came under sharp criticism in late 2008 when the collapse of the global housing bubble triggered the failure of large financial institutions, the bailout of banks by national governments and downturns in stock markets around the world

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Fair value accounting and the financial crisis:The meltdown

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Fair value accounting and the financial crisis:The meltdown

The tipping point occurred in September 2008, when

The U.S. government took control of Fannie Mae and Freddie Mac.

Lehman Brothers declared bankruptcy

Merrill Lynch was rescued by Bank of America and Goldman Sachs and Morgan Stanley converted to bank holding companies

Washington Mutual was seized by the FDIC and Wachovia was acquired by Citigroup

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Fair value accounting and the financial crisis:The Controversy – either change accounting rules or change regulations

Emergency Economic

Stabilization Act of 2008 (EESA) was

introduced

October 2008

FASB issues fair value accounting

study

January 2009

Thirty one financial services firms form Fair Value Coalition

February 2009

April 2009

FASB eases some rules but fair value accounting remains

intact

December 2008

SEC concludes the mark to market

rules should not be suspended

Legislation is introduced to

broaden oversight of the FASB to four

other agencies

March 2009

FASB and IASB continue seeking ways to improve the fair value rules. An ongoing FASB/IASB joint project aims to ensure that

fair value has the same meaning in U.S. GAAP and IFRS

FASB and IASB continue seeking ways to improve the fair value rules. An ongoing FASB/IASB joint project aims to ensure that

fair value has the same meaning in U.S. GAAP and IFRS

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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.

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

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