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$)$