Tài chính doanh nghiệp - Chapter 7: The role of financial information in contracting

The Role of Financial Information in ContractingRevsine/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 EducationLearning objectivesWhat 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 Street7-*Conflicts of interestContract terms are designed to eliminate or reduce conflicting incentives that arise in business relationships.7-*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 covenantsThe interest of creditors and stockholders often diverge.7-*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 covenantsCreditors protect themselves from conflicts of interest in several ways:7-*One way is to charge a higher rate of interest on the loan to compensate for risky actions.Debt covenants:Preserve repayment capacityProtect against credit damaging eventsProvide signals and triggersAnother 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.Loan agreements:Affirmative covenantsThese covenants stipulate actions the borrower must take and serve three broad functions:Preservation or repayment capacityProtection against credit-damaging eventsSignals and triggersExamples: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 covenantsThese 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 1.0Management has flexibility7-*Loan agreements:How financial covenants limit risky actionsFixed-charge coverage ratio must be greater than 1.0As defined by the loan agreemente.g. depreciation and amortizationDividends in excess of $15 will violate the covenantNotice how this covenant limits dividend payouts.7-*Loan agreements:Negative covenantsThese 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-*Loan agreements:Negative financial covenantsRestrictions 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-*Loan agreements:Events of defaultThis 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 dueInaccuracy inrepresentationsCovenant violationFailure to pay otherdebts when dueWaive violationRenegotiate debt covenantSeize collateralInitiate bankruptcySeverity of violationMinorExtremeWhen a covenant is violated, the lender can:7-*Mandated Accounting ChangesElectronic Data Systems (EDS)7-*In compliance!!17% higher than the covenantSafety Margin=$1,092 million ($7,512 - $6,420)But, if EDS adopted the newly mandated pension accounting rulesnet worth could drop by as much as $1,060 million eliminating most of the safety marginSafety MarginAs a result many loan agreements rely on fixed GAAP, that is, accounting rules in place when the loan is first grantedManagers’ Responses to Potential Debt Covenant ViolationsViolating a covenant = $$7-*Readers of financial statements must be able to recognize and understand these incentives and their affect on these choicesManagers have strong incentives to make accounting choices that reduce the likelihood of technical defaultOccurs when the borrower violates one or more loan covenants but has made all interest and principal paymentsThese maneuvers may increase earnings or improve balance sheets in the short-run, but they can mask deteriorating economic fundamentals.Management compensation:How executives are paidBase 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 mix7-*Management compensation:Annual (short-term) incentives7-*Annual Incentive PlanIncentive based on two performance measuresExecutive pay PlanManagement compensation:How the annual bonus formula worksComputer Associates InternationalNo bonus payoutBonus payout increases with performanceBonus payout is cappedFigure 7.37-*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 plans7-*Management compensation:Accounting incentives and short-term focusStock options and stock ownership give managers strong incentives to avoid shortsighted business decisions.Structure of annual performance bonusesBig bathExceed minimum performanceStockpile for next year7-*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: 7-*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 utilitiesGAAP Retailers Manufacturers Other non-regulated firmsAre 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 performance7-*RAP accounting sometimes differs from GAAP accounting.RAP sometimes shows up in the company’s GAAP financial statements.Regulatory accounting:Banking industryBanks 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-*Regulatory accounting:Banking industryRegulators have a powerful weapon to encourage compliance with minimum capital guidelines. For example, a noncomplying bank:7-*Is required to submit a comprehensive planCan be examined more frequentlyCan be denied a request to merge, open new branches or expand servicesCan be prohibited from paying dividendsRegulatory accounting:Electric utilities industryUtilities 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 illustrationAllowed revenue= Operating costs + Depreciation + Taxes + (ROA x Asset base)= $300 million + (10% x $500 million)= $300 million + $50 million = $350 millionThe rate per KWH is equal to :Rate =Allowed revenueEstimated total KWHNote: Different types of customers are charged different ratesChange the contractChange the accounting rulesSame result – adding more $ to the asset base increases the allowed revenue stream for a rate-regulated company7-*Regulatory accounting:TaxationAll 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-*Fair value accounting and the financial crisisFair 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 upBut 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 world7-*Fair value accounting and the financial crisis:The meltdown7-*Fair value accounting and the financial crisis:The meltdownThe tipping point occurred in September 2008, whenThe U.S. government took control of Fannie Mae and Freddie Mac.Lehman Brothers declared bankruptcyMerrill Lynch was rescued by Bank of America and Goldman Sachs and Morgan Stanley converted to bank holding companiesWashington Mutual was seized by the FDIC and Wachovia was acquired by Citigroup7-*Fair value accounting and the financial crisis:The Controversy – either change accounting rules or change regulationsEmergency Economic Stabilization Act of 2008 (EESA) was introducedOctober 2008FASB issues fair value accounting studyJanuary 2009Thirty one financial services firms form Fair Value CoalitionFebruary 2009April 2009FASB eases some rules but fair value accounting remains intactDecember 2008SEC concludes the mark to market rules should not be suspendedLegislation is introduced to broaden oversight of the FASB to four other agenciesMarch 2009FASB 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 IFRS7-*SummaryConflicts 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-*