Chapter 7 - The role of financial information in contracting. In this chapter you will learn: What 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;. | The Role of Financial Information in Contracting Revsine/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 Education Learning objectives What 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 Street 7- Conflicts of interest Contract 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 covenants The 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 covenants Creditors 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 capacity Protect against credit damaging events Provide signals and triggers Another 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 covenants These covenants stipulate actions the borrower must take and serve three broad functions: Preservation or repayment capacity Protection against . | The Role of Financial Information in Contracting Revsine/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 Education Learning objectives What 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 Street 7- Conflicts of interest Contract 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 .
