A bank has lending arrangements with three companies, including a 40% benchmark for the debt/equity ratio. Bank borrowing is the only form of debt which the companies have. Company Borrowing Equity Purpose of Borrowing CEO bonus based on A 150,000 400,000 Building Shares B 150,000 750,000 Fleet of Vehicles Share options 150,000 2,000,000 Overdraft facility Cash The following table summarises changes in accounting policies in the current year Company Depreciation Doubtful Debts A No change From 5% to 3% B From reducing balance to units of use No change From straight line to reducing balance From 2% to 4% Inventory From WAC to FIFO From FIFO to WAC No change Required i ii As a loan manager, briefly outline how the purpose of each loan would affect 2 marks debt covenants with customers. Briefly outline which company is most likely to engage in under-investment 2 marks For the company in (ii), explain two ways in which the accounting policy 4 marks changes may have contributed to earnings management. For the company in (i), suggest another specific earnings management 2 marks strategy that it may use apart from changing accounting policies. iv V 4 marks 4 marks Explain whether bonuses based on cash or shares are likely to create more value for shareholders. vi Explain whether bonuses based on shares or share options would be preferable for CEOs. vii Briefly outline which company is most likely to encounter political costs, providing one example. 2 marks A bank has lending arrangements with three companies, including a 40% benchmark for the debt/equity ratio. Bank borrowing is the only form of debt which the companies have. Company Borrowing Equity Purpose of Borrowing CEO bonus based on A 150,000 400,000 Building Shares B 150,000 750,000 Fleet of Vehicles Share options 150,000 2,000,000 Overdraft facility Cash The following table summarises changes in accounting policies in the current year Company Depreciation Doubtful Debts A No change From 5% to 3% B From reducing balance to units of use No change From straight line to reducing balance From 2% to 4% Inventory From WAC to FIFO From FIFO to WAC No change Required i ii As a loan manager, briefly outline how the purpose of each loan would affect 2 marks debt covenants with customers. Briefly outline which company is most likely to engage in under-investment 2 marks For the company in (ii), explain two ways in which the accounting policy 4 marks changes may have contributed to earnings management. For the company in (i), suggest another specific earnings management 2 marks strategy that it may use apart from changing accounting policies. iv V 4 marks 4 marks Explain whether bonuses based on cash or shares are likely to create more value for shareholders. vi Explain whether bonuses based on shares or share options would be preferable for CEOs. vii Briefly outline which company is most likely to encounter political costs, providing one example. 2 marks