RCB Ltd. is a large entertainment company with an established customer base and a diversified product portfolio. The company has performed very well and has constantly beaten market's earnings expectations for five years. The company currently has a loan contract with Bank L. One of the debt covenants in the contract specifies that the sum of R&D and capital expenditure of RCB Ltd. should not exceed 10% of its revenue every year. Bank L. has been very confident about RCB Ltd's future performance and is discussing a new loan to RCB Ltd. after the current loan ends.

The company also plans to raise additional capital by issuing shares in the market to fund the development of a new technology. This technology is key to a promising new product. Currently, it is neither publicly known whether the R&D will be successful, nor whether it is economically viable. Only several senior executives have inside information on both dimensions.

CEO of RCB Ltd., Jennifer Lane, is concerned about an accounting standard change that will be implemented by the end of this fiscal year. While this standard change has no direct impact on any firm operations, it will likely cause the firm to violate the existing debt covenant.

i. Explain one agency problem between RCB Ltd and Bank L.

ii. Explain how a debt covenant that constrains capital expenditure can reduce the agency problem identified in (i).

iii. What might give arise to Jennifer Lane's incentives to manage earnings in the case described above? Explain.

iv. What earnings management method might be chosen by Jennifer Lane? Explain

v. Evaluate whether Jennifer Lane will perform good or bad earnings management. Justify your evaluation.

Answer rating: 100% (QA)

i Agency Problem between RCB Ltd and Bank L An agency problem arises when there is a conflict of interest between the shareholders represented by the ... View the full answer