Accounting theory assignment – 3 questions (parts a b and c)

Question 1 (14 marks)

In July 2011, financial media reported that Glencore International, plc, a large, Swiss-based multinational producer of metals, energy, and agricultural commodities, had decided to stop reporting quarterly financial results from the second quarter of 2011. Glencore’s first-quarter 2011 sales and earnings were sharply higher than they were for the same quarter of the previous year, but it appeared that earnings for the first quarter still fell short of market expectations.

Required

(4 marks)

Outline two possible reasons why Glencore reduced its information production in this manner.

(4 marks)

How do you predict that the stock market will react to this decision by Glencore? Explain.

(6 marks)

The covenants in Glencore’s debt contract required the company to report quarterly. To overcome the rigidity inherent in debt contracts, Glencore offered to make a cash payment to consenting bondholders of 0.25% of their holdings, up to a maximum of $2.4 million, if they agreed to drop the covenant. If you were a Glencore bondholder, would you accept Glencore’s offer or not? Explain your reasons.

Question 2 (18 marks)

Income smoothing is a common earnings management pattern. Many managers feel that their reputations, and their firms’ share prices, are enhanced by a smooth, steadily growing sequence of reported earnings.

Required(4 marks)

A behaviourally biased investor observes a firm’s earnings increasing steadily over time. The investor decides that this firm is a growth firm. Identify the specific behavioural bias that may underlie this investor behaviour and explain why it leads to identifying the firm as a growth firm. Is the investor necessarily correct in this identification as a growth firm? Explain why or why not.

(4 marks)

Some firms have used low-persistence accruals to smooth net income to a level that the firm’s managers felt would persist. Is this type of earnings management good or bad in terms of usefulness to equity investors?

Does such smoothing benefit the manager whose compensation depends on reported net income? Explain why or why not.

(5 marks)

A researcher finds that firms that are growing rapidly have, on average, a lower proportion of manager compensation based on net income, relative to share-based compensation, than firms that are not growing rapidly. Explain why. Use concepts of recognition lag, sensitivity, and precision in your answer.

(5 marks)

A firm that has smoothed earnings for many years needs to manage its earnings upwards this year to maintain the pattern of smooth, steady earnings that it has been reporting. The firm anticipates a period of lower earnings next year. Would the firm manager be wise to smooth earnings this year? Explain why or why not.

Question 3 (18 marks)

In January 2011, the U.S. Securities and Exchange Commission (SEC) adopted a requirement that companies give shareholders a “say on pay” of senior management. This requirement is part of the implementation of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by the U.S. congress in response to the 2007-2008 market meltdowns, including widespread concerns that senior managers were overpaid. Shareholders will be asked to vote on executive compensation packages at least once every three years. The result of the vote is non-binding on the company. Results of the shareholder vote must be publicly disclosed.

In Canada, the Ontario Securities Commission is considering similar requirements.

Required

(2 marks)

With what theory of executive compensation is say on pay most consistent? Explain.

(6 marks)

The SEC is proposing that the compensation committee of the board of directors must consist of members independent of management. Also, the committee will have full authority to retain consultants, lawyers, and other advisors. Would such proposals, if implemented, eliminate the need for giving shareholders a say on pay? Explain.

(4 marks)

The expected utility of compensation to a manager can be much less than the sum of dollar compensation, share, and option awards. Explain why.

(6 marks)

Do you think the “say on pay” requirements and implementation of the SEC proposals on compensation committee member independence and freedom to hire advisors will be effective in increasing the efficiency of executive compensation contracts? Explain. Define a (second-best) efficient compensation contract as part of your answer.

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