Only Question C

CapLink plc (CapLink) is a large and multinational firm, headquartered in the UK and listed on a UK stock exchange. Over the past years, CapLink's CEO has invested a substantial amount of time and money into establishing and cultivating good relations with CapLink's shareholders. The shareholders are, in general, satisfied with the CEO, but have recently learned that CapLink repeatedly disclosed its financial statements too late. After receiving several written warnings to comply with disclosure deadlines, of which the CEO did not inform the shareholders, CapLink had to pay a fine of half a million pounds. To avoid late disclosures in the future, the shareholders voted in favour of hiring a compliance officer at the last annual general meeting (AGM). At the same AGM, the shareholders brought forward proposals for changes in the compensation contract of the CEO, which, as some shareholders fear, puts too much emphasis on short-term earnings. The current contract stipulates that an increase in short-term earnings results in a financial reward for the CEO. REQUIRED: a) Financial accounting regulation has three different components: written rules, their implementation and enforcement. i) Explain the components of financial accounting regulation, both in general and by means of examples taken from the description of CapLink above. ii) Provide an additional example of a written rule that applies to CapLink. Explain this rule and how it is implemented and enforced. (10 marks) b) CapLink's shareholders are concerned that the compensation contract of the CEO induces the CEO to focus too much on short-term earnings. Academic researchers attempt to measure whether such a focus results in earnings management by estimating accrual models. A specific accrual model is the Dechow and Dichev (2002) model: AW Cit = o + CFO i(t-1) + CFO it + 3CFOi(t+1) + Eit where i stands for firm and t for year. AWC is the change in working capital and CFO is cash flow from operations. i) Explain the idea underlying accrual models. ii) Explain the motivation for including each of the above components in the Dechow and Dichev (2002) model. iii) Assume that academic researchers have estimated the Dechow and Dichev (2002) model and can provide the shareholders with the results for CapLink. Explain which measures the researchers would include in their results and which result would be an indication of earnings management. (17 marks) c) Schipper (1989, p. 91) states that not including earnings in managerial compensation contracts "exclude[s] a potentially very informative signal about 4 Please turn over managerial productivity, and [..] ignores the possibility that earnings management has the essentially beneficial role of providing a means for managers to reveal their private information" [Schipper, K. (1989). Commentary on earnings management, Accounting Horizons 3(4): 91-102]. i) Explain Schipper's statement. You can, but do not have to, refer to arguments made in Schipper (1989). ii) Propose a mix of accounting measures that could be used in the compensation contract of the CEO and that might alleviate the concerns of the shareholders. You should identify and discuss at least three different accounting measures. CapLink plc (CapLink) is a large and multinational firm, headquartered in the UK and listed on a UK stock exchange. Over the past years, CapLink's CEO has invested a substantial amount of time and money into establishing and cultivating good relations with CapLink's shareholders. The shareholders are, in general, satisfied with the CEO, but have recently learned that CapLink repeatedly disclosed its financial statements too late. After receiving several written warnings to comply with disclosure deadlines, of which the CEO did not inform the shareholders, CapLink had to pay a fine of half a million pounds. To avoid late disclosures in the future, the shareholders voted in favour of hiring a compliance officer at the last annual general meeting (AGM). At the same AGM, the shareholders brought forward proposals for changes in the compensation contract of the CEO, which, as some shareholders fear, puts too much emphasis on short-term earnings. The current contract stipulates that an increase in short-term earnings results in a financial reward for the CEO. REQUIRED: a) Financial accounting regulation has three different components: written rules, their implementation and enforcement. i) Explain the components of financial accounting regulation, both in general and by means of examples taken from the description of CapLink above. ii) Provide an additional example of a written rule that applies to CapLink. Explain this rule and how it is implemented and enforced. (10 marks) b) CapLink's shareholders are concerned that the compensation contract of the CEO induces the CEO to focus too much on short-term earnings. Academic researchers attempt to measure whether such a focus results in earnings management by estimating accrual models. A specific accrual model is the Dechow and Dichev (2002) model: AW Cit = o + CFO i(t-1) + CFO it + 3CFOi(t+1) + Eit where i stands for firm and t for year. AWC is the change in working capital and CFO is cash flow from operations. i) Explain the idea underlying accrual models. ii) Explain the motivation for including each of the above components in the Dechow and Dichev (2002) model. iii) Assume that academic researchers have estimated the Dechow and Dichev (2002) model and can provide the shareholders with the results for CapLink. Explain which measures the researchers would include in their results and which result would be an indication of earnings management. (17 marks) c) Schipper (1989, p. 91) states that not including earnings in managerial compensation contracts "exclude[s] a potentially very informative signal about 4 Please turn over managerial productivity, and [..] ignores the possibility that earnings management has the essentially beneficial role of providing a means for managers to reveal their private information" [Schipper, K. (1989). Commentary on earnings management, Accounting Horizons 3(4): 91-102]. i) Explain Schipper's statement. You can, but do not have to, refer to arguments made in Schipper (1989). ii) Propose a mix of accounting measures that could be used in the compensation contract of the CEO and that might alleviate the concerns of the shareholders. You should identify and discuss at least three different accounting measures