Question $3(20$ marks$)$

Part $($a$)$

Positive Accounting Theory $($PAT$)$ considers a firm as a nexus of contracts which are designed to reduce contracting costs, and is concerned with predicting such actions as the choices of accounting policies by firm managers and how managers will respond to proposed new accounting standards.

Required

a$)$

Assume that a company has a bonus plan based on net income, as well as debt covenants based on debt$-$equity and times interest earned ratios. An exposure draft for a proposed new accounting standard has been issued that will result in immediate recognition of expenses which have hitherto been deferred. How do you expect the management of the company to react to the proposed standard? Provide two reasons why they would react as predicted. $(3$ marks$)$

b$)$

An implication of PAT is that efficient securities markets notwithstanding, there are economic consequences of accounting policy choice. Provide one example in support of the economic consequences argument $(2$ marks$)$

Part $($b$)$

Real earnings management $($REM$)$ refers to actions taken by managers to alter reported earnings in a particular direction. Examples of such activities include overproducing inventory or cutting discretionary expenditures. Managers tend to have stronger willingness to manage earnings through REM than through accruals.

Required

a$)$

Provide two reasons why managers appear to prefer REM over accruals to manage earnings $(2$ marks$)$

b$)$

Assume that a manager decides to overproduce inventory. Explain whether this will result in earnings maximization, minimization, smoothing or bath $(2$ marks$).$

c$)$

Assume that a manager decides to cut spending on research and development. What will be the likely result of such an action in the short$-$run and in the longer$-$run? $(2$ marks$)$

d$)$

Assume that a manager wishes to smooth earnings. What is the likely result of such an action on stock prices in the short$-$run and in the longer$-$run? Explain briefly $(2$ marks$)$

Part $($c$)$

A dysfunctional effect of basing CEO incentives on stock price is to encourage excessive risk taking. Such risk taking affects not only the creditors of the company but also other stakeholders including taxpayers and potentially the financial system as a whole. Credit Default Swaps $($CDS$)$ offer creditors an opportunity to get default insurance. The issuer of the CDS $($typically a financial institution$)$ provides the buyer with compensation in case of default by company that issued the loan or bond $($called the reference obligation$).$ For this, the CDS issuer receives premiums from the buyer. CDSs are derivatives, i$.$e$.$ financial instruments whose value depends on the riskiness of the reference obligation. The value of the CDS is measured in the form of its spread. A CDS

spread indicates the premium that is required to insure $$100$ of the reference obligation.

As the riskiness of the underlying reference obligation increases, the value of the CDS increases. As such, CDSs are actively traded and are often bought by investors who do not own the underlying loan or bond.

Required

a$)$

Explain why companies base some part CEO compensation on stock price when this will likely result in excessive risk taking $(2$ marks$)$

b$)$

Explain whether you expect the degree of CEO risk taking to be higher or lower for a company that is highly levered, i$.$e$.$ with a large amount of debt $(2$ marks$).$

c$)$

Buying a CDS without owning the underlying reference obligation amounts to short selling the reference obligation. Briefly explain the concept of short selling and why investors would wish to buy the CDS in order to short a company$$s bonds $(2$ marks$)$

d$)$

What reaction do you expect from securities markets to a proposed regulation that seeks to limit executive compensation by making shareholders$$say on pay$$ binding? Explain briefly $(1$ mark$)$