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 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. How and why managers cater to Wall Street 7-2

Conflicts of interest Conflicts of interest 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. 7-3

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. 7-4

Loans and debt covenants 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: Preserve repayment capacity Protect against credit damaging events Provide signals and triggers 7-5

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. 7-6

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 7-7

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 Notice how this covenant limits dividend payouts. Dividends in excess of $15 will violate the covenant 7-8

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. 7-9

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: 7-10

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 Minor Extreme When a covenant is violated, the lender can: 7-11

Mandated Accounting Changes Electronic Data Systems (EDS) In compliance!! Safety Margin = $1,092 million ($7,512 - $6,420) 17% higher than the covenant But, if EDS adopted the newly mandated pension accounting rules… Safety Margin …net worth could drop by as much as $1,060 million eliminating most of the safety margin As a result many loan agreements rely on fixed GAAP, that is, accounting rules in place when the loan is first granted 7-12

Managers’ Responses to Potential Debt Covenant Violations Managers have strong incentives to make accounting choices that reduce the likelihood of technical default Violating a covenant = $$ 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. Readers of financial statements must be able to recognize and understand these incentives and their affect on these choices 7-13

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 7-14

Management compensation: Annual (short-term) incentives Annual Incentive Plan Incentive based on two performance measures Executive pay Plan 7-15

Management compensation: How the annual bonus formula works Figure 7.3 Bonus payout is capped Bonus payout increases with performance No bonus payout Computer Associates International 7-16

Management compensation: Incentives tied to accounting numbers Performance measures used in annual and multi-year cash incentive plans 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. 7-17

Management compensation: Accounting incentives and short-term focus Structure of annual performance bonuses Stockpile for next year Exceed minimum performance Big bath 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). 7-18

Why meet earnings goals? Meeting benchmarks helps us: 7-19

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 Are they the same or different? RAP accounting sometimes differs from GAAP accounting. GAAP Retailers Manufacturers Other non-regulated firms RAP sometimes shows up in the company’s GAAP financial statements. Knowing how a company accounts for its business transactions – GAAP or RAP – is essential to gaining a clear understanding of its financial performance 7-20

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. 7-21

Regulatory accounting: Banking industry Regulators have a powerful weapon to encourage compliance with minimum capital guidelines. For example, a noncomplying bank: 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 7-22

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 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 Note: Different types of customers are charged different rates 7-23

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). 7-24

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 7-25

Fair value accounting and the financial crisis: The meltdown In the early to mid 1990’s, loans were easy to obtain and the price of homes increased by 124% between 1997 and 2006 Mortgage-backed securities (MBS) and collateralized debt obligations (CDO) greatly increased due to the ability to raise cash quickly Investors put money into these MBS’s and CDO’s. The availability of new forms of mortgaging increased housing demand Speculative bubble eventually proved unsustainable. Interest rates edged up in 2007, mortgage defaults rose and home prices fell Be the end of 2007, 12% of all U.S. mortgages were either delinquent or in foreclosure 7-26

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 7-27

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 Legislation is introduced to broaden oversight of the FASB to four other agencies March 2009 FASB issues fair value accounting study January 2009 December 2008 SEC concludes the mark to market rules should not be suspended April 2009 FASB eases some rules but fair value accounting remains intact Thirty one financial services firms form Fair Value Coalition February 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 7-28

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. 7-29