The Role of Financial Information in Contracting Revsine/Collins/Johnson/Mittelstaedt: Chapter 7 Copyright © 2009 by The McGraw-Hill Companies, All Rights Reserved. McGraw-Hill/Irwin

RCJM: Chapter 7 © 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.

RCJM: Chapter 7 © 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

RCJM: Chapter 7 © Loans and debt covenants  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: 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. Debt covenants: 1. Preserve repayment capacity 2. Protect against credit damaging events 3. Provide signals and triggers

RCJM: Chapter 7 © 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.

RCJM: Chapter 7 © 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.

RCJM: Chapter 7 © 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 in representations Covenant violation Failure to pay other debts when due Waive violation Renegotiate debt covenant Seize collateral Initiate bankruptcy Severity of violation MinorExtreme  When a covenant is violated, the lender can:

RCJM: Chapter 7 © 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 choicesDiscretionary accruals Accounting methods Accounting estimates Transaction timing Non-cash financial statement adjustments

RCJM: Chapter 7 © 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

RCJM: Chapter 7 © 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

RCJM: Chapter 7 © 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). RAP GAAP Banks Insurance companies Public utilities Retailers Manufacturers Other non-regulated firms Are they the same or different?

RCJM: Chapter 7 © 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.

RCJM: Chapter 7 © 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 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 set equal to : Rate = Allowed revenue Estimated total KWH

RCJM: Chapter 7 © 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).

RCJM: Chapter 7 © 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.