ac3103 seminar 6 answers

7/23/2019 AC3103 Seminar 6 Answers

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AC3103: SEMINAR 6

8-4.

Under the efcient contracting orm o PAT, managers are motivated to minimize

the rm’s contracting costs. One such cost arises rom the act that unoreseen

circumstances ma arise during the !ie o the contract. As an e"am#!e, contractsoten de#end on accounting varia$!es such as re#orted net income or de$t-to-

e%uit. &uch contracts can $e in orce or a !ong time and it is difcu!t to

antici#ate changes in 'AAP that might ta(e #!ace over the !ie o the contract

and a!!o) or them in the contract itse!. As a resu!t, i 'AAP does change, this

can a*ect the amount o manager com#ensation and+or induce technica!

vio!ation o de$t covenants, $oth o )hich can im#ose costs on the rm.

o)ever, the manager ma $e a$!e to )or( out rom under these costs $

managing accrua!s or changing accounting #o!icies. That is, a!!o)ing managers

some e"i$i!it to choose rom a set o accounting #o!icies can reduce e"#ected

costs o contract vio!ation or renegotiation o!!o)ing rom unoreseen state

rea!izations.

Under the o##ortunistic orm o PAT, rm managers )i!! #reer a set o

accounting #o!icies rom )hich to choose so as to $e a$!e to inuence re#orted

net income and de$t in their o)n interests. Then, the can use accounting #o!ic

choice so as to ma"imize their $onuses, and to ma(e !ie easier or themse!ves

$ minimizing #o!itica! costs or the #ro$a$i!it o technica! vio!ation o de$t

covenants.

8-

a. /rom an efcient securities mar(et #ers#ective, the 0n1ana manager need

not $e concerned. 'iven u!! disc!osure, the efcient mar(et )i!! !oo(through the increased earnings vo!ati!it and rea!ize that there is no e*ect

on cash o)s. /urthermore, #rior to the accounting standard change, the

mar(et )ou!d have (no)n the amounts o oreign e"change gains and

!osses rom nancia! statement inormation a$out U.&. denominated de$t

outstanding and (no)!edge a$out e"change rates2the 33 changes did

not add to )hat the mar(et a!read (ne) in this regard. 1onse%uent!,

there shou!d $e no e*ect on share #rices or the rm’s cost o ca#ita!. Thus

there shou!d $e no e*ect on its a$i!it to !oc( in ne) nancing at

avoura$!e rates.

$. /rom the #ers#ective o contracting theor, The 0n1ana manager ma $ecorrect to $e concerned. 5ncreased earnings vo!ati!it increases the

#ro$a$i!it o vio!ation o de$t covenants $ased on net income 6such as

de$t-to-e%uit ratio and times interest earned7, other things e%ua!.

enders )i!! $e concerned a$out the increased #ro$a$i!it o vio!ation and

ma $e re!uctant to end at current rates. The rm ma have to as( or !ess

stringent covenants in ne) !ending agreements, to (ee# the #ro$a$i!it o

vio!ation at reasona$!e !eve!s. o)ever, !ess stringent covenants reduce

!enders’ #rotection, again !eading to higher rates.

9anager concern )ou!d a!so arise i his+her com#ensation de#ended on

re#orted net income. Then, increased earnings vo!ati!it ma !ead to



increased com#ensation vo!ati!it. This reduces the e"#ected uti!it o

com#ensation or ris(-averse managers.

9anage concerns )ou!d $e enhanced i the set o a!!o)a$!e accounting

#o!icies avai!a$!e to the manager restricted his+her a$i!it to manage

earnings to o*set their increased vo!ati!it.

8-8.

a. The $onus #!an and de$t covenant h#otheses #redict that oi! com#anies

)i!! )ant to re#ort high #rots sooner rather than !ater. This is $ecause the

managers o these com#anies )ou!d #reer high $onuses no) rather than

some time in the uture, other things e%ua!, since the #resent va!ue o a

do!!ar o $onus is higher the sooner it is received. A!so, higher re#orted

#rots )i!! reduce the #ro$a$i!it o technica! deau!t on de$t covenants,

at !east in the short run. Thus, the oi! com#anies )ou!d $e #redicted to

increase the #rice o gaso!ine and to avoid e"cessive reserves or

environmenta! costs, maintenance and !ega! c!aims.

$. /or a U. &. com#an, 5/O )ou!d $e most e*ective in ho!ding do)n #rots.

On a rising mar(et or crude oi!, and assuming shortages do not undu!

de#!ete inventor !eve!s, 5/O )i!! re#ort a higher cost o gaso!ine sa!es

than /5/O or average cost methods.

c. 0fcient securities mar(ets theor #redicts that the strateg )ou!d not $e

e*ective, given u!! disc!osure, since the securities mar(et )ou!d see

through the accounting #o!ic choices that ho!d do)n re#orted #rots.

5ndeed, the oi! com#anies ma )e!! end u# su$:ect to greater #o!itica!

costs than i the had not used accounting #o!ic choice to reducere#orted #rots. The )ou!d $e o#en to charges o tring to hide their

e"cess #rots.o)ever, severa! arguments suggest that the #o!ic ma $e e*ective in

reducing #o!itica! #ressure;- 'iven the theor and evidence that securities mar(ets are not u!!

efcient, the mar(et ma not u!! a##reciate the e"tent to )hich

accounting #o!ic choices are driving do)n #rots, #articu!ar! i

gaso!ine #rices are $eing he!d do)n at the same time.- &ince the amounts and timing o the various #rovisions are su$:ect to

management determination o amounts and timing, the are inc!uded

in o#erations rather than e"traordinar items. Then, it ma $e #ossi$!e

or the com#anies to disguise their strateg $ !ess than u!! disc!osure.

/or e"am#!e, it is not c!ear that #rovisions or maintenance #rograms

)ou!d need com#!ete disc!osure. 0ven )ith u!! disc!osure, good

arguments can$e made or environmenta!, maintenance and !ega! c!aims #rovisions,

inde#endent! o the #rice o crude oi!.- The efcient mar(ets h#othesis a##!ies #rimari! to investor and

securities #rice $ehaviour. 5t is !ess c!ear that #o!iticians and the

genera! #u$!ic )ou!d a##reciate the im#act o accounting #o!ic

choices on re#orted #rots. One reason is sim#! that the ma $e !ess

(no)!edgea$!e a$out accounting matters. o)ever, a more

undamenta! reason is that the ma have !ess incentive to dig into



re#orted #rots. 5ndividua! consumers ma not $e sufcient! a*ected

that the )i!! $other to go on the <)ar#ath.= Po!iticians ma $e content

)ith the a##earance o !o)er #rots i the #u$!ic is not aroused, since

other)ise the )ou!d have to conront a !arge and #o)eru! industr. Thus, the strateg ma )e!! $e e*ective. An increase in the #rice o

gaso!ine can $e $!amed on events outside the oi! com#anies’ contro!and, i re#orted #rots do not signicant! increase, #o!iticians and the

#u$!ic ma acce#t the higher #rices.

8->3

a. The ans)er de#ends on m ris( aversion, m $e!ies a$out the state o the

econom, m a$i!it to eva!uate the air va!ue o the de$t, and the

investment a!ternatives avai!a$!e to me.?ith res#ect to investment a!ternatives, 5 )ou!d $e )i!!ing to invest in

tranches o covenant-!ite de$t i saer de$t, such as government de$t and

de$t issued )ith covenants attached, o*ered a return !ess than the return

o*ered on the covenant !ite tranches. 5 )ou!d $e )i!!ing to $ear greaterris( in order to o$tain a higher return.?ith res#ect to the state o the econom, the higher are m $e!ies that

the state is high, the more !i(e! that 5 )ou!d $e )i!!ing to invest in

covenant-!ite de$t. This is $ecause the higher the state o the econom,

the !ess !i(e! that rms )i!! deau!t on their de$t, other things e%ua!.5 )ou!d $e !ess )i!!ing to invest in tranches o covenant-!ite de$t to the

e"tent that 5 am una$!e to eva!uate the air va!ue o such de$t. 0va!uating

air va!ue is more difcu!t, even im#ossi$!e, un!ess there is trans#arenc o

re#orting on the under!ing de$t com#onents o the tranche. 5 the tranche

is rated $ a credit rating agenc, m concerns a$out trans#arenc )ou!d

$e reduced. o)ever, !ac( o (no)!edge o the rating agencies’ va!uationmethodo!og, inc!uding the mode!s the use, )ou!d !eave me )ith some

concerns even i the tranche is rated high!. These concerns )ou!d urther increase i 5 )as a)are that rating agencies

)ere hired and #aid $ the rms )hose A@&s 5 )as $uing. ?ith res#ect to

m ris( aversion, the greater it is, the !ess !i(e! that 5 )ou!d $e )i!!ing to

sacrice greater securit on government and covenant-attached de$t or a

higher return. o)ever, m ris( )i!! $e reduced to the e"tent the tranche

o covenant-!ite de$t in )hich 5 invest is s#read over a !arge num$er o

rms and di*erent industries. is( )i!! $e urther reduced to the e"tent the

tranche is #rotected $ 1B&.

$. The mora! hazard #ro$!em is that i de$ts com#osing a tranche have no

covenants attached, the rm issuing such de$t has !itt!e incentive to

#rotect the interests o the tranche ho!ders $ maintaining ratios such as

de$t-to-e%uit and interest coverage, $ #rotecting )or(ing ca#ita!, and

maintaining e%uit $ maintaining s#ecied !eve!s o these items.

Pament o e"cessive dividends $ the rms issuing the de$t, or e"am#!e,

)ou!d reduce tranche ho!ders’ securit.

c. The reason is counter#art ris(. Buring a severe mar(et co!!a#se, rms

issuing 1B&s ma ace so man c!aims that the do not have the nancia!

resources to honour them a!!. This is #articu!ar! the case i s#ecu!atorscan $u 1B&s )ithout having to o)n a #osition in the under!ing de$t.



Then, the amount o 1B&s outstanding or a s#ecic de$t securit ma $e

severa! times the amount o the de$t.

ac3103 seminar 6 answers

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