Exam 7: The Role of Financial Information in Contracting

The methods and procedures that must be followed for financial statements that are utilized by regulatory agencies are known as RAP.

Since 2002,stock options have become a smaller component of long-term incentive pay due to a fundamental change in the tax treatment that options receive.

In the banking industry,the ratio of invested capital/gross assets,as defined by RAP,is the

In industries that are subject to unwanted attention from politicians,managers sometimes use accounting methods to make the company seem less profitable than it really is.

Executives often prefer taking "real actions" as opposed to "accounting actions" to hit earnings targets because auditors cannot as readily challenge real economic actions.

Innovative securities permitted mortgage originators to convert loans into immediate cash rather than having to wait for borrowers to make periodic payments.

Under RAP,loan charge-offs decrease bank capital and reduce bank net income.

A common action taken by creditors in the event of default is to renegotiate the loan.

Debt covenants benefit creditors because the covenants reduce default risk.

Borrowers do not appear willing to pay substantially higher interest rates to retain accounting flexibility that may help them avoid covenant violations.

A study examining how incentives arising out of debt contracts affect managers' accounting choices found that the most common violations of accounting-based covenants occurred with

Sam Jones is the president of Apollo Finance,a payday lender.The company's proxy statement contains the following description of Mr.Jones' pay package. Mr.Jones is eligible for an annual incentive bonus equal to 1% of Net Income of the company and is eligible for an additional bonus based upon annual increases in EPS only after earnings exceed 15% over the prior year.The additional bonus is determined as follows: Assume no change in the number of shares of outstanding stock during the year. Required: a.Suppose that Apollo Finance had $75 million of Net Income for the year.How much of a bonus would Mr.Jones receive if the EPS increase for the year was 12%? b.Suppose that Apollo Finance had $75 million of Net Income for the year.How much of a bonus would Mr.Jones receive if the EPS increase for the year was 28%?

Managers wishing to avoid loan covenant violations may resort to making accounting changes that increase reported earnings.

Why do loan agreements often contain covenants tied to accounting numbers? Are there any disadvantages to this common practice?

The recent financial crisis was not caused by fair value accounting but it may have been aggravated by the way in which mark-to-market losses reduced regulatory capital.

On October 31,2010,Sterling Construction Company entered into a credit agreement with Comerica Bank.The following appeared among the agreement's financial covenants: "Commencing with the fiscal quarter ending December 31,2010,maintain as of the end of each fiscal quarter a Fixed Charge Coverage Ratio of not less than 1.25 to 1.00." The credit agreement also contained a "definitions" section where this item was listed: "'Fixed Charge Coverage Ratio' shall mean as of any date of determination a ratio the numerator of which is EBITDA for the Applicable Measuring Period,minus cash taxes and cash tax distributions with respect to such period and the denominator of which is the sum of Current Maturities of Long Term Debt plus interest paid during the trailing twelve month period,plus twenty-five percent (25%)of the daily average total non-amortizing debt during the trailing twelve month period." Required: a.What is a minimum fixed charge coverage ratio and what purpose does it serve in the company's loan agreements? b.Why is it necessary for the loan agreement to precisely define "Fixed Charge Coverage Ratio?"

Most executive compensation plans link bonus awards to one or more

Research has shown that research and development expenditures during the years immediately prior to a CEO's retirement tend to

Firms must now provide detailed disclosure of three broad executive pay categories.Which of the following is not one of these categories?

Banks and other financial institutions are required by federal and state regulatory agencies to meet minimum capital requirements.