Reference no: EM132670292
Question: Agency Theory
Rejectus Limited is a corporate group historically in operating in the retail industry, but recently having diversified into casinos and tourism. Its CEO, as well as chief decision makers of its various divisions, are rewarded with a mixture of short-term and long-term compensation. In addition to fixed salaries, members of upper management are rewarded with bonuses from a pool consisting of 5% of the total profit of the company. Of these bonuses, half are paid in cash and half are allocated as restricted Rejectus shares. Twenty percent of the awarded shares become free to sell by the employee in the year of award and in each of the ensuing four years.
The company has recently sold out of the DwarfPlanet Casino Corporation (DCC) complex after substantial losses there due to allegations that the DCC has been laundering funds for organised crime. As a result, most of Rejectus's top management left last year, and new management has been appointed to consolidate operations.
As a result, the Board has agreed that it will sell or restructure its operations, particularly its badly performing subsidiary SustainableMiningCorp Ltd (SMC), as well as its BlueSky Antigravity (BSA) research and development subsidiary. This restructuring activity is likely to take two to five years.
Each of these subsidiaries has substantial depreciating assets which are almost certainly impaired. Moreover, BSA is being sued by the spouse of one of its researchers, who died in a tragic accident while testing its latest Jump-to-work anti-gravity device. It is very likely that the case will be lost, but not judgement has yet been issued in the case.
The Rejectus group also controls the wholly owned subsidiary WarStuff Ltd, which was purchased in 1968 and has all of its assets carried at cost. WarStuff sells army surplus equipment and is the one jewel in Rejectus's portfolio, being consistently very profitable. All Property, Plant and Equipment held by WarStuff is recorded at cost, including land and buildings that were purchased in the 1960s.
a) Management incentives
Required: The new CEO is eager to turn the business around, but realises that the Rejectus group's return to profitability will take two to three years. As the CEO is subject to the compensation scheme described above, describe two types of accounting changes the CEO might consider and describe in detail why the manager would benefit from such changes. It may be useful to show any relevant journal entries (but without any numbers) to clarify the relationship between the accounting changes and the manager's self-interest.
Ignoring any real business changes. Assume that the Rejectus group carries very little debt on its balance sheet.
b) Debt contracting
Required: Now assume that the Rejectus group carries debt equal to 25% of its total assets. Rejectus's debt contracts include a covenant restricting the debt-to-asset ratio to 30%. However, the debt contracts contain no restriction whatsoever on how accounting numbers are measured, except that they must be measured in accordance with AASB standards. Describe what accounting actions management can take to avoid any negative impact on debt contracts of the behaviour described in your answer to part (i) Describe in detail the linkages between the accounting numbers affected by these accounting actions and the application of the terms of the borrowing contracts.