Deck 7: The Role of Financial Information in Contracting

Question 1

Negative covenants tend to be less significant than affirmative covenants because they place direct restrictions on the actions lenders can take.

Answer 1

False

Question 2

Affirmative covenants stipulate actions the borrower must take.

Answer 2

True

Question 3

When agents do not act on behalf of their principals,the agency cost is borne by the principal alone.

Answer 3

False

Question 4

Payment default occurs when the borrower violates one or more loan covenants but has made all principal and interest payments.

Question 5

Financial covenants establish minimum financial tests with which a borrower must comply.

Question 6

Some debt covenants preserve repayment capacity by preventing mergers and acquisitions unless the debt is first repaid.

Question 7

One way to reduce conflicts of interest between lenders and borrowers is by writing contracts that restrict the borrowers' ability to harm lenders by taking risky actions.

Question 8

Contract terms can be designed to eliminate or reduce conflicting incentives that arise in business relationships.

Question 9

Commercial lending agreements may contain provisions that are designed to protect the lender from a deterioration of the borrower's creditworthiness.

Question 10

When conflicts of interest exist,lenders impose higher interest rates to reflect greater default risk.

Question 11

Debt covenants can be designed to serve a signaling function by assuring a steady flow of information from borrower to lender.

Question 12

Debt covenants benefit creditors because the covenants reduce default risk.

Question 13

Financial accounting numbers can be used to define contract terms and monitor compliance with contract terms.

Question 14

In many contracts,the rights and obligations conferred by the contract will depend on data in financial statements that are issued after the contract is executed.

Question 15

When one party to a business relationship can make decisions that benefit him or her but harm the other party a conflict of interest arises.

Question 16

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

Question 17

It is possible to lower the interest rate on a loan by accepting more stringent loan covenant restrictions.

Question 18

Debt covenants help guard against conflicts of interest between creditors and bank regulators.

Question 19

"Triggers" enable the lender to decide whether it might be appropriate to modify or waive restrictions,or to demand immediate repayment.

Question 20

Contracting parties understand that financial reporting flexibility affects how contracts are written and enforced.

Question 21

Stock options are the most common short-term incentive device.

Question 22

A covenant that specifies a required minimum level of net worth and working capital is a compliance covenant.

Question 23

Although covenant compliance can be jeopardized by mandated changes in accounting principles,few loan agreements have financial covenants that rely on the accounting rules in place when the loan is first granted.

Question 24

Management tends to make accounting changes and to manipulate discretionary accruals that increase income in order to avoid violating debt covenants.

Question 25

Managerial strategies and decisions clearly affect stock prices both in the short and long run.

Question 26

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

Question 27

Seizure of collateral is one possible remedy for breach of covenant restrictions.

Question 28

Stock options come in various forms,the choice of which is largely dependent on the tax treatment for the executive and the company.

Question 29

Covenants restricting the use of funds for dividend payments,share repurchases,capital expenditures,and other business purposes are included so the creditor has greater assurance that cash will be available to make principal and interest payments when due.

Question 30

When "fixed GAAP" is not permitted by the loan agreement,lenders still have the option to waive or renegotiate covenants that are harmed by a new accounting standard.

Question 31

The events of default section of a loan agreement describes circumstances in which the creditor has the right to terminate the lending relationship.

Question 32

Technical default occurs only when the borrower fails to make interest and principal payments when due.

Question 33

Because covenant compliance can be jeopardized by mandated changes in accounting principles,many loan agreements have financial covenants that rely on the accounting rules in place when the loan is first granted.

Question 34

Most executive compensation packages involve a base salary,an annual incentive,and a long-term incentive.

Question 35

Long-term incentives motivate and reward executives for the company's growth and prosperity in three to seven years.

Question 36

The most common financial performance measure used in annual incentive plans is GAAP net income or some variation thereof.

Question 37

Potential conflicts of interest between managers and owners can be overcome if compensation packages are tied to improvement in firm value.

Question 38

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

Question 39

As a general rule,the proportion of pay "at risk" falls off for executives on the higher rungs of the corporate ladder.

Question 40

A technical default occurs when the borrower violates one or more loan covenants but has not missed any interest or principal payments.

Question 41

The wide use of accounting-based incentives is controversial because earnings growth does not automatically translate into increased shareholder value.

Question 42

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

Question 43

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

Question 44

IRS regulations govern the computation of net income for the SEC.

Question 45

RAP sometimes shows up in a company's GAAP financial statements.

Question 46

Information about a company's executive compensation practices can be found in the company's annual report.

Question 47

Accounting-based incentive plans can encourage managers to adopt a long-term business focus.

Question 48

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.

Question 49

Firms are required to disclose executive retirement and other postemployment compensation,generally for the ten most highly paid executives serving as corporate officers.

Question 50

Stock options provide a set of "golden handcuffs" for retaining executives during the restriction period.

Question 51

Critics of stock options as a form of compensation argue that stock options encourage managers to cater to Wall Street's short-term earnings expectations.

Question 52

Firms now must provide a compensation discussion and analysis in the proxy statement which describes the specific items of corporate performance that are taken into account when making compensation decisions.

Question 53

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.

Question 54

A bank's estimated bad debt expense associated with its loan receivables is the loan loss provision.

Question 55

Research shows that managers sometimes use accounting flexibility to evade contract constraints in order to gain bonus benefits.

Question 56

Decreasing discretionary spending for such items as research and development is a popular technique for meeting earnings targets.

Question 57

A factor that can reduce managers' short-term focus is the fact that incentive compensation plans are administered by a compensation committee that can intervene when circumstances warrant modification of the scheduled incentive award.

Question 58

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

Question 59

Some companies have adopted formal "compensation recovery" policies whereby executives forfeit various incentive payments if it is later discovered that they engaged in conduct detrimental to the company.

Question 60

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

Question 61

Firms are rewarded for reporting continuous growth in annual EPS.

Question 62

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

Question 63

Loan provisions that are specifically designed to restrict asset substitution are called

A)debt covenants.
B)debt obligations.
C)credit covenants.
D)credit agreements.

Question 64

Affirmative covenants generally would not include which of the following stipulations?

A)The lender has the right to inspect business assets and business contracts.
B)Limits on the borrower's total indebtedness.
C)The borrower must maintain insurance on business properties.
D)Specific financial covenants and reporting requirements.

Question 65

A covenant that specifies a required minimum level of net worth and working capital is a/an

A)compliance covenant.
B)financial covenant.
C)implicit covenant.
D)negative covenant.

Question 66

Debt covenants benefit

A)lenders.
B)borrowers.
C)both lenders and borrowers.
D)neither borrowers nor lenders,but are required by the SEC as a condition of issuing debt securities.

Question 67

Based on a comprehensive survey of U.S.companies,the most common financial performance measure used in annual and long-term incentive plans for senior executives is

A)return on equity.
B)economic value added.
C)return on capital.
D)net income or revenues.

Question 68

When one party to a business relationship can make decisions that benefit him or her but harm the other party a

A)lawsuit is automatically filed.
B)contract arises.
C)conflict of interest arises.
D)contingent liability arises.

Question 69

Many loan agreements have financial covenants that rely on

A)floating GAAP.
B)fixed GAAP.
C)flexible GAAP.
D)regulatory accounting procedures (RAP).

Question 70

One low-cost,effective way of eliminating or reducing conflicts of interest in business relationships is to

A)only deal with related parties.
B)carefully specify mutual expectations in contract terms.
C)use lawyers to negotiate all terms.
D)use an arbitrator for all negotiations.

Question 71

Differences between reported EPS and analysts' expectations only matter to investors when the differences are relatively large.

Question 72

Potential conflicts of interest permeate

A)few business relationships.
B)only relationships between investors and managers.
C)only relationships between borrowers and lenders.
D)many business relationships.

Question 73

It is commonly believed that to some degree many companies use accounting loopholes to "massage their numbers."

Question 74

Which of the following is not an example of a negative covenant provision?

A)Limits on capital expenditures.
B)Limits on the borrower's total indebtedness.
C)Limits the use of the loan to an agreed-upon purpose.
D)Restricts the payment of cash dividends.

Question 75

A lender may be protected from deterioration of the borrower's creditworthiness if the commercial lending agreement requires the borrower to maintain a

A)current ratio above a certain level.
B)return on assets above a certain level.
C)specified return on equity.
D)specified accounts receivable turnover.

Question 76

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.

Question 77

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

Question 78

Which one of the following is not a broad function served by debt covenants?

A)Debt covenants usually preclude the borrower from being a merger target.
B)Debt covenants serve as both signals and triggers,thereby assuring a steady flow of information from borrower to lender.
C)Debt covenants are designed to preserve the borrower's repayment capacity.
D)Debt covenants offer the lender some protection against credit-damaging events affecting the borrower.

Question 79

Financial executives overwhelmingly believe that meeting earnings benchmarks helps maintain or increase the firm's stock price.

Question 80

Shareholders usually benefit when managers take real actions to maintain appearances of the firm's performance.