AC3103: SEMINAR 6

8-4.
Under the efficient contracting form of PAT, managers are motivated to minimize
the firms contracting costs. One such cost arises from the fact that unforeseen
circumstances may arise during the life of the contract. As an example, contracts
often depend on accounting variables such as reported net income or debt-toequity. Such contracts can be in force for a long time and it is difficult to
anticipate changes in GAAP that might take place over the life of the contract
and allow for them in the contract itself. As a result, if GAAP does change, this
can affect the amount of manager compensation and/or induce technical
violation of debt covenants, both of which can impose costs on the firm.
However, the manager may be able to work out from under these costs by
managing accruals or changing accounting policies. That is, allowing managers
some flexibility to choose from a set of accounting policies can reduce expected
costs of contract violation or renegotiation following from unforeseen state
realizations.
Under the opportunistic form of PAT, firm managers will prefer a set of
accounting policies from which to choose so as to be able to influence reported
net income and debt in their own interests. Then, they can use accounting policy
choice so as to maximize their bonuses, and to make life easier for themselves
by minimizing political costs or the probability of technical violation of debt
covenants.
8-7
a. From an efficient securities market perspective, the EnCana manager need
not be concerned. Given full disclosure, the efficient market will look
through the increased earnings volatility and realize that there is no effect
on cash flows. Furthermore, prior to the accounting standard change, the
market would have known the amounts of foreign exchange gains and
losses from financial statement information about U.S. denominated debt
outstanding and knowledge about exchange ratesthe 2002 changes did
not add to what the market already knew in this regard. Consequently,
there should be no effect on share prices or the firms cost of capital. Thus
there should be no effect on its ability to lock in new financing at
favourable rates.
b. From the perspective of contracting theory, The EnCana manager may be
correct to be concerned. Increased earnings volatility increases the
probability of violation of debt covenants based on net income (such as
debt-to-equity ratio and times interest earned), other things equal.
Lenders will be concerned about the increased probability of violation and
may be reluctant to end at current rates. The firm may have to ask for less
stringent covenants in new lending agreements, to keep the probability of
violation at reasonable levels. However, less stringent covenants reduce
lenders protection, again leading to higher rates.
Manager concern would also arise if his/her compensation depended on
reported net income. Then, increased earnings volatility may lead to

increased compensation volatility. This reduces the expected utility of

compensation for risk-averse managers.
Manage concerns would be enhanced if the set of allowable accounting
policies available to the manager restricted his/her ability to manage
earnings to offset their increased volatility.
8-8.
a. The bonus plan and debt covenant hypotheses predict that oil companies
will want to report high profits sooner rather than later. This is because the
managers of these companies would prefer high bonuses now rather than
some time in the future, other things equal, since the present value of a
dollar of bonus is higher the sooner it is received. Also, higher reported
profits will reduce the probability of technical default on debt covenants,
at least in the short run. Thus, the oil companies would be predicted to
increase the price of gasoline and to avoid excessive reserves for
environmental costs, maintenance and legal claims.
b. For a U. S. company, LIFO would be most effective in holding down profits.
On a rising market for crude oil, and assuming shortages do not unduly
deplete inventory levels, LIFO will report a higher cost of gasoline sales
than FIFO or average cost methods.
c. Efficient securities markets theory predicts that the strategy would not be
effective, given full disclosure, since the securities market would see
through the accounting policy choices that hold down reported profits.
Indeed, the oil companies may well end up subject to greater political
costs than if they had not used accounting policy choice to reduce
reported profits. They would be open to charges of trying to hide their
excess profits.
However, several arguments suggest that the policy may be effective in
reducing political pressure:
- Given the theory and evidence that securities markets are not fully
efficient, the market may not fully appreciate the extent to which
accounting policy choices are driving down profits, particularly if
gasoline prices are being held down at the same time.
- Since the amounts and timing of the various provisions are subject to
management determination of amounts and timing, they are included
in operations rather than extraordinary items. Then, it may be possible
for the companies to disguise their strategy by less than full disclosure.
For example, it is not clear that provisions for maintenance programs
would need complete disclosure. Even with full disclosure, good
arguments can
be made for environmental, maintenance and legal claims provisions,
independently of the price of crude oil.
- The efficient markets hypothesis applies primarily to investor and
securities price behaviour. It is less clear that politicians and the
general public would appreciate the impact of accounting policy
choices on reported profits. One reason is simply that they may be less
knowledgeable about accounting matters. However, a more
fundamental reason is that they may have less incentive to dig into

reported profits. Individual consumers may not be sufficiently affected

that they will bother to go on the warpath. Politicians may be content
with the appearance of lower profits if the public is not aroused, since
otherwise they would have to confront a large and powerful industry.
Thus, the strategy may well be effective. Any increase in the price of
gasoline can be blamed on events outside the oil companies control
and, if reported profits do not significantly increase, politicians and the
public may accept the higher prices.
8-12
a. The answer depends on my risk aversion, my beliefs about the state of the
economy, my ability to evaluate the fair value of the debt, and the
investment alternatives available to me.
With respect to investment alternatives, I would be willing to invest in
tranches of covenant-lite debt if safer debt, such as government debt and
debt issued with covenants attached, offered a return less than the return
offered on the covenant lite tranches. I would be willing to bear greater
risk in order to obtain a higher return.
With respect to the state of the economy, the higher are my beliefs that
the state is high, the more likely that I would be willing to invest in
covenant-lite debt. This is because the higher the state of the economy,
the less likely that firms will default on their debt, other things equal.
I would be less willing to invest in tranches of covenant-lite debt to the
extent that I am unable to evaluate the fair value of such debt. Evaluating
fair value is more difficult, even impossible, unless there is transparency of
reporting on the underlying debt components of the tranche. If the tranche
is rated by a credit rating agency, my concerns about transparency would
be reduced. However, lack of knowledge of the rating agencies valuation
methodology, including the models they use, would leave me with some
concerns even if the tranche is rated highly.
These concerns would further increase if I was aware that rating agencies
were hired and paid by the firms whose ABSs I was buying. With respect to
my risk aversion, the greater it is, the less likely that I would be willing to
sacrifice greater security on government and covenant-attached debt for a
higher return. However, my risk will be reduced to the extent the tranche
of covenant-lite debt in which I invest is spread over a large number of
firms and different industries. Risk will be further reduced to the extent the
tranche is protected by CDS.
b. The moral hazard problem is that if debts composing a tranche have no
covenants attached, the firm issuing such debt has little incentive to
protect the interests of the tranche holders by maintaining ratios such as
debt-to-equity and interest coverage, by protecting working capital, and
maintaining equity by maintaining specified levels of these items.
Payment of excessive dividends by the firms issuing the debt, for example,
would reduce tranche holders security.
c. The reason is counterparty risk. During a severe market collapse, firms
issuing CDSs may face so many claims that they do not have the financial
resources to honour them all. This is particularly the case if speculators
can buy CDSs without having to own a position in the underlying debt.

Then, the amount of CDSs outstanding for a specific debt security may be
several times the amount of the debt.