The Role of Financial Information in Contracting Revsine/Collins/Johnson/Mittelstaedt: Chapter 7 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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 7-2

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 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.  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 7-4

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. 7-5

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. 7-6

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: 7-7

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 7-8

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 7-9

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 7-10

Regulatory accounting principles (RAP)  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. RAP GAAP Banks Insurance companies Public utilities 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 7-11

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. 7-12

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 7-13

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 then set equal to : Rate = Allowed revenue Estimated total KWH 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 7-14

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). 7-15

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 7-16

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 By the end of 2007, 12% of all U.S. mortgages were either delinquent or in foreclosure 7-17

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 7-18

Fair value accounting and the financial crisis: The Controversy – either change accounting rules or changes regulations Emergency Economic Stabilization Act of 2008 (EESA) was introduced FASB issues fair value accounting study Thirty one financial services firms form Fair Value Coalition Legislation is introduced to broaden oversight of the FASB to four other agencies October 2008  Over the next several months: January 2009 December 2008 March 2009 February 2009 April 2009 SEC concludes the mark to market rules shouldn’t be suspended FASB eases some rules but fair value accounting remains intact 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 7-19

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. 7-20