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.

Required:

i) As a loan manager, briefly outline how the purpose of each loan would affect debt covenants with customers.

ii) Briefly outline which company is most likely to engage in under-investment

iii) For the company in (ii), explain two ways in which the accounting policy changes may have contributed to earnings management.

iv) For the company in (ii), suggest another specific earnings management strategy that it may use apart from changing accounting policies.

v) 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.

Transcribed Image Text:

Company Borrowing Equity Purpose of Borrowing CEO bonus based on A 150,000 400,000 Building Shares В 150,000 750,000 Fleet of Vehicles Share options C 150,000 2,000,000 Overdraft facility Cash The following table summarises changes in accounting policies in the current year Company Depreciation Doubtful Debts Inventory A No change From 5% to 3% From WAC to FIFO В From reducing balance to units of use No change From FIFO to WAC From straight line to reducing balance From 2% to 4% No change Company Borrowing Equity Purpose of Borrowing CEO bonus based on A 150,000 400,000 Building Shares В 150,000 750,000 Fleet of Vehicles Share options C 150,000 2,000,000 Overdraft facility Cash The following table summarises changes in accounting policies in the current year Company Depreciation Doubtful Debts Inventory A No change From 5% to 3% From WAC to FIFO В From reducing balance to units of use No change From FIFO to WAC From straight line to reducing balance From 2% to 4% No change

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Ans Given A bank has lending arrangements with three companies including a 40 benchmark for the debtequity ratio Bank borrowing is the only form of debt which the companies have To find i As a loan ma... View the full answer